Why are commodity prices rising so fast?

Well, today they’re not, they seem to be plummeting.  Still they have been rising rapidly for years.  Paul Krugman surveys some views, click through to the Frankel post as well.  Yes I do think high and rising commodity prices have been a bubble — but not just a bubble — and no I don’t think that low real interest rates are much of a factor.  (Recall Cowen’s Third Law: "All propositions about real interest rates are wrong.")

My basic explanation for rising commodity prices is simple.  Most commodities are produced under conditions of short-run rising costs, often quite steeply rising short-run costs.  Furthermore many production processes cannot do without these commodities in the short run.  Coal, copper, and the like are not always easily substitutable for a factory within the medium run.  (Furthermore until you are sure that the price increase is permanent, why re-gear at all?  Why switch from copper plumbing to plastic plumbing, when price of copper might fall again?)

Now China has become wealthy quite fast but the country didn’t become wealthy by producing more commodities.  That’s Albert Hirschman’s "unbalanced growth."  So demand for most commodities has outstripped the supply, production can’t make up the difference in the short run, and commodity prices can rise sharply.  Don’t forget that logistics and transport are a big part of the production process and so infrastructure often constrains the flow of supply.

In the long run price will adjust (even if you believe we are near "peak oil" this is true for most commodities.)  People will substitute or find new sources of the commodity or find new ways of producing the commodity more efficiently.  Infrastructure improves.  But yes those adjustments can take ten years or more.  And in the meantime we have a commodity price boom and on top of that a bubble to make these items look even more expensive.

One final kicker: lots of commodities are produced by governments and/or their production is heavily controlled by governments, most of all oil.  Then supply adjustments will be especially slow and cumbersome.  Read this article about coal:

…94 percent of India’s coal mining is in the hands of government-owned companies. The biggest, Coal India, produces four-fifths of the country’s coal. Because the government is worried about social unrest, the prices for coal and electricity are kept low.

See the problem?

The bottom line: The best long-run bet is still that there is nothing special about risk-adjusted rates of return on commodities.  That probably means falling real prices and falling real costs over time.  The Chinese demand aberration is a temporary blip superimposed on very consistent longer-run trends.

Comments

You can find some evidence of the short-run inelasticity of supply in the oil market here.

XOM can earn an eye-popping return on capital of 32% at current levels of output and face little incentive to invest in increased output.

Academic paper that may be of interest (addresses the risk-adjusted return of commodity futures issue):
"Facts and Fantasies about Commodity Futures"

RE: China demand is an aberration

From the 1/16 WSJ: “While wealthy nations still use the majority of oil consumed globally in barrel terms, the annual growth in crude consumption is coming from developing-nation consumers, who have little incentive to conserve because of huge government subsidies that shield them from high prices.

Reflecting that new development, the IEA said overall demand in China, the world's second biggest oil consumer after the U.S., "would probably be largely unaffected" by high oil costs because of price caps.†

A very well-capitalized, socialist regime doesn't come along every day. That, plus price caps, is the perfect cocktail for an aberration.

On Hotelling, he assumed no extraction costs and a constant supply. In the real world technology has pushed down the cost of extracting resources be it lumber, oil or coal. Think about the dramatic improvment in lumber harvesting technology over the last 75 years and its not hard to imagine why real prices have fallen. Second, hotelling also assumed a constant supply. Since the 1950s the proven reserves of most major commodities have been increasing. When you add in these two factors I think the observed prices are consistent with the basic intuition that Hotelling provided.

The answer is simple: there was a demand shock.

Normally, the demand curves for commodities move outwards in a slow but basically continuous fashion. The supply curve moves outwards in step-wise fashion as new chunks of production capacity get built. This results in price cycles, which are easily observed in the past.

As the good professor notes, rising maerginal costs are prevalent, and in an industry with a finite capacity, the supply curve goes vertical when we hit those capacity constraints.

What is different this time is that the demand curve moved out in a step-wise fashion when China started its building binge about 5 years ago. We quickly started to hit the capacity constraints in raw commodities, and prices shot up. This is beginning to reverse, as new capacity for metals and minerals comes online. If Chinese growth slows down after the Olympics, expect to see commodity prices fall to their 2003 levels.

And about Hotelling, the biggest false assumption that one has to make to apply it is the assumption that the stock of the commodity is finite and known from the beginning. The second of these propositions is almost never true.

Look at stocks (inventories of commodities) are they rising or falling? look at the rates of increases in consumption. Look at the rates of replenishment of stocks vs those rates of increases in consumption.

Look at the factors necessary for replenishment (crop lands, infrastructures needed for mining and other extractions, equipment, etc.)

Note the rising restrictions on exports in command economies; the limits on transport, etc.

And don't overlook dwindling water.

Tune in on Demopolis, Alabama's Jimmy Rogers.

I'm a bit puzzled as to the price of rice in particular, It was my understanding that both China and India produce their own rice consumption, unless the exports from these countries have come down drastically (India has banned exports, but i donno how significant that is), can the increased demand or mass migration to cities from these two countries be of any relevance to the increase in price of rice?

Every success is based on continuous efforts. It is not possible be done over nigh.

It seems we will be in economy ression for quite a long time. We can see the economy crisis effect everywhere.

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