High commodity prices are the new normal

This week, Rio Tinto and Xstrata, two leading miners, both announced sharp falls in revenues and profits for the first half of the year. They blamed the slowdown in the Chinese economy and the eurozone crisis for causing volatile markets and another cyclical downturn in commodity prices.

However, they should be cheered by recent research from HSBC, which argues that the outlook for producers remains buoyant — barring a collapse in economic activity.

Many large emerging economies are either in or are about to enter the “commodity-intensive stage of development”, and that should keep commodity prices well above historical average levels, according to Paul Bloxham, chief economist for Australia and New Zealand, and Andrew Keen, global head of metals and mining research.

During the past decade, 12 countries have entered the commodity-intensive stage, while five have left, leaving a net increase of seven more countries at this critical stage, the largest of which are China, India, the Philippines and Vietnam. In addition, countries at the commodity-intensive stage of development now contribute 44% of global output compared to 22% ten years ago, while they also contain most of the world’s population.

The HSBC team noted that historical comparisons indicate that the commodity-intensive stage starts at a GDP per capita of around $3,000 and ends at around $20,000.

Last year, real commodity prices reached their highest levels in more than 30 years, and generally trended stronger during the decade from record lows at the turn of the century. Global growth had been largely driven by the developed economies in the 1980s and 1990s, which helps to explain the very low levels of commodity prices in those decades.

But, “the pendulum has now swung the other way, with the emerging world now the key driver of global growth”, and that is likely to continue.

Economic growth is now more commodity-intensive, so commodity prices are back to previous average levels in real terms. The rise has mainly been driven by Asian and especially Chinese demand. That surprised commodity producers and meant that there was significant underinvestment in resource supply capacity in the 1980s and 1990s.

Higher prices prompted major investment plans by producers, but the long-term nature of mining projects means that there is a significant lag in supply relative to current demand, helping to sustain high prices.

Supply capacity across a range of resources — particularly industrial commodities — is likely to come on line in the next couple of years, which will dampen prices as global growth trends lower. However, although prices appear to have peaked in 2011, marking the top what economist call a “hog cycle”, the balance of demand and supply is expected to remain tight for some time yet.

The key driver of this structural shift is the demand from emerging countries as they change the nature of their economies and raise their standards of living.

“A country enters the commodity-intensive stage of development when it moves from the agricultural/subsistence stage to the industrialisation/urbanisation stage, as this significantly boosts investment in infrastructure and energy generation capacity, which requires hard commodities, particularly energy and metals,” said Bloxham.

As a result, “it may be that the current high level of commodity prices is the new normal”, and HSBC expects prices to settle well above the lows reached in the 1980s and 1990s.