Digging Deeper

Why do commodity prices keep falling?

Photo: Pedro Perez. Source: Morguefile

The world is awash in oil right now. And it’s the same story for copper, zinc, and a host of other industrial materials. The price of oil is down 60% from its peak last year; a broad-based index is down almost 30%. What’s going on?

Part of the answer has to do with the dollar’s status as a reserve currency. The US is doing better than the rest of the world, so interest rates are going up here, while they’ve been falling almost everywhere else. Most commodities are priced in dollars, so in order to compensate for the dollar’s rise, their prices have to fall—just to keep from going up in non-dollar terms.

Part of the explanation has to do with China. For the last three decades, China has developed at an amazing rate—using exports to leverage its economy on the rest of the world’s growth. But China is now a $10 trillion economy. Unless they find interstellar markets for their goods, there are limits to how much they can sell outside their borders. They have to transition from an outward-oriented manufacturing economy to an inward-focused service economy. That leaves a lot of capacity—that previously fed China’s growth machine—looking for new markets. And those firms have been cutting their prices.

China GDP. Source: Bloomberg, World Bank

And part of the fall in metals prices has to do with the entrepreneurial nature of a capitalist system. When prices fall, production is supposed to fall as well. But this doesn’t happen right away. A lot of large and small companies borrowed money to expand capacity when prices were high. When prices fell, smaller companies increase their output, trying to bolster revenues in order to service their debt. And bigger companies—with less debt—hope that by driving prices lower they can put their smaller competitors out of business—and maybe scoop up their assets in bankruptcy court.

Eventually, these transitional factors will reverse themselves, and production will fall. Supply and demand have to balance; markets eventually clear. Short-term effects are not the same as long-term effects. But suppliers will have to get through the short-term storm to reach the growing global market that is over the rainbow.

Douglas R. Tengdin, CFA

Chief Investment Officer

By | 2017-07-17T12:22:20+00:00 November 25th, 2015|Global Market Update|0 Comments

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