Surinder Sud: The price surge in commodities

Globally, the commodities sector has seldom been so upbeat in decades as it has been in recent months. Prices are ruling high across almost the entire sector despite economic growth uncertainties in several countries.

Although market watchers differ on how long the uptrend that began in the mid-2003 will last, the most dominant opinion (also expressed by Goldman Sachs) is that prices may become relatively more violent before declining due to returns-driven output hikes.

Significantly, India is no exception in this regard. Though the domestic price trends are in tandem with international prices on the whole, there are some striking dissimilarities, too, in certain sectors.

The usual peak marketing season price crash for agro-commodities was missing this time, although the country has reaped good kharif as well as rabi harvests.

The prices of non-agricultural commodities, including metals and cement, have also remained firm and are still going up in several cases.

However, the implications of the firm commodities market for India differ from those for several other countries where commodities constitute a crucial investment sector.

The investors there have reaped good returns, thanks to a bullish market, and may continue to do so if the conditions remain the same for some time to come.

But in India, investors' interest in commodities, barring a few traditional mass consumption, non-cereal agro-commodities, is only recent.

So, the scope for gathering good returns is relatively slim. Of course, the global price rally can influence export earnings but there again, India's export availability is guided more by the dynamics of the domestic demand-supply scenario than mere international prices.

However, the situation may change in the future as indicated by the growing investor participation in trading at the recently set-up commodity exchanges.

In value terms, the trading in these exchanges tripped in just one year to touch Rs 1 lakh crore in 2002-03.

The projections are that commodity-derivatives trading may rise anywhere from Rs 30 lakh crore to Rs 55 lakh crore in the next five years. In such a scenario, the importance of the commodities sector will grow appreciably.

A closer look at global trends reveals that in the case of metals, the past few months have been rather tumultuous at the London Metal Exchange (LME), pushing up the prices of these commodities to their several-year high.

While metals like copper, lead and tin have hit their eight-year high, others like aluminium and zinc are ruling at a three- to four-year high.

The prices of steel have clocked a double-digit growth for quite some time now. Among other non-agricultural commodities that are on the boil, the most significant is coke, which has surged three-fold in a year.

Indeed, analysts are unable to pinpoint a single reason for this trend. For, it is neither entirely production-driven nor totally demand-driven.

Although earlier, erosion in the value of the dollar was being held responsible, this is no longer so: the uptrend has persisted despite the dollar firming up perceptibly. A huge spurt in demand from China has also been among the significant factors but analysts are at a loss to explain how one economy, however fast growing, could exert the kind of sweeping influence that is being attributed to it.

A tangible resurgence of the global economy in general, and Europe in particular, is another reason put forth. Besides, there are the time-tested price determinants, such as demand, supply and inventories held by the main suppliers. In fact, all these factors seem to have played a role in pepping up commodity prices.

However, market watchers are not unanimous on how long this price rally will last, although most believe that it is unlikely to abate soon and may turn more violent in the near future. One view is that the heat is out of the markets and any further increase in prices is unlikely.

Besides, the strengthening dollar may cap the upside for at least those commodities where prices have been riding on the back of currency-value movements.

Inventory levels and supplies, too, are changing constantly since production cycles vary for different commodities in different countries. Naturally then, demand, too, varies. All these factors are, obviously, influenced by the pace of growth in different economies.

On the other hand, Goldman Sachs has in its latest global commodity report, described the current trend of price appreciation as the first phase of the rally, to be followed by the second phase, which is characterised by extreme price volatility.

In other words, the report states that in the first phase of a commodity rally, the market deficits begin to draw on inventories, leading to a steady price appreciation as inventories decline.

But once the inventories are depleted, the market shifts into the second, more volatile phase as extreme price spikes are required to bring demand down in line with supply in the absence of inventories.

This phase can persist for an extended period of time, until new supplies or demand destruction generates a large enough market surplus to rebuild inventories.

Indeed, it is yet to be seen whether the Indian commodities sector that has opened up to global forces only now will also go by this hypothesis, especially in view of the diverse nature of this sector and the vast domestic market.

However, what is apparent is that the present scenario does not bode too well for commodity-based industries. A situation seems to be emerging where it could hurt the user industry by pushing up costs beyond absorption capacity, so much so that consumer resistance may ensue at some stage.

The steel industry has already started feeling the pinch with costs outpacing the rise in end-product prices.

Consequently, although the export of ferrous goods "" including iron and steel products and consumer durables "" has risen (thanks partly to hefty orders from China), the exporters' margins have shrunk perceptibly.

Among the agricultural commodities, cotton is a case in point where the impact of higher prices is expected to be felt down the line.

Industry watchers have warned that cotton consumption, domestic as well as international, will be negatively affected by higher cotton prices. In sugar, another major agri-commodity, unabated rise in domestic prices could adversely impact export prospects as well as margins.

However, in some other export-oriented agri-commodities such as tea and coffee, the export scenario is already none-too-bright. The reasons, though, are non-price factors.

In the case of spices, too, reduced availability and poor produce quality due to adverse weather in the southern spices-belt has shrunk export availability.

Rubber export prospects, on the other hand, seem good thanks to firm and steady international prices; but, here again, most of the orders are coming from China "" a situation that may change if that country really opts to cool down its over-heated economy.

The most significant among the few commodities that may be net gainers from the high prices is soybean, which is in great demand in the export market thanks to poor crops in some key countries.