The nature of global commodity markets has changed in fundamental ways in recent years. This structural transformation is likely to have far-reaching implications for the GCC economies. The nature of changes in the commodity space is broad-based, involving the demand side, the supply of commodities, and the practices and platforms used for trading in them. The likely result of these trends will be a steady secular increase in the prices of many key commodities even if the implications of short-term cyclical fluctuations can still be profound.
A demand side shift. The changes on the demand side are both quantitative and qualitative. The most important quantitative change is intimately linked to the impressive rise of emerging markets over the past two decades or so. These economies rely heavily industry, whose ravenous appetite for energy and other inputs has been amplified by the massive infrastructure spending underway in most of these countries. At the same time, the rapid economic growth and higher living standards have resulted in higher consumption of food, consumer durables, and energy. A dynamic demographic situation in many emerging economies – with notable exceptions such as China and Russia – is likely to drive forward these processes for an extended period. At least for the time being, the strength of demand will be perpetuated by a widespread use of subsidies for key commodities, along with a still heavy reliance in many cases on energy-intensive and outdated technology. While the resource conservation efforts so common in the West are beginning to manifest themselves also in emerging economies, their impact is still far more limited.
But the demand side has also evolved dramatically because of the emergence and growth of many new types of important buyers. The most important change in this regard has happened in the financial sector. Whereas large institutional investors – insurance companies, pension funds, etc. – used to place the lion’s share of their assets in government bonds, the appeal of these assets has waned because of extended periods of low interest rates, which has made it difficult for many institutions to make adequate returns by traditional means. At the same time, financial de-regulation in many countries has resulted in fewer restrictions on the portfolio allocation of these investors. Commodities have gained favor for portfolio diversification purposes, given their different cyclical properties, but also because of the attractive returns many of them have offered. Having once been a relative rarity, commodities are now a common and rapidly growing component of many institutional portfolios. Also many financial intermediaries, including banks, have become more active in the physical commodity space, partly because of regulatory concerns about derivatives trading.
A changing supply side. Also the way in which commodities are produced and brought to the market place has changed in important ways. The commodity market is relatively unusual in as much as the supply side tends to relatively rigid. A large number of commodities are available in finite quantities but even the supply of renewable resources tends to be relatively inelastic in the short term. In agriculture, decisions to modify the supply of a particular commodity have to follow the harvest cycle and hence require time. The supply challenges in many cases are made greater by the increasingly intense competing claims on resources that have multiple uses. For instance, in food commodity markets, the rise of production for alternative bio-fuels has diminished the availability of land and other resources for food.
Of particular importance are efforts by commodity-producing and exporting nations to exert grater control over the extraction and pricing of their resource wealth. The rise in the profile of the so-called national oil companies, often at the expense of the international oil majors, represents a particularly important example of this. These practices look likely to continue to gain ground and lead to a situation where key commodity producers can potentially significantly increase their price-setting and bargaining power. The impact of such steps can be increased through cartels which, while they can serve as sources of stability as Opec, can also involve attempts to significantly alter the terms of trade.
At the same time, many key consumers of commodities are also seeking to affect the supply side by means of strategic acquisitions. For instance, China is aggressive pursuing a resource security agenda which, apart from the creation of domestic strategic reserves, involves acquisitions of land, resource deposits, and commodity-related companies elsewhere in the world. The food security concerns of the GCC economies have forced them to start paying increasing attention to similar acquisitions in the agricultural space. These trends, which are likely to not only continue but actually intensify, will inevitably lead to more fragmented commodity markets. While this can benefit the national agendas of individual economies, it will also erode the scale and breadth of many key commodity markets by effectively earmarking a growing proportion of the marketable surplus for individual consumers. In some cases, the strategic rivalry risks pushing up prices.
New markets. Also the way commodities are traded has changed. There has been a dramatic increase in the number of products enabling investors to tap the commodity markets. Commodity derivatives are an obvious case in point but there are also a growing number of commodity funds, including exchange-traded funds, which enable even individual investors to buy into the commodity story. Commodity-based assets under management globally increased from approximately USD5bn in 2000 to USD80bn in 2005 and the figure is likely to surpass USD250bn in 2010. In 2008, the global commodity market stood at USD15.3trn, with around 85 per cent of the transactions taking place in the OTC market. From 2002 to 2008 the notional value outstanding of commodity OTC derivatives increased by more than 500 per cent, and commodity-derivative trading on exchanges grew by more than 200 per cent. The growing interest has been reflected in new products, indices, and unprecedented hiring of commodity market analysts. The leading banks now have significant holdings of physical commodities and many are acquiring new warehousing facilities.
Commodity markets have also become increasingly fungible. The one-time preference for long-term delivery contracts has over the years increasingly given way to spot pricing. A key case in point are the changes that occurred in the iron and steel markets in the spring. There has even been discussion of imposing greater flexibility of the natural gas markets. This is likely to make the markets increasingly volatile around the increasing trend, suggesting that little remains as it once was in the world of commodities. For the GCC, this implies a potentially important windfall thanks to oil but growing challenges in ensuring its access to most of commodities, whether food or industrial inputs.
Email the writer:
j.kotilaine@alrroya.com
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