Revision: The Surge in Commodity Prices – Cause and Consequence
In recent years we have seen a sharp rise in the prices of many internationally traded commodities such as oil,
gas, iron ore, palm oil, rubber, copper and many foodstuffs. This revision note looks at some of the demand and
supply-side explanations for this and also covers some macroeconomic consequences for various countries.
The revision note will also highlight some micro and macro concepts from the AS and A2 specification.
Some of the evidence
World Prices for Different Types of Steel
The Economist Commodity Price Index
325
US dollars per tonne
325
900 Cold Rolled Coil 705
300
Industrial Metals
275
275
250
250
225
225
Index
All Commodities
200
200
175
175
150
150
125
USD/Tonne
300
800
800
700
700
600
600
500
500
400
400
300
300
125
Food
100
200
100
04
900
Hot Rolled Coil 630
Hot Rolled Plate 837
05
06
07
200
01
08
02
03
Cold Rolled Coil
Source: Reuters EcoWin
Hot Rolled Coil
06
07
Hot Rolled Plate
Wheat - World Price
US dollars per tonne
Malaysia Palm Oil Futures Price, USD per tonne
1400
1400
900
1300
1300
800
1200
1200
700
1100
1100
1000
1000
900
900
800
800
700
700
600
600
500
500
987.0202156
600
Price
USD/Tonne
05
Source: Reuters EcoWin
World Palm Oil Prices
1000 World, Vegetable Oils, Palm Oil, Malaysia Palm Oil Futures, USD
04
500
400
300
200
100
00
01
02
03
04
05
06
07
08
Source: Reuters EcoWin
400
400
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
07
Dec
Jan
Feb
Mar
08
Source: Reuters EcoWin
Explaining the rise in commodity prices
There are many factors at work here
1. Strong GDP growth in emerging market countries including China, India, Brazil, Russia, Indonesia,
Vietnam et al (see the Goldman Sachs analysis on the BRICS and N-11)
a. The China effect:
i. Huge rise in manufacturing output (the workshop of the world)
ii. Massive infrastructural spending including preparations for the Olympics
iii. Rising per capita incomes – driving demand higher for food especially meat – which
then increases the demand for grain (income elasticity of demand relevant here!)
b. Many other emerging market countries are booming
i. Strong derived demand for fuels e.g. oil and gas
ii. High derived demand for materials and components e.g. cement, copper wiring, steel
and energy
iii. Many have accumulated high trade surpluses and can therefore afford to pay high
prices for the imports they need
2. Impact of some extreme weather events cutting supply for a range of commodities
a. Australian drought
b. Drought in China
c. Floods in the UK
d. Hurricane Katrina in the USA
3. Supply constraints from war and geo-political tensions and the effects of cartel behaviour by energy
producers including OPEC
4. Previous lack of investment in supply capacity e.g. affecting the oil and gas industry
5. Big shifts of scarce resources towards bio-fuels e.g. 1/3rd of US wheat production now goes into
meeting demand for bio-fuels – taking supply out of the food chain and causing agflation.
6. The fall in the external value of the US dollar – most commodities are priced in dollars, so a weaker
dollar makes them cheaper for consumption.
a. The Credit Crunch has amplified this effect with the Fed Reserve slashing interest rates –
creating expectations that the dollar will fall further
7. Speculative demand for commodities
a. Many soft and hard commodities now seen as an asset class in their own right
b. Weak stock markets and recession in property is causing hedge funds and other investors to go
long on commodities
c. IMF believes that speculation plays a big part in the explanation for the commodity price boom
When explaining the price changes – one useful distinction to make is between
•
Fundamental factors e.g. globalisation, urbanisation, industrialisation of emerging economies –
fuelling increased demand
•
Cyclical factors e.g. strong demand from countries in the boom phase of their economic cycle
•
Short term factors e.g. speculative activity, short term volatility of exchange rates and interest rates
Remember the importance of elasticity!
The prices of commodities are inherently volatile. At AS level you would be expected to explain this in terms of
the low price elasticity of demand and low price elasticity of supply of many commodities. When elasticity is
low, shifts in demand and/or supply feed through straight away into big changes in equilibrium price.
Drought and other supply-side problems
cause an inward shift of market supply
and a rise in price
The effect of speculative demand in the
market for wheat
Price of X
Price of Wheat
S1
S2
S1
P2
P1
P1
D2
P2
D1
Q1
D2
Q2
Q1
Q2
Quantity
Quantity
SRAS1 – SRAS2 is an inward shift of AS causing a contraction of AD, a fall in
real national output and an increase in the general price level
Inflation
LRAS
P2
P1
SRAS2
SRAS1
AD
Y2
Y1
Yfc
Real National Income
Some of the Economic Consequences
This gives you a great chance to develop your evaluation skills – using where possible either the evidence you
are given in a stimulus question or your own knowledge based on wider reading and supplementary notes.
Changes in commodity prices are often called “external economic shocks”
1. How large is the change in the price of one or more commodities? Are we measuring prices in nominal
or real terms?
2. Does the evidence suggest a trend change in price? Or perhaps something that is more temporary and
might be reversed in a short period of time?
3. Which industries are affected by the price change? And how important are those industries to a
particular economy?
4. Who gains and who loses from a price movement? Producers? Suppliers? Consumers? Sovereign
Wealth Funds? Smaller farmers in China? The government? Commodity price changes give you the
chance to discuss the question of equity.
5. How might a change in commodity prices affect macroeconomic variables such as:
a. Real GDP growth
b. The components of AD (C+I+G+X-M)
c. Trade in goods and services
d. The exchange rate (especially for countries that export / import a significant volume of
commodities)
e. Input price and consumer price inflation and expectations of inflation
f.
Policy decisions on interest rates
g. Real incomes, business and consumer confidence
h. The economic cycles of other countries / wider consequences for the global economy
6. Consider second round effects
a. Multiplier effects e.g. rise in unemployment causes fall in propensity to spend
b. Accelerator effects e.g. rise in demand for oil causes increase in investment in exploration and
extraction
c. The inter-related nature of markets – for example:
i. A rise in oil prices might lead to an increase in demand for and profitability of
renewable energies
ii. A rise in copper and steel prices will lead to an improvement in the profitability of
recycling – good for the environment?
iii. One country’s trade deficit is (in part) another country’s trade surplus e.g. how might
the petro-dollars flowing into the economies of oil and gas exporters be used?
7. Identify both demand and supply-side effects – which appear to be stronger?
8. Ask yourself the question – what has actually happened? Am I basing my answer on supposition and
theory? Or can I use some of my wider knowledge to score really high marks for evaluation
9. At AS and A2 level, you must make use of AD-AS (macro) analysis to explain some of the
consequences. There might be other opportunities to other diagrams too e.g. PPF, supply and demand.
So – for the UK….the recent increase in global commodity prices has had costs and benefits…..
Costs
Rise in input costs (variable costs) – leading to surge in producer price inflation – now showing through in a
rise in consumer price inflation …. Which has follow through economic effects
Higher food price inflation (agflation)
Seemingly – an end to the era of cheap food
Damaging to lower income groups? Especially those with little/no wage bargaining power
People’s experiences of inflation don’t seem to tally with the official data on CPI
Fall in real incomes and less income available to spend after ‘essentials’ such as food and utilities
Rising cost of living now hitting consumer confidence – risks causing a slowdown
CPI inflation has been rising – BoE expects it to head higher in 2008
Gives the BoE less room to cut interest rates in response to the credit crunch
BoE concerned that inflationary expectations are rising – a danger in the medium term
Higher input costs for businesses
Hits profits especially if manufacturers cannot pass on to final consumers
May accelerate trend towards out-sourcing production to lower cost countries
Possible damage to export businesses if rising costs worsen competitiveness
Risk of stagflation
Worsening trade deficit
UK is a net importer of foodstuffs and also now a net importer of oil!
Increased bill for raw materials and components – affecting producers throughout the supply chain
Trade deficit is a leakage from the circular flow – causing a slowdown in AD
But … not all bad news!
Higher food prices good for our farming sector which has suffered from years of declining real prices and real
incomes. (That said, farming contributes less than 1 per cent of UK GDP!)
Boost too for sectors such as renewable energy and if fuel prices remain high this may have important
environmental benefits – e.g. encourage car manufacturers to invest more in improving fuel efficiency / change
the pattern of demand towards smaller cars. Will rising food prices contribute to less obesity? Or have the
reverse impact?
A stimulus to the North Sea oil and gas industry and related sectors
Inflation has risen but it is not out of control – the Bank of England can manage it – few signs of a damaging
wage-price spiral talking hold
The pound has been strong against the US dollar which helps to limit the impact of rising commodity prices
which are priced in dollars.
Business profits have been strong (helped by 16 years of economic growth) – most businesses have been able
to cushion the impact of rising input costs.
There are signs that commodity prices will start heading lower in 2008 especially if the US economy goes into
recession and China’s economic growth slows down.
UK economy is still growing and unemployment remains low. A slowdown – yes / A recession - probably not.
Some evidence on the macroeconomic effects for the UK
Economic Growth, Inflation and Oil Prices
UK Real GDP Growth and CPI Inflation. annual percentage change, Brent Crude $s per barrel
USD/Barrel
100
90
80
70
60
50
40
30
20
10
100
90
80
Brent Crude Oil Price $s
70
60
50
40
30
20
10
9
9
8
7
6
5
4
3
2
1
0
-1
-2
-3
7
Real GDP growth
Percent
5
3
1
Consumer price inflation
-1
-3
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
Source: Reuters EcoWin
UK Balance of Trade in Selected Goods
Annual trade balance, £ billions
10
Semi-manufactures
0
0
Food, beverages & tobacco
-10
-20
-20
-30
-30
billions
GBP (billions)
-10
10
Crude oil
-40
-40
Finished manufactures
-50
-50
-60
80
-60
82
84
86
88
90
92
94
96
98
00
02
04
06
Source: Reuters EcoWin
UK Inflation and Crude Oil Prices
USD/barrel
Annual percentage change in the Consumer Price Index and monthly average for Brent Crude
110
100
90
80
70
60
50
40
30
20
10
Percent
4.0
110
100
90
80
70
60
50
40
30
20
10
Crude Oil Price
4.0
Consumer Price Inflation
3.0
3.0
2.0
2.0
1.0
1.0
0.0
0.0
00
01
02
03
04
05
06
07
08
Source: Reuters EcoWin