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 There has been a sharp rally in some commodity prices over the summer. However, QNB Group's analysis suggests that the rally is largely due to certain specific and temporary factors. Therefore, it is unlikely to be extended substantially and could easily be reversed if there is further global economic deterioration.

During August, the S&P GSCI, a key index of global commodity prices, increased by 6.2%, its most rapid monthly increase since April 2011. This came on top of a 6.1% increase in July, and brought the total increase since 21st June to 20.8%.

S&P GS Commodities Index (Jan-Aug 2012)

S and P GS Commodities Index Jan Aug 2012

Source: Standard & Poors and QNB Group analysis


The index, constructed by Goldman Sachs and maintained by Standard & Poors, is used as a benchmark for many funds investing in commodities. Each commodity is weighed in proportion to their level of production, and hence to their importance in the global economy. As a result, it is dominated by oil, which partly explains the index's sharp rise in recent months. It has also been bolstered by rising agricultural commodity prices.

Although oil and food prices have both rallied strongly since late June, driving up commodity indices such as the S&P GSCI, they have done so for different reasons. Meanwhile, some other commodities, such as natural gas and industrial metals, have performed weakly over the same period.

This suggests that the current rally is very different in nature to the one seen in summer 2008. In that case, the spike came in the context of booming emerging market economies and a very weak US dollar, which encouraged investors to buy commodities as a hedge against inflation. That rally involved a broader range of commodities and was the culmination of a years-long trend of rising prices.

The current rally, by contrast, is partly a bounce back after a period in which the prices of risk assets, including commodities, had been declining due to concerns about the Eurozone and the health of the wider global economy. This risk-asset bounce did not happen because of a dramatic turnaround in the situation. Indeed, much of economic data released in recent months has continued to be negative. Instead, the market has just become more hopeful about the prospects for state intervention and stimulus, particularly in the Eurozone, US and China. This has driven up equities, which had hit a low point in early June, and also contributed some of the momentum to commodities. Some commodities, especially gold are also seen as a safe haven in times of uncertainty.

Gold has rallied by 7.1% since 24th July, and spiked to a five-month high after a speech on 31st August by the US Federal Reserve ("the Fed") chairman, Ben Bernanke. This is because the market generally judged that the tone of the speech was supportive of further quantitative easing (QE), although he made no direct policy announcements. QE involves buying back government bonds and tends to boost markets as investors who sell their bonds to the Fed reinvest them in other assets. It also tends to devalue the dollar by increasing the supply of the currency in circulation.

Evidence of this effect is seen in exchange rates as well as Gold prices. The Dollar Index, a measure of the dollar's value against a basket of major currencies, fell by 3.5% from 24th July to 31st August, the period in which expectations that QE might happened increased in response to further poor US economic data.

Commodities, which are priced in dollars on global markets, benefited during August from the moderate weakening in the US dollar. A weaker dollar makes commodities cheaper in other currencies, and hence their dollar price tends to rise to match the foreign demand. However, the weakening dollar can only explain part of the commodity price rally in August, and none of it before then.

The bulk of the rally since late June has been driven by factors that are specific to certain commodities. Food prices have increased the most and some items, such as wheat, spiked up by over 40% in a month and hit all-time highs in late July. This was a consequence of the sudden intensification of drought in the US during the critical summer growing season. Meanwhile, Brent crude has risen by 29% from its low point on 21st June, with geopolitical risk factors contributing to this increase.

In contrast to oil and food, the prices of industrial metals, such as copper and aluminium, have been fairly flat over the summer and are well below their level a year ago. This is a sign of weak demand in the global economy, particularly in China which is the largest purchaser of industrial metals.

Looking forward, QNB Group expects increases in oil and food prices to be limited, with significant downside risks. Oil supply is expected to increase at least as rapidly as demand according to IEA and OPEC forecasts. Meanwhile, as the food market shifts focus to the southern hemisphere and winter harvests that are expected to be normal, some of the heat should come off prices.

QNB Group notes that the downside risks to commodities include the Fed deciding not to launch a third round of QE, which would strengthen the dollar and hence weaken commodities. More significantly, if there is a further deterioration in the global economy then this could weaken demand and led to falls in oil and other commodity prices. Threats include a fresh flare up in the Eurozone debt crisis or a failure by the US to mitigate its approaching 2013 fiscal cliff of spending cuts and tax rises.


Selected Commodities (21 June - 31 Aug 2012)

(Rebased to value on 21 June = 100)

Rebased to value on 21 June

Source: Forexpros and QNB Group analysis


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