FOR the past 18 months economies worldwide have been at the mercy of the biggest ever commodity price boom. The benchmark CRB commodity index rose 15% in the opening three months of this year, eclipsing moves in the Seventies. Oil has led the advanc
e with a doubling of the price in barely a year.
The boom has combined with a global credit crunch to create a massive policy crisis for governments and central banks. Little wonder that the commodities boom, along with record oil prices, inflation and the wavering dollar are centre stage of the G8 summit this weekend in Japan. This killer combination is driving the world's most powerful economies towards a painful and extended slowdown – and with pressure on central banks to raise interest rates, not cut them. Inflation in America rose 0.8% last month to an annual rate of 4.2%.
The G8 wields little influence over oil markets. These have been driven by strong demand from India and China and concerns about supply. Indeed, demand outside the OECD seems to be holding up. More recent factors include stockpiling by China ahead of the Olympic Games. What the G8 is seeking to do is to arrest a slide in the US currency that has prompted investors to buy oil futures and other commodities to hedge their dollar risks.
Soaring commodity prices, especially of oil and food, have sharply increased inflationary pressures. Italy floated a plan at the G8 summit to make speculation in oil futures more difficult and France welcomed the US currency's rebound of the past week.
The boom, in the eyes of a growing number, has come to resemble a speculative bubble. And they warn that like all bubbles before it – emerging markets in the Eighties, technology and internet stocks in the Nineties, house prices in the US and Britain in the past six years – it will end in bust.
George Soros warned earlier this month that the investment flood into commodity indexes bore eerie similarities to the craze for portfolio insurance that led to the stock market crash of 1987. Investment institutions, he told a US Senate committee on energy manipulation, "are piling in on one side of the market and they have sufficient weight to unbalance it. If the trend were reversed and the institutions as a group headed for the exit as they did in 1987, there would be a crash."
Paul Walker, of GFMS metals and mining consultancy, believes so. He says we are seeing a "last hurrah" in commodity markets – a final surge upwards in prices as the credit crisis lurches towards its conclusion – and that we will see a severe retrenchment of prices as financial markets recover.
The US Commodities Futures Trading Commission suspects so too. It has been probing how agricultural commodities are traded and pondering moves that could curb financial speculation in grains, soy beans and other foodstuffs. It has also launched inquiries into the recent heavy speculative activity in oil futures.
So why hasn't the bubble burst before now? There are two problems with the 'bubble' thesis. One is that there has always been speculative activity in these markets and that warnings of a bust have been around for a long time.
The second is that matters have been exacerbated by the behaviour of central banks. The oil boom, buoyed by recent confident predictions that the price is heading towards $150 a barrel, if not $200 over the next few months, has to a significant degree been driven by a weak dollar for most of this year – a policy tacitly agreed by the US authorities as an antidote to the credit crunch. More recently the oil price rose sharply on warnings from Jean Claude Trichet, head of the European Central Bank, that it may soon raise interest rates – a warning that backfired as it pushed down the dollar and drove up the oil price by almost $10 to $138. The price has now pulled back to $134.60 a barrel, but a sustained fall is needed before we can be sure of a speculative exhaustion.
How long can the oil price stay above $130? The supply-demand fundamentals do not explain the sharpness of the ascent this year – 60% since January. Nor does it make any allowance for the reaction of the end consumer. Stockbrokers Charles Stanley estimate that oil speculators have amassed 1.1 billion barrels of oil, more than eight times the amount added by the US to its strategic reserve, making them the largest single influence on oil-related commodity futures trading. William Enghadi, research associate at the Centre for Research on Globalisation, conservatively estimates that "at least 60% of today's crude oil price comes from unregulated futures speculation by hedge funds, banks and financial groups".
It would be wholly wrong to suggest that speculative activity in the futures market is solely or even mainly to blame for the spectacular rise in oil. But it has certainly exaggerated the price trend in recent months. One characteristic of a pending bust is when the price of a share or commodity becomes a national – or supra national – obsession. That is certainly the case now, with riots across Europe and Asia and haulier protests and blockades in the UK.
It doesn't necessarily follow that prices then automatically behave in the manner that presidents and finance ministers would like. But a growing determination to see a firmer dollar would certainly help drive the oil price down. And the key factor most likely to make speculators switch positions is already evident: an adverse market response to an ever higher price.
There are signs that the commodities bubble may already be bursting in some areas. Prices for wheat and rice have come off the boil. Nickel prices have fallen by 25% since mid March.
The economies of the oil consumers are now slowing and oil demand falling as businesses and households cut back.
At the same time, governments in developing countries that have been operating price subsidies to shield consumers from the full impact of fuel price rises have been forced to lower or withdraw these subsidies in a move that will hit demand hard. Longer term, oil demand will be further hit by the accelerated push towards alternative energy sources.
Falling oil demand is every inch as fundamental a consideration as constraints on supply. With clear signs of a slowdown in both developed and developing country economies, the likelihood of oil rising much above current levels looks ever more stretched. Meanwhile oil companies have a greater incentive to step up exploration and development that will in time boost supply.
The more these two reactions become evident, the greater the likelihood traders will turn speculative long positions into short ones – betting on a price fall. Expressions of concern at G8 summits and regulatory attention by the US authorities will not in themselves have much effect. But allied with consumer cutbacks, they could mark the turning of the tide. The bursting of the bubble will ease matters greatly. But it will mark an epochal shift, from a prosperous era to one altogether more chastened.
The full article contains 1205 words and appears in Scotland On Sunday newspaper.
