2. COMMODITIES: There's price relief in sight, but few see it lasting (Greenwire, 05/07/2008)

Nathanial Gronewold, Greenwire reporter

NEW YORK -- The soaring prices of oil and other commodities are expected to decline soon, providing relief to people buying gas and groceries. But the good times won't last, analysts and traders warn.

Tomorrow the European Central Bank is scheduled to hold a meeting on monetary policy in the common currency zone. The bank regulates the base interest rates in the euro countries, just as the Federal Reserve regulates those in the United States, but the ECB has kept rates higher than the Fed has, a factor driving down the value of the dollar, foreign-exchange traders say.

While the bank's policy is not expected to change tomorrow, the business community is waiting to hear what the ECB president, Jean-Claude Trichet, says after the meeting. European exporters are taking a beating from their expensive currency, and growing signs of an economic downturn in Europe are causing a change of mood among European regulators. That could lead Trichet to hint at lowering rates the next time around.

That will send the dollar's value higher, and oil, natural gas and industrial metal prices will fall, experts say. At least that is what will happen initially.

"That is a relationship that is tenuous at best," warned Yra Harris, an independent commodities and currency trader running Praxis Trading in New York. "We know that the price of oil has certainly outstripped the depreciation of the dollar."

The traditionally tight correlation between a falling dollar and rising commodity prices has come unbuckled in this latest economic cycle, many analysts say. So even if weaker economic conditions in the United States and Europe move the ECB to follow the Fed on interest rates and energy and metals prices fall, it is likely prices would resume their climb later this year -- if what Harris and others say is true.

"The initial thrust was demand-driven," Harris said. "The whole supply-demand curve was changing as you saw growth in the so-called BRIC [Brazil, Russia, India, China] world, and then some."

How long and how deep prices dip following a rebound in the value of the dollar could ultimately answer the question of who is right in the ongoing debate among market watchers over what is fueling the current energy and commodities boom.

Some continue to fear a bubble driven solely by low interest rates and the weak dollar -- a bubble that is ripe for popping. They point to past precedents in the market cycle when robust commodities prices collapsed following Fed rate hikes.

But others say this time is inherently different. These are proponents of the commodities "super cycle" theory, which argues we are in the midst of a new industrial era and a fundamental shift in the global economic reality that will take some time for raw input producers to catch up to.

Link to dollar

Nobody doubts that there's a relationship between commodities prices and the value of the dollar. What is subject to dispute is how strongly the two are related.

"Swings in commodity prices are often attributed to swings in the dollar rate," said Jacob Vinding Jensen, a commodities strategist at Jyske Bank, in a report to clients. "A dollar depreciation has an immediate effect because most commodity trades are settled in dollars."

While consumption is an obvious driver of price, the demand for commodities as an asset class is arguably just as strong. As the dollar has dipped, investors have sought hard assets that they believed would hold their real value or even appreciate.

At one time, real estate was the darling of such hard-asset investors, but the collapse of that market has driven new players -- including private equity and hedge funds -- to oil, gold, copper, iron ore, aluminum and most recently, coal. And lately, investors even seem to be pumping up the market for art.

As a result, bubble watchers say, prices have soared well beyond the rate of increase in consumption demand and are now at unstable highs. For instance, oil prices more than doubled last year, even though total global demand grew by barely 1 percent, according to the International Energy Agency. The cost of copper has shot up more than 450 percent since 2000.

"Powerful performance in commodities over the last couple of years raises the plausibility that aggressive assumptions have further driven up prices that appear to be on the verge of correcting," Citigroup equity strategist Tobias Levkovich warned in an analysis.

Analysts at Citigroup seem particularly bearish about prospects of commodities maintaining their record high price levels as the global economic downturn deepens. Slowing industrial activity in the United States and Europe will take their toll this year, they warn, regardless of the performance of emerging economies like China and India.

"As U.S. industrial trends worsen by mid-year and into [the second half of] '08, we would expect the demand for commodities to slide further," Levkovich said.

But the real catalyst, Levkovich said, will be action by the European Central Bank to lower interest rates, which could happen by midsummer. "The potential for currency market intervention is growing because the rapid descent of the dollar ... has governments and central bankers worried about local economic impact," he said.

Continued demand pressure

While an ECB rate change will have an immediate impact that could see the prices of hard assets dive, other market insiders, including analysts at Merrill Lynch and most traders at the New York Mercantile Exchange, insist that it won't last.

The fundamentals still support higher prices over the long run, they say, especially for oil. And higher energy costs will continue to fuel higher metals prices as the costs of extraction and transportation keep marching upward.

Indeed, some analysts point to evidence from the markets over the last few years that suggests commodities prices are no longer as tightly correlated to the value of the dollar as they have been in the past.

"The relatively big year-on-year rises in metal prices have only to a minor degree been accompanied by falls in the dollar index," argued Jensen of Jyske Bank. "Actually, metal prices rose by more than 33 percent in 2005, a year when the dollar strengthened."

Jensen and others also note that prices for oil, natural gas, coal and industrial metals have risen relative to other major currencies, although not as strongly as they have in dollar terms. Prices for metals have on average risen by 270 percent in yen terms and 160 percent when expressed in euros, Australian dollars and Canadian dollars, he notes.

"Metal prices have risen significantly expressed in all currencies, which indicates that the fundamentals have been the main driver," he said.

Yra Harris of Praxis Trading agrees, arguing that any market correction brought about by looser E.U. monetary policy will be relatively short-lived. The reason, he and others say, is that the price spike is being driven by a market "super cycle," with rapid growth in emerging economies fundamentally shifting the supply-demand curve upward. Market speculation is having only a negligible impact, they say.

"If global growth keeps going, the commodity prices are going to hold," Harris said. "The supply-demand curve in the energy market is changing dramatically. That's exactly what we're looking at."

In past commodity super cycles, the argument goes, the price for energy and industrial materials shot up when rapid economic growth in one or more countries created new demand that outstripped the ability of mines and oil and gas wells to keep up. And once they had, the market by then had adjusted and prices stayed at their new high levels. This was seen from the early 1900s to the Great Depression, when the United States overtook Great Britain as the world's largest economy, and again after World War II when the United States continued to grow and Western Europe and Japan rebuilt.

Now we are in a new cycle led by the developing world, which had been building steam but has really kicked off in recent years -- precisely correlating to the start of the most recent run-up in prices, "super cycle" theory proponents say. Prices will fluctuate, they admit, but they should eventually stabilize around new permanently high plateaus.

"A couple times before this move when oil would get to $40 [a barrel], it would always spike to new highs on fears of supply disruption and then fall back down," Harris said. "But this time, it broke through there, and when it came down, it held those tops. So this is a far different game going on."

Decisions driven by resource scarcity

If super cycle theorists are correct, then over the next several years the decisions that consumers and producers make will be driven more by resource scarcity than by relative abundance. The same goes for global food prices, which have also been driven upward by a supply crunch, higher fuel costs and greater trading volume.

If the dollar rallies in the weeks ahead, most analysts expect energy, metals and perhaps even food prices to begin sliding back at some point. The value of the dollar has been shown in the past to affect food commodity prices and could also influence where prices are headed in the coming months.

In a 2002 presentation to the U.N. Food and Agriculture Organization on commodity prices, Robert Mundell, an economics professor at Columbia University and winner of the 1999 Nobel Prize, gave evidence that the relationship between the dollar and the value of commodities, including food, is very close, at least when reading past statistics. But that won't necessarily last, he warned.

"Despite the weight of the United States economy in the world economy, there is not necessarily a direct causal relationship between the strength of the dollar in currency markets and commodity prices," Mundell said. "It could be that the same factors that cause the dollar cycle also cause the commodity cycle."

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