The Turmoil from High Commodity Prices
In the world of higher commodity prices, corporate winners and losers fall into two distinct camps. Commodity producers are big beneficiaries, their business outlooks generally strong and their ratings stable, as scarcity and worldwide demand affect everything from corn to copper. But companies that rely heavily on grain, oil, or other commodities to make finished goods face increasing costs and thus weaker profits if the slowing U.S. economy makes raising prices more difficult.
The fallout from high commodity prices will be unequally distributed and determined by whether one is a buyer or seller of commodities. The level of commodity input into finished goods and the ability to raise prices will determine how serious the impact will be for commodity users.
Low steel costs, for instance, are certainly better than higher costs for automakers. But steel is a relatively small part of a car's cost, and the woes of Detroit's Big Three (oil prices and labor costs, for example) go far beyond steel prices. Baked goods, cereals, meat, poultry, eggs, and dairy products all contain, directly or indirectly, large amounts of corn or wheat, so the impact of higher prices for those grains is widely felt among food processors. And the high price of oil will clearly be deleterious for industries like refiners or airlines, where oil is a major input.
Meanwhile, the impact of rising commodity prices on U.S. consumers has been more straightforward. Prices for gas, home heating oil, and food have skyrocketed in the past year, boosting inflationary fears and crimping discretionary spending. Higher commodity prices don't account for all of the present economic slump (falling home prices and rising unemployment clearly play key roles), but they don't help, either. How high and how fast commodity prices rise will continue to be a worry for consumers and business alike this year.
The Speculation Factor
One of the most frequently voiced suspicions concerning commodity prices is whether they're being manipulated higher by speculators. There is no easy answer to this. Many commodity prices have risen for reasons clearly evident. Rising demand from India and China, for instance, has spurred on higher metal prices. The same can be said for oil, and a growing worldwide demand for food and for corn-based ethanol has boosted agricultural prices.
But the volatility of commodity prices leaves a deep suspicion in some corners of the financial community that it's not the traditional, commercial end-users of commodity futures contracts, options, and other derivatives that are responsible for pushing prices higher. An increasing number of hedge funds, pension funds, and other large investors are buying commodities in search of better returns than other investment vehicles—stocks, bonds, and real estate—are now providing. Trading volumes have increased greatly. The Futures Industry Assn. reports that 15.2 billion contracts were written in 2007, a 28% increase from the year before.
The other evidence for speculative forces is that some commodities seem priced far higher than fundamental supply and demand would indicate. We at Standard & Poor's believe, for example, that the price of oil, now north of $100 per barrel, will settle at roughly $91 by yearend. Over the longer term, we're expecting a price of $75, which is about 25% lower than it is today, as supplies remain adequate (although refining capacity remains a problem). Gold surged to more than $1,000 per ounce and then, in early March, saw the largest dollar price drop in almost 28 years on interest rate worries. Macroeconomic factors play a part, to be sure, but such volatility cannot always be attributed to big-picture economics.
To curb undue market volatility, several U.S. agricultural exchanges have already increased margin requirements (the amount of cash, as opposed to credit, required to buy a contract) on futures trading.
The Chicago Board of Trade, the Kansas City Board of Trade, and the Minneapolis Grain Exchange all recently raised the minimum margins for wheat futures, while the Chicago Board of Trade has also announced higher margin requirements—but also wider trading limits—on corn, soybean, and soy oil futures.
It is too soon to know if asking investors to plunk down more of their own cash to execute these trades will mark an end to the unsettling price volatility in agricultural commodities. But the idea that speculators are having an unhealthy influence on the markets is widely held. Late last year, government officials in India asked U.S. and British authorities to consider a shutdown of oil trading on their commodity exchanges as a step to help curb the high price in India. That has not happened, of course, but the fact that the idea is even being broached shows how unpredictable commodity prices have become and how much governments worry that their economies will be at their mercy.
Inflation Heating Up
We expect the U.S. economy to grow only 1.2% this year, but as higher commodity prices ripple through the economy, we could see the unholy alliance of low growth and higher inflation. That is not good either for commodity-dependent producers or for consumers, who, if they stop spending, will further depress the economy.
With oil still above $100, we expect gasoline prices to soar; $4-per-gallon gas is not out of the question in many areas as the summer driving season approaches. In February, according to the government consumer price index, gas prices were already 32.7% higher than they were a year earlier, while home heating oil was 33% more costly. Overall food costs climbed 4.6% during the past year, but several specific foods outpaced that gain: meat, poultry, eggs, and fish (considered one category by the government) climbed 4.8%; cereals and grain products were 6.6% more expensive; fats and oil were up 7.7%; and dairy products rose 13.3%.
The effect of higher commodity prices can also be seen in the producer price index (PPI), which has been rising steadily. Although the overall PPI rose only a modest 0.3% in February, the index for finished goods galloped along, registering year-over-year increases of more than 6% each month since October, 2007. Higher consumer prices are likely to follow.
What's Driving Up Oil Prices?
Demand from the big, rapidly growing economies of China and India has been, and is likely to remain, a major reason for higher oil prices. Speculation might also be partly responsible. Nevertheless, the balance of supply and demand suggests that the price of oil should come down. Why doesn't it?
For one, constant worries about the reliability of supply—whether because of violence in Nigeria, politics in Venezuela, or production cuts by OPEC—are keeping prices high. In addition, little of the world's proven reserves are actually under the control of major exploration and production companies, such as ExxonMobil (XOM) or Royal Dutch Shell (RDSA). By one estimate, 77% of the world's proven reserves are controlled by government-owned oil companies. If national producers in Iran, Venezuela, and Russia are badly managed, as some believe, and incompetent at finding new reserves within their borders, it will keep oil prices high. Then, of course, there are producers that simply want to keep prices high and have little incentive to find new reserves or boost production.
The falling U.S. dollar also makes oil expensive for Americans. As the dollar continues to drop against most major currencies, consumers are seeing a bigger rise in the price of gas and heating oil than are consumers in countries with stronger currencies. Oil prices are dollar-denominated, so when the price rises, those with strong currencies vis-à-vis the greenback see smaller increases than Americans.
The continued trade deficit and reversed interest rate gap with Europe should put downward pressure on the dollar through the spring, making some recovery likely after the second quarter if, as we expect, the Fed stops easing and the European Central Bank starts.
Higher Grain Prices Mean Higher Food Prices
When we feed more corn to cars than to cows, there is going to be a problem: Higher food prices are largely attributable to the diversion of corn to ethanol production. (The irony here, of course, is that increasing use of ethanol has done nothing to bring down the price of imported oil.) When farmers plant more corn to take advantage of high prices, they take land for wheat, soybeans, or other crops out of production. That makes any foodstuff dependent on grains susceptible to rising prices. Dairy and egg prices, for instance, are hopping because of higher feed costs. Note that there is more corn in a dozen eggs than in a box of corn flakes.
Consumers don't eat much grain directly, but the cows, pigs, and chickens they consume have to be fed, and the feed is largely grain. The impact on prices is more immediate for chicken because chickens have a short life cycle. It will take longer for beef prices to be affected, as cattle have a longer life cycle (pigs are somewhere in between). In addition, beef prices have taken longer to reflect higher feed costs because when those costs initially rose last year, many farmers thinned their herds by slaughtering their cattle early rather than spend the extra money to continue to feed them. The additional beef on the market helped to moderate prices. But that cycle is over, and with new herds, consumers can expect higher beef prices.
Better nutrition in developing countries is also pushing up food prices. In many developing countries, people are increasingly switching to diets that are richer in meats and poultry. This global demand for the grains to feed livestock and poultry is also a factor in rising commodity food prices.
Paying More for Metal
The same factor driving energy prices higher is also responsible for higher metal prices: demand from China and India. Those economies are expected to continue growing faster than in Europe or the U.S. this year. We expect, however, that eventually more smelters will begin production and more mines will open, mitigating the pressures on metal prices. But new facilities are both expensive and take time to bring online. The good news, at least for the U.S. economy, is that because metal is a much smaller percentage of consumer purchases than food and energy, price rises are not expected to have as serious an effect as oil and grain.
Although fundamentals remain sound for most metals companies, we remain concerned about factors that could present risks in the near to medium term. Higher energy, raw material, and labor costs could offset some of the benefits of higher prices. In addition, the weak U.S. economy could depress demand and pricing. And if the dollar reverses course and strengthens, it might encourage greater imports and disrupt the currently favorable supply situation for domestic companies.
The Road Ahead
The runup in commodity prices highlights the vulnerability of many industries to rising energy and raw material costs, despite production improvements and substitution efficiencies designed to lessen their impact. It is also apparent that many commodity producers have intertwining interests that are not easily separated. Aluminum producers, for instance, can benefit from higher aluminum prices but are still on the hook because aluminum production is energy intensive. Corn prices might be high because U.S. corn is being used for ethanol in gas, but neither oil nor gas prices in the U.S have fallen.
The effects of commodity inflation might not always be clear, but one thing is: Commodity prices have steadily increased over the past five years, and we believe that because of international demand, they could continue rising for another five years, until global economies adjust. Dealing with that reality will remain a challenge for consumers and producers alike.