The recent dramatic increase in many commodity prices has stimulated debate over what may be driving it and questions about whether it can be sustained. Chapter V of the IMF’s latest World Economic Outlook takes a closer look at developments and argues that average prices will recede.
Among nonfuel commodities, price increases have been particularly strong in metals. In July 2006, metals prices were, in real terms, 180 percent above their average value during 2002—outpacing even the real price of oil, which rose by 157 percent (see chart). There is no doubt about the boom, but there is considerable debate about its causes.
The price of rising demand
Drawing on its analysis, the WEO sides with those who argue that rapid growth of demand, particularly in China, is driving metals prices. Quite simply, demand has outpaced the speed at which supply can be expanded. Consumption of aluminum, for example, grew by 7.6 percent a year during 2002-05, compared with 3.8 percent a year during the previous decade. Given long investment gestation lags, prices can rise significantly in response to unexpected demand increases.
How much of this is driven by China? According to the WEO, that country accounted for about half of the increase in net world consumption of the main metals (aluminum, copper, and steel) over the past four years. Yet Chinese demand is not out of line with fundamentals—in per capita terms, its consumption of metals is now similar to that of Japan and Korea during their initial development phase. Given its fast growth and rising share in the world economy, China is expected to retain its critical role in driving commodity markets.
For food and other nonfuel commodities, the price response to strong global growth has been much less dramatic. Consumption of agricultural commodities has grown more slowly than that of metals, and agricultural supply has responded considerably faster to demand growth.
Have financial investors also had a hand in driving up non-fuel commodity prices? Apparently not. The WEO notes that speculative investments in commodity futures markets have increased significantly over the past several years, but finds that investors have built long and short positions that have effectively offset each other in terms of price movements.
There is also little statistical evidence that net speculative positions drive changes in spot prices. On balance, investors seem to follow rather than create price trends. Interestingly, net speculative positions in the copper market declined during the run-up of copper prices earlier this year.
Rise and fall
Metals prices have shot up recently but are likely to shed much of this gain over the next few years.
Citation: 35, 22; 10.5089/9781451968637.023.A008
Note: Monthly data in nominal terms.
1Weighted average of aluminum, copper, lead, nickel, tin, and zinc prices.
Data: Barclays Capital; Bloomberg Financial Markets, LP; and IMF, Commodity Price System database and staff calculations.
As for the future, the WEO sees little likelihood that current highs in metals prices can be maintained. Metals prices are above sustainable levels under various assumptions about global growth, additions to productive capacity, and the price responsiveness of supply and demand. In the baseline scenario, the real prices of aluminum and copper are forecast to decline by 35 and 57 percent, respectively, by 2010.
Metals prices tend to converge to production costs in the medium term, and current prices are well above production costs. At present, the ratios of market prices to costs are between 1½ and 2¾ for the main metals. Futures markets are consistent with this situation, predicting a gradual price decline for most metals over the next five years.
For food and other agricultural commodities, real prices are likely to follow the longer-term downward trend as continued technological progress offsets rising input costs. Possibly bucking this trend are the commodities closely linked to energy, such as sugar and corn (through ethanol production for flex-fuel vehicles) and natural rubber.
Finally, the temporary nature of the current boom holds significant implications for policymakers in exporting countries. For the longer-term well-being of these economies, it will be critical that income windfalls be either largely saved or used to support future growth in noncom-modity sectors.
IMF Research Department