Like bear markets, recessions and pornography, financial bubbles are easier to recognize than to define precisely. Roughly speaking, they are characterized by the price of something rising much more quickly than its cost of production. Bubbles are also marked by widespread enthusiastic expectations for further gains. By that definition, commodities are now a bubble.
Prices have been rising fast. The S&P GSCI commodities index is up 74% in the last 12 months. The price of iron ore in the benchmark Chinese contract will be 90% higher this year than last. In a world where economic growth is slowing, these increases look out of kilter.
What about commodity production costs? They’ve also been rising — by something like 10-15% annually. But that’s a lot less than the 31% average annual increase in the GSCI index over the last five years. And a good portion of the cost increase comes from the higher commodity prices themselves. It takes energy to extract oil or grow corn, so more expensive oil makes oil and corn more expensive to produce.
The other sign of a bubble — enthusiastic expectations for more — is also present. True, there is a small squadron of doubters. But the enthusiasts are a veritable army. Barclays Capital, for example, disparages bubble-talk as ill-informed. It sees only “robust” demand growth overall meeting “supply-side problems” for oil and many metals.
The commodity bulls offer persuasive analyses of wells, mines and Chinese economic growth. But financial bubbles always expand from solid foundations in the real economy. The prospects for demand growth for tulips, Internet services and the US houses were also good. The bubbles came from the vast amount of money that buyers were willing and able to throw at these assets.
Since bubbles are financial, it’s hardly surprising that “speculators” are getting blamed for rocketing commodities prices. The best evidence is the rapid increase in investment funds dedicated to this asset class — up from $70 billion (almost Rs3 trillion today) to $220 billion in the last three years, according to Barclays Capital. It’s easy to paint a sinister picture of money-men pushing up prices, forcing the world’s poorest to shiver and starve.
But it’s not that simple. For some commodities, the additional funds chasing higher prices may have helped push prices up.
But if only investors were involved, then the price of iron ore would not have risen so far. This commodity is not in any indexes and is mostly sold on year-long contracts between miners and steel makers.
What industrial buyers and investors share is the ability to pay up. Think of the US housing market during its halcyon years. Financial buyers — the flippers (people who typically sought fast money by rapidly buying and selling homes to capture a profit on each as prices soared) and landlords — played a role in inflating the bubble. But genuine users, homeowners, did most of the blowing. They could afford to bid up house prices because banks were willing to lend.
Readily available money turns a small shortage into huge price increases. That’s because of a basic rule of markets: The price keeps rising until enough buyers walk away to bring the market into balance.
Oil at $60 (Rs2,568) and $100 a barrel didn’t do the trick. Perhaps $150 will. It’s a matter of both psychology — when buyers say “That’s just too much” — and the availability of funds.
Right now, it looks like the monetary variable is the crucial one. The desire for more commodities is strongest where growth is fastest — particularly China and other fast growing Asian countries. Most of these countries have lots of dollars from running large trade surpluses. They are using those funds to bid up prices. Loans from commodity-exporting countries, which are also running big trade surpluses, serve the same purpose.
The bubble will burst, eventually. Prices will fall to — or below — the cost of production. But trade surpluses are still high and production growth is still modest for most commodities. This bubble could get bigger still.