The Raw Material for Economic Turmoil
By David Wyss, chief economist for Standard & Poor's
In the world of higher commodity prices, corporate winners and losers fall into two distinct camps.
Commodity producers are big beneficiaries. Their business outlooks appear generally strong and their ratings stable, in our view, as scarcity and worldwide demand affect everything from corn to copper. But companies that rely heavily on grains, 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 are not entirely responsible for the present economic slump (falling home prices and rising unemployment clearly play key roles), but they don't help either.
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 has some suspicious that the market is being manipulated. 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 Association reports that 15.2 billion contracts were written in 2007, a 28% increase from the year before.
The other evidence seen supporting the theory of speculative forces is that some commodities seem priced far higher than fundamental supply and demand would indicate. We believe, for example, that the price of oil, which neared a record $120 per barrel on April 22, will settle at roughly $91 per barrel by year-end. Over the longer term, we're expecting a price of $75 per barrel, as supplies remain adequate (although we think 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, in our view.
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 to help curb the high price in India. That has not happened, of course, but we believe 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.
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 well above $100 per barrel, we expect gasoline prices to soar; we believe $4 for a gallon of gas is not out of the question in many areas as the summer driving season approaches. In March, according to the government consumer price index, gas prices were already 26% higher than they were a year earlier, while home heating oil was 40% more costly. Overall food costs climbed 4.5% during the past year, but several specific foods outpaced that gain: meat, poultry, eggs, and fish (considered one category by the government) climbed 3.8%; cereals and grain products were 8.1% more expensive; fats and oil were up 7.7%; and dairy products rose 11%.
The effect of higher commodity prices can also be seen in the producer price index (PPI), which has been rising steadily. According to the Bureau of Labor Statistics, the PPI for finished goods increased 1.1% in March, seasonally adjusted. The gain followed a 0.3% rise in February and a 1% increase in January.