The oil price briefly hit a record $89 (Rs3,497.70) a barrel on Wednesday. Traders were talking Turkey and Iraq, but the real story is something else. It’s why the price of oil and other commodities is up rather than down since the beginning of the credit squeeze in August.
After all, the price of a scarce asset is set by the amount of money buyers can find to pay up. The credit squeeze should have reduced that supply. To the extent that oil is a financial asset, it should have suffered just like houses or credit risk.
Indeed, at the beginning of the crunch, the price of oil and other commodities fell. But there has been a big reversal. Since the low, the oil price is up 22% (16% in euros), wheat is up by a third and copper by 17%. The shares of the four big UK mining companies have jumped by an average of 45%.
What’s going on? To start with, these assets have two things in common. They are distant from the epicentres of the credit problems—US subprime mortgages and complex structured debt products. And they are familiar assets which are likely to be appealing in the epicentres of excess cash in the world—Asia and West Asia. Thanks to the gently falling US trade deficit, these countries may have a little less new money to invest. But there’s still more than enough free cash to prop up commodity prices. What’s more, there is talk of increasing investments in less dollar-sensitive and more inflation-resilient assets. Commodities fit the bill.
But this cash flow can only explain the resilience of commodity prices, not what looks like a renewal of bubble thinking. For that, look to the 50 basis point interest rate cut in the US and an indefinitely postponed increase in the Eurozone. Cheaper funding has given speculators fuel to burn. Traders look for assets with momentum, and go with the flow.
The rally has been impressive, but it looks fragile. Commodity prices could be hit by many things—a slowdown in economic growth, a renewed tightening of credit conditions, or just by traders losing their nerve.