Commodities on the climb

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Never has there been a commodities boom like it. Not only oil but also copper and iron ore are fetching record prices, while aluminium and zinc have in the past few weeks hit their highest levels for many years. Copper has more than doubled in value in the past two years and recent long-term iron ore contracts agreed by Japanese steelmakers have been at prices nearly three-quarters higher than last year.

The gains have not been limited to metals and minerals: coffee, at five-year highs, and raw sugar are both at least 50 per cent up on last year. This is the first time that there has been such a strong synchronised rise across so many different commodities.

The increases have driven up the shares of global energy and mining stocks and boosted the economies of commodity-rich countries. But inflation is also starting to rise and there are increasing fears that high commodity prices are going to squeeze corporate profits and global economic growth.

Is this just a normal commodities cycle of boom followed by bust - or are there structural reasons for believing it will continue for longer than normal? The International Monetary Fund warned last week of a "permanent oil shock" that will result in sustained high oil prices over the next two decades. Citigroup has talked of a "super-cycle", characterised by an extended period of high demand for raw materials, and Goldman Sachs suggests oil prices, currently about $57 a barrel, may exceed $100 in what it terms a "super-spike".

The price of oil has almost doubled in the past two years and is nearly 30 per cent higher so far this year. But as Michael Lewis, head of commodities research at Deutsche Bank, points out, oil price surges in the early 1970s and in 1979-80 were not accompanied by a broader climb in commodity prices.

The effects stretch well beyond the resources sector. Shipping companies are receiving record freight rates, with shipyards in South Korea, Taiwan, Japan and China fully booked for the next three years as ship owners look to expand their fleets to carry increasing volumes of oil, natural gas, iron ore, coal and grains. Port operators are expanding loading bays to keep pace with a surge in shipping traffic. Makers of heavy machinery for the mining and farming sectors are recording their best sales in years.

The popular explanation for the boom is China. With its economy growing at 9.5 per cent a year, the country has become the biggest importer of a number of commodities, such as iron ore, copper and alumina. Mr Lewis describes China's economic expansion as on a par with the industrial revolution in Britain in the 1850s, the development of the western US in the late 19th century and the industrialisation of Japan after the second world war.

"Events on this scale happen about once every 50 years, and that is what we are seeing in China," he says. Demand has also been strong from the economically resurgent US, which remains overall the world's biggest consumer of commodities. At the same time, the weak dollar has helped drive up commodity prices, nearly all of which are quoted in the US currency.

Sometimes there are specific reasons for a particular resource to have risen in value. Indium, used in flat-screen televisions, has reached a record $1,000 per kilogram after trebling in price in a year. Other exotic metals have also been boosted: ferro-molybdenum, an alloy employed in steel production, and selenium, which is used in glass-making, are both at about 30-year highs.

There are also huge supply constraints. At the height of the dotcom boom five years ago, miners and oil producers were deemed "old economy" and were neglected by investors who were shovelling funds into technology stocks. This meant producers failed to invest sufficiently in new mine or oil well capacity.That was compounded by underinvestment in railways, ports, pipelines and shipping fleets, leaving bottlenecks all along the supply chain. The result: supply has been unable to respond to the recent surge in demand and prices have therefore been forced sharply higher. Richard Elman, chief executive of the Hong Kong-based Noble Group, one of Asia's largest commodities traders, predicted recently that the global shortage of raw materials might not be resolved for years, because of the infrastructure bottlenecks and the long lead-time needed for new natural resources projects.

Yet physical supply and demand cannot by themselves explain the gains. Speculative money has also poured into commodities markets. Indeed, comparisons are increasingly being made between the current commodities price boom and the dotcom bubble. In a research note this month entitled "Are resources the new tech?", David Bowers, global equity strategist at Merrill Lynch, reminded clients that in 1999-2000 "everybody thought that the business cycle as a concept was dead" - adding that "in 2005 many investors have begun to behave as though the business cycle is dead". He asked rhetorically: "After all, Chinese GDP can grow at 8 per cent per annum all the way out to 2050 can't it? If the US economy slows, who cares . . . China will consume anything that the US does not consume and more, won't it?"

Kevin Norrish, head of commodities research at Barclays Capital, says the comparison with the technology boom is unfair: "The internet bubble represented a misallocation of capital where too much capital was spent on too few assets, whereas prices in the commodities market are signals that more needs to be spent on supply infrastructure."

Strong commodity prices have attracted investors, including banks, which in recent years have become owners of utilities and other energy production facilities and are hedging their exposure in derivative markets. Hedge funds have shifted vast sums of capital into commodities in the search for above average investment returns. Longer-term investors such as pension funds and mutual funds have also been allocating more to commodities as part of diversification strategies.

Goldman Sachs estimates almost $50bn (€39bn, £27bn) is invested globally in products based on various commodity indices, saying investment linked to its own such index totals $35bn, triple the level of 2002. To adjust their exposure to the indices, pension funds have also been taking positions in futures contracts of specific commodities, which analysts say is a significant factor behind the rise in long-term oil prices. The US benchmark oil futures contract, for West Texas Intermediate, is priced at above $50 a barrel for the rest of the decade. Long-term prices were about $18-$20 for most of the 1990s.

"The change in the long-term price is the most significant development in the oil market," says Jeffrey Currie, managing director of global investment research at Goldman Sachs. Raghuram Rajan, IMF chief economist, says the oil price rise is being "generated by strong economic growth". Furthermore, Mr Lewis from Deutsche expects the higher long-term pricing trend to be replicated in industrial metals as they benefit from many of the factors that have been bolstering the oil market: strong demand from China, while supply struggles to keep pace and bottlenecks hamper deliveries.

BHP Billiton, the world's largest mining group (see below), has raised its long-term price forecasts for iron ore and coking coal, the two key raw materials for making steel, because of the increased cost of finding and developing new resources.

Stock and bond markets, which usually fall when commodities are rising, have remained relatively resilient so far. But the equity market rally has stalled in recent weeks - partly because of record oil prices - and long-term bond yields have risen on increased inflation concerns. One reason that market sentiment has in general been relaxed, however, is that many analysts continue to expect the commodity price rises to be temporary. Another is that developed-world economies are less dependent on oil than they were 25 years ago.

Despite rising oil prices, world economic growth is estimated to have hit 5 per cent last year, according to the IMF - the fastest rate since 1976, while oil prices were at their highest levels in real terms since the mid-1980s. "Nobody knows where oil prices start to hurt economic growth," says one executive with a large US hedge fund. "Last year, people thought it was over $40, then they started to think it was $50. We have passed those two levels and we are still seeing strong demand for oil, so right now the question is, 'How high does the price go before it starts destroying demand?'."

Even though oil demand has risen by more than 50 per cent over the past 30 years, its share of global gross domestic product has fallen. That reflects advances in technology, the increased dependence of western countries on services rather than manufacturing, and efficiency and productivity gains. This is one reason why economists believe the global economy is not heading towards imminent recession.

But the world could still be approaching a period of slower growth. Can the Japanese economy, which imports nearly all its oil, maintain its recovery with crude prices at these levels? The higher price has already led to forecasts for European growth this year being cut. It has also helped drive up the US trade deficit - the world's largest consumer of oil spent about $175bn on importing energy related products last year, about one-third of the entire US trade deficit and up by a third on the previous year.

In any case, the threat to the global economy remains potent, not least through inflation, as factory costs rise and manufacturers are pressed into passing on higher costs to consumers. Financial markets would be more nervous if any significant commodities reached new highs in real terms. Yet those prices would have to rise far higher if they were to consume a similar share of consumer spending as in 1980, when oil prices spiked to a level that - adjusting for inflation - would have been about $80 a barrel. Goldman Sachs said last month that oil would have to reach more than $135 before it took the same 6 per cent share of US personal disposable income as then.

But beyond $105 a barrel, the investment bank added, drivers of gasoline-guzzling sports utility vehicles would be changing their habits - and the possibility of prices hitting that level was real. "We believe oil markets may have entered the early stages of . . . a 'super-spike' period - a multi-year trading band of oil prices high enough to meaningfully reduce energy consumption," Goldman said, adding that the current environment looked more like the 1970s than any time since.

One notable figure from that period agrees. "History is repeating itself," says Sheikh Ahmad Zaki Yamani, the former Saudi Arabian oil minister. But he expects oil prices to fall from current levels, just as they did after earlier shocks, simply because high prices will deter buyers. "What happened by the late 1970s and early 1980s will be repeated. It is only a matter of time," says the oil industry veteran, who was the most powerful man in the business during the oil shocks of the 1970s.

One reason for this is that there is an obvious self-correcting mechanism: the higher oil prices rise, the more attractive alternative energy sources become. The problem, though, is that substituting those energy sources for current consumption of oil and petroleum products is seldom simple.

If oil prices fall, the movement may again be in tandem with other commodities. Mr Lewis, at Deutsche, says high commodity prices have stimulated more investment in new energy and metals production, which is expected to bring significantly increased supply from 2008. At the same time, any slowdown in global economic activity - particularly in the US and China - would quickly be felt in commodity markets.

"When does the resources bubble burst?" asks Merrill's Mr Bowers. "Possibly sooner than we all think. The current talk of a commodity super- cycle may be premature." He adds: "The key issue for us is what combination of Fed tightening [of US monetary policy] and higher oil prices will dampen US domestic demand growth to such an extent that it start to adversely impact the US supply-chain in Asia."

If US consumers sharply reined back their spending, Chinese manufacturing and economic growth would almost certainly suffer. In that scenario, there is little doubt that commodity prices would fall sharply.The most dramatic and diverse resources boom to date would be over. How "super" the cycle turned out to be would depend largely on how long it had lasted.

Deals signal a hot future down the mines

This time last year, when asked about the likelihood of large takeovers in the mining sector, the top chief executives in the industry all gave the same answer: assets were too expensive, writes Rebecca Bream. Although they thought commodity prices would stay high for a while, the heads of BHP Billiton, Rio Tinto, Anglo American and Xstrata all said it would be better to make acquisitions in a few years, when the cycle was past its peak and valuations of companies had cooled.

But attitudes have shifted. While Anglo and Rio Tinto, among the more conservative companies in the industry, remain cautious on acquisitions, others have embarked on a spending spree. The prime example came when the Swiss-based Xstrata, which mines coal, copper and zinc, bid A$8.2bn (US$6.3bn, €4.9bn, £3.4bn) for WMC, an Australian group with copper, nickel and uranium assets. But in March Xstrata’s offer was trumped by BHP Billiton, the world’s largest mining group. BHP’s bid won but the A$9.2bn it was willing to pay puzzled some analysts: WMC’s market value had been less than A$6bn before takeover speculation took hold.

The battle to control WMC highlighted how eager mining groups are to secure mineral deposits, which are in scarce supply after years of underinvestment in exploration. It also indicated that companies were starting to believe in the idea of a commodities super-cycle, in which assets that look dear today might seem like bargains in a few years’ time.

The time needed to develop mineral deposits into mines is, along with shortages of vital mining equipment, helping to prop up commodity prices. “A lot of fact ors are coming together to prolong this price cycle and companies are re-evaluating what they think is a fair price to pay for assets,” says Peter Davey, head of mining and metals at Ernst Young in London.

The same dash for assets is happening in the oil and gas industry, on an even bigger scale. ChevronTexaco’s $18bn acquisition of Unocal, announced last week, was the biggest deal in the industry for three years and some observers think it could kick off a new wave of consolidation. The US-based Unocal has significant operations in Asia, an area where oil majors are trying to build their reserves.CNOOC, China’s third biggest oil producer, was also interested in Unocal.

In the mining sector, further merger activity is expected. Having failed in its bid to buy WMC, Xstrata says it has an alternative takeover target in its sights. The WMC acquisition means that BHP is now considerably bigger than Rio Tinto and Anglo, which may thus feel under pressure to do deals to keep up. Buyers are also likely to com e from developing markets such as Russia and China. China’s huge appetite for raw materials may lead to Chinese companies taking stakes in mining companies to secure supplies of iron ore, coal and copper.

Russian metals companies such as Norilsk Nickel as well as Rusal and Sual, two aluminium groups, are also emerging as potential players in the global consolidation of the mining industry. They are cash-rich and have signalled an interest in listing in London or New York and expanding internationally through acquisition. Sual last year hired Brian Gilbertson, ex-head of BHP Billiton, as chief executive, a move seen as an illustration of its international ambitions.

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