business

Commodities: Boom or Gloom?

Some see a "supercycle" in climbing prices for oil, gold, and the like. But others say a slowing U.S. economy could drag them down

Commodity prices opened 2008 just like they finished 2007—on the rise. In the first six trading days of the New Year, oil has traded for $100 a barrel, gold neared $900 an ounce, corn reached an 11-year high, and soybeans hit the highest price since the 1970s.

But at the same time, worries about the health of the U.S. economy have grown as the subprime mortgage mess continues to spread. The unemployment rate rose to 5% last month and Wall Street economists at Goldman Sachs (GS) and Morgan Stanley (MS) are now predicting an imminent recession.

The two trends present a puzzle: Slowing economic activity usually drags down commodity prices.

Historically, U.S. economic growth has been the greatest driver of demand for raw materials and thus the engine behind commodity price increases. Commodity bulls like investment adviser Marc Faber have argued the current boom is different because growth in China and other developing nations, coupled with shrinking global supplies, has created a "supercycle" that will push up prices for years to come. Thus the great debate in commodity investing circles for 2008: Can the supercycle be stopped?

Impact of China and India

Academics who have studied previous commodity price rallies find some evidence to support the bullish outlook. Gary Gorton, a finance professor at the University of Pennsylvania's Wharton School, likens the current environment to the early 1970s, when droughts and low inventories kept commodity prices on the rise even when the U.S. economy hit the skids. Currently, demand for basic commodities from China and India along with increasing usage of biofuels such as ethanol have pushed supplies to similarly low levels.

"The China [and] ethanol effects will last for some time," Gorton says. "The U.S. economy may go into a recession but that will not change demand from China. Even if China goes into a recession it's not clear that inventories could quickly replenish."

Globalization has also diluted the impact of a U.S. recession on commodity prices, Duke University professor Cam Harvey notes. "Extreme caution needs to be exercised in comparing historical growth episodes," Harvey says. "The strong correlation between the commodity prices and the U.S. business cycle has been diminished by the rise of key emerging markets."

The Flip Side…

But the supercycle argument riles some analysts who follow commodities closely, especially the contention that this time is somehow different. While precious metals have rallied, prices for industrial metals including copper and aluminum have already fallen, they point out. "Once we actually get into a recession and the numbers start to look really weak, commodities will be vulnerable," says Edward Meir, a commodities analyst at MF Global (MF) in Chicago.

Much of China's growth depends on demand from U.S. consumers, too, he says. "Our economy is seven times bigger than China's, and we have a $200 billion trade deficit with them," Meir says. "Everything is still mainly focused on the U.S."

The real reason commodity prices haven't reacted much to the slowing U.S. economy yet is an influx of new investors interested in the sector as a diversification play, maintains Harry Kat, a professor at the Sir John Cass Business School at City University London. (Indeed, a Jan. 9 rally in gold prices may have been spurred by the first day of trading in gold futures on the Shanghai exchange.) The falling value of the dollar has also helped shield commodity prices from the inevitable, he adds. Neither trend can keep prices rising endlessly, he says.

"The supercycle mafia uses this to prove their point but that doesn't mean they're right," Kat says. "They're just lucky all this is happening right now at the same time." If the U.S. hits a recession this year, that lucky streak may come to an end.

    Before it's here, it's on the Bloomberg Terminal. LEARN MORE