Still brushing away the suds left behind after the bursting of this year’s price bubble and facing the deepest global economic downturn in decades, world commodity markets have continued to get pounded in recent weeks. So far in November, the TD Commodity Price Index (TDCI) in U.S. dollars has slumped by a further 13% compared to the same period in the prior month, bringing the total losses since its July peak to about 50%. And as we show in the chart on page 2, there have been few places to hide. Among the 18 commodities tracked, only newsprint prices have gained ground since July, while the bellwether oil and copper markets have topped the list of decliners.

These massive drops might leave the impression that commodity prices have returned to their bear-market levels of the late 1990s and early 2000s. Yet both the overall TDCI and the ex-energy component have only retraced the gains recorded since January 2007, which corresponded with the beginning of the most powerful leg of the rally that started to take root in late 2001. Relative to the 2001 starting point, the index remains up some 60% (about 45% in real terms). The comparable figure for the TDCI excluding energy is 75% (60% real).

The news that prices continue to hold up at relatively high levels compared to their 10-year benchmarks will provide cold comfort given that signs of a bottoming in the market remain elusive. But while the rout in prices has yet to run its course, we do see a light at the end of the tunnel.

When will the bottom be reached?

In many respects, the seeds of the commodity recovery have already begun to be sewn. The hefty drop in commodity prices thus far – combined with a lack of credit availability worldwide – are spurring project delays and significant cuts to supply across the commodity complex. Notably, all base metals prices (with the sole exception of copper) have dropped to unprofitable levels, joining other distressed areas like lumber and hogs. In the oil sector, OPEC has been engineering significant output cuts to mitigate the risk of an impending supply glut, and more are likely in store.

But while supply is being curtailed, commodity markets will likely remain on shaky ground until the demand side of the equation firms up. In the past, commodity prices have tended to be a coincidental or even slightly lagging indicator of world economic activity. The challenge for commodity producers is that despite announcements of massive government stimulus packages in China, Europe and the United States, we see little hope of a quick turnaround in the global credit market situation. Nor do we see a firming in world economic growth until the mid-part of 2009. It is at that point that U.S. housing prices will likely have stabilized, removing a major strain off both the U.S. economy and the global financial system. Still, we’re not counting on the usual forceful rebound in world real GDP that traditionally follows a recession, since the legacy of the past massive buildup in global indebtedness will continue to reer its ugly head. (For more details, please see our October 31st report Revised Economic Forecasts)

How much further will prices drop?

Although commodity markets will likely continue to sell-off on bearish demand news, the speed of the decline is expected to taper off significantly going forward, essentially stabilizing by the second quarter of 2009. This deceleration is partly owing to the sheer amount of froth that has already been skimmed off markets over the past 5 months. But as well, we believe that recent selling pressure has been accentuated by the surge in the U.S. dollar and the forced liquidation of commodity positions by hedge funds and other institutional investors. Looking ahead, we don’t expect these forces to be as prominent. Notably, as 2009 gets underway, the recent upward trend in the U.S. dollar should reverse course due to the potent combination of very weak U.S. growth, near-zero interest rates and the expansion of government borrowing that will result from the Administration’s various bail-out packages.

Building in these factors, we project that the overall TDCI will slip by an additional 10% from their mid-November levels to its first-quarter 2009 low. This decline is cushioned by natural gas prices, which are proving less vulnerable to the impact of the global slowdown and account for about one-fifth of overall index weighting. Excluding natural gas, another 15% price drop on average is anticipated, with crude oil prices falling to just over US$45 per barrel in the early part of next year.

What will prices look like once the dust settles?

Just as there will likely to be considerable disagreement among analysts about when the bottom will be reached and what price commodities will hit at their trough, there will be ample discussion on where commodity prices will head once the global economy regains traction.

Despite the wild ride in prices over the past few years, we still see a good longer-term story for commodity prices. Notwithstanding the implementation of its massive government stimulus package, China appears set to slow in the coming quarters, but it will undoubtedly return as a powerful driver of world commodity demand. And while the global slowdown should deliver some good news to resource producers in the form of a gradual reprieve in cost pressures (look no further than the plunge in the Baltic Dry Index), persistent high costs for finding and developing deposits in areas such as crude oil and base metals will remain an impediment to supply down the road.

However, we’re not in the camp that predicts a return to prices back to their nosebleed 2007-08 levels once there’s a whiff of global economic recovery. In our view, the recent period was an aberration that came about due to a series of developments that are unlikely to be repeated any time soon. First, as already noted, we are not likely to return to the days of heady 5% world economic growth that was induced by massive global leveraging and risk-taking. Our base case forecast has world economic growth accelerating to only 4% in 2010, which on top of this year’s weak 2% turnout would still leave the level of global real GDP quite depressed compared to where it would have been had the slowdown not been suffered. China’s growth rate should return to 9% in 2010, which represents a sizeable 3 percentage point slowdown vis-a-vis recent years. Moreover, the recent spike in commodity prices triggered behaviour changes – notably in energy conservation – that are unlikely to be fully reversed in the future. These factors combined will keep growth in commercial demand for commodities running at a slower trend rate that experienced earlier this decade.

The second major factor that will limit the upside to commodities during the recovery phase is investment demand. Investors piled into commodities over the past few year as a way of hedging against plunging stock markets, rising inflation and a rapidly declining U.S. dollar. Indeed, a trading pattern that emerged was taking short positions in the U.S. dollar and offsetting them with long positions in commodities. We don’t see these factors influencing trading patterns to the same degree over the next few years. For one, the economic and financial woes of other major economies mitigate the risk of a sharp decline in the U.S. dollar over the medium term. Even more importantly, commodities as an asset class will face significant competition from other areas, such as equities, over the medium-to-longer term. A major strike against commodities as an investment is that they don’t pay an income stream.

As such, even with gains of up to 50% projected between mid-2009 and the end of 2010, prices on average will end the forecast period significantly below their recent peak set in 2007 or 2008. If the frothy 2007-08 period is ignored, the commodity price profile during the 2009-10 period maintains the gradual upward trend that has been in place since 2001. Some have referred to this longer-term path as a commodity super-cycle, although the upward slope is probably shallower than many had bet on a year ago.

What are the implications for Canada?

It is little secret that commodity-producing industries are vital to Canada’s economic well-being, accounting directly for some 15% of real GDP, 40% of its total good exports and over 40% of the weighting on Canada’s benchmark S&P TSX stock market index. Above all, given the importance of commodities to exports and Canada’s overall terms of trade, the boom in resource prices has provided a massive boost to the nation’s overall income performance, as evidenced by a surge in nominal gross domestic product over the past several years. The importance of commodities raises the question of how TD’s forecast profile will impact the nation’s economy over the next few years.

Undoubtedly, the current down-cycle in commodity prices will lead to a near-term reversal in some of the huge income gains that were chalked up during the boom period of 2007-08. On the plus side, the rapid expansions in both commodity investment and cost pressures were unsustainable, necessitating the need for a cooling off period. And, as we’ve noted, despite the risk of overshooting in the near term, the current dramatic correction should set the stage for a continuation of the longer-term uptrend in 2010. Accordingly, the sector will remain a major driver in Canadian income and jobs over the longer haul, even if the economic impacts of the current price correction continue to be felt into 2010.