Everyone knows the theory that rising commodity prices should mean erosion in demand will occur and the price will stabilize and even fall as the supply/demand balance begins to change as a result. For the last 2-3 years, various analysts have been looking for that price effect on oil and other commodity demand. But it hasn't actually occurred – not yet anyway. In fact, demand for just about all commodities appears to be rising despite increased prices and judging from some of the fundamental data, will continue to do so for some time to come.

The US Dollar

The problem is that today's price rises have been disguised to some effect by a weakening US Dollar such that, in real terms, for non-Americans, prices haven't actually had a huge impact. Yes, in parts of the world, the oil prices and increased price for commodities is having a terrible impact — such as on African and other third-world economies — but the fact is that any demand erosion by these smaller consumers is swallowed whole by the rise in demand from countries like China, India and yes — even the USA. Looking at Asian demand, it shows no real signs of slowing and there are even now concerns about falling stocks in the region.

A sustained period of underinvestment in industry infrastructure combined with a demand side surprise, primarily from Asia, is responsible for the supply/demand tightness seen in commodity markets. When supplies are deemed to be tight, other factors come into play in a heightened manner when it comes to price formation. For oil, this includes terrorism (real or perceived), other geopolitical events, and unplanned supply disruption due to unplanned maintenance or weather events and so on. When this is combined with greater ease of access to markets via electronic exchanges, new instruments and new trading mechanisms, we see greater liquidity but also increased volatility. While some will blame ‘speculation', the simple fact of the matter is that there wouldn't be speculators at all if the fundamentals hadn't attracted them in the first place. So bemoaning speculators is simply an excuse to color people's judgment and hide the fact that government energy policy and the industry's forward vision has failed spectacularly. That's my opinion.

Commodity Inter-relationships

There are many differences between this bull market for commodities and those in the past; however, that also bears some discussion. One hot topic of discussion is the intimate inter-relationships between commodities that become obvious in times of high prices. For example - biofuels.

Biofuels have been long held out as a potential solution to the world's oil thirst, for example, but the rush to biofuels has proven to be largely flawed. By creating a virtual goldmine for farmers from Corn for Ethanol, the US Government has simply managed to change farmer's behavior in that they have switched acreage to Corn creating a ripple effect throughout the entire agricultural complex. We now see potential shortages of other grain crops and rising prices for wheat, soybeans and other crops that ultimately get passed on to the consumer. We see cattle being slaughtered sooner rather than later to keep feed costs down and Beef prices are weak as a result. Milk prices are rising because of the increased costs of feed, too. I could go on for paragraphs providing examples of this inter-relationship between commodities and prices. Meanwhile, Ethanol prices have declined because there is a view that there is too much Ethanol production coming on stream in the USA and the gap between economically produced Ethanol and subsidized Ethanol is broadening.

And what about metals? Well, on the back of the increased demand from Asia as it builds out its infrastructure resulting in rising Copper and other base metal prices, we also observe that the environmental pressure is having an additional impact. The popularity of diesel engines in Europe and Asia is causing Molybdenum prices to surge as it is used in the diesel engine. As Nuclear energy gets a fresh and serious look to solve the world's future power needs so too does the price of Uranium increase dramatically. And, one must not forget the US Dollar again which is helping drive up Gold and other Precious metals prices. Again, the issue is lack of investment in the infrastructure and a demand-side surprise. This truly is a bull cycle for commodities.

When Will It End?

The question therefore comes back to when it will end. When will the rising cost of commodities have a demand side impact and what sort of impact will it be? One could very well argue that when it comes, it comes as a global recession. Again, part of the issue is the US Dollar and the fact that a good deal of the countries that drive demand are shielded, to some extent, from its effects.

However, we are beginning to potentially see some light at the end of the tunnel. According to Ed Morse, Chief Energy Economist at Lehman Brothers for example, there is the potential for a sizable build out of refining (outside of the USA) which will increase capacity beyond demand and should result in downward price pressures. Concerns over CO2 emissions and the adoption of some form of cap and trade market in the USA could also dampen demand there. Finally, the US consumer is beginning to feel the full effect of rising prices and this eventually simply has to translate into consumer behavior change.

My Own View

This time around, the knock on effects of commodity prices is also having a broader impact on the consumer. It's not just a focus on the cost of energy (where that has a minor effect on finished goods prices) but the broader rippling effect across the basics of life that will eventually temper this bull market.