The second quarter of 2008 capped off the 3rd straight in which the TD Commodity Price Index (TDCI) charged ahead at a double-digit rate.  And on a year-over-year basis, the TDCI in U.S. dollars is up by a whopping 40%.  For those who have studied past up and down cycles in commodity markets, this year’s experience stands out. Rational expectations would hold that a massive 1.5-percentage-point slowdown in world real economic growth this year – or mounting evidence that even China’s blockbuster rate of growth may have started to ease from a peak – would pour some cold water on the commodity rally. In such an economic environment, market players would have an added incentive to adjust their production and purchasing decisions accordingly, bringing commodity price index readings off their highs.  

But wait a minute. A closer look at recent commodity trends says it is too early to throw away your Economics 101 text book. In fact, buried under the headline commodity price index reading, a response to good old supply-demand fundamentals was indeed alive and well in most markets in the second quarter. After soaring by 30% in the first three months of the year, agricultural product prices declined by 10% in the April-June period, as investors bet on a major increase in crop yields as producers scurried to increase seeded acreage following last year’s price surge. Most metals prices lost ground during the period, as demand – particularly in developed countries – slowed in line with weakening economies and inventories mounted. Forestry was one of the few areas to record a price gain in the second quarter, as producers responded to plunging U.S. housing activity and last year’s price slump by slashing capacity.

The energy sector was one of the few notable areas in the second quarter where prices seemed to become increasingly disconnected from underlying supply-demand fundamentals. Notably, despite growing evidence of demand destruction in the second quarter, crude oil prices soared by a further 27%. The 15% drop in WTI prices recorded since the peak was reached in mid-July suggests that the crude oil market has begun to respond to the oil demand adjustments that are being made globally.

In our view, there is scope for energy prices to decline significantly further over the next 12 months, pulling the overall TDCI down by 20% from the average level in June 2008. Look for crude oil prices to retreat to US$100 per barrel in early 2009, before strengthening gradually later next year. Barring an active hurricane season, natural gas prices have probably peaked, while coal prices are unlikely to buck the trend towards lower energy prices.

Excluding energy, the 6-quarter look ahead is mixed. Metals prices are likely to lose some further ground in a slower growth environment. At the same time, however, forestry prices are projected to rise by 13% on average, as supply cuts and early signs of a stabilizing in U.S. housing demand set the stage for a 30% jump in lumber prices. Hog prices are expected to rise over the next six quarters, ending 2009 up 11% from current levels. Similarly, after falling for the past four quarters, uranium prices are poised for a recovery throughout the remainder of the forecast period. Overall, the TDCI ex-energy is expected to hold relatively firm in the coming quarters.

Dina Cover, Economist
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