The commodity market bulls will run out of puff next year
For years now it has been an article of faith among brokers and a good many investors that commodity prices can only climb higher.
They believe commodity markets are mid-way through a 20-year super-cycle. Their argument is that limited supplies, coupled with solid demand from the mainland as it raises living standards and builds up its meagre capital stock, will propel a multi-decade bull market in everything from soya beans to zinc.
It's an enticing story, and one backed by the price performance of major commodities over the last 10 years. Both oil and copper, for example, have risen by more than 400 per cent. Even rice - hardly the most widely traded commodity - has climbed by 260 per cent.
So it is no surprise that many of the brokers that have so enthusiastically promoted commodities as an investment over the last 10 years are sticking with their bullish calls for 2012.
Goldman Sachs, for example, is forecasting that the price of crude oil will climb 19 per cent by the end of next year, while zinc will rise 20 per cent and copper 22 per cent.
Yet investors should be wary of these predictions of handsome near-term gains. Commodity prices have indeed risen over the last decade, but they have also shown extreme volatility (see chart). Since the beginning of May this year, for example, the widely followed Rogers International Commodity Index has slumped by 17.5 per cent.
There may be more price falls to come in 2012. Commodity enthusiasts typically base their bullish price forecasts on projections of growing demand from the mainland. And it is certainly true that China has emerged in recent years as by far the world's biggest consumer of some commodities. In 2010, China accounted for 37 per cent of world demand for copper, 41 per cent of aluminium demand and 57 per cent of iron ore demand.
Even so, it is not clear that Chinese demand will be enough to support prices across the board in the face of recession in Europe and sluggish growth in the United States.
Consider the price of oil. Mainland oil demand currently stands at about 10 million barrels a day. With the economy expected to grow by 8 per cent next year, and with Beijing investing heavily to reduce its dependence on imported energy, oil demand on the mainland is likely to rise by about 5 per cent in 2012, or 500,000 barrels a day.
As analysts at Lombard Street Research point out, that's roughly the same as the amount by which US oil demand is declining each year, as the sluggish economy dampens energy demand and Americans switch to burning cheaper natural gas.
Add to that the likely fall in demand from oil-intensive European economies as the euro zone slides into recession. In 2009, European Union oil demand fell by 750,000 barrels a day. As a result, if next year's recession is only half as deep, the world could easily find itself facing a net fall in demand for oil in 2012, despite China's growth.
Barring political upheavals affecting the big oil producers of the Middle East, that makes calls for a near 20 per cent rise in the crude price look hard to justify.
Meanwhile, there are doubts over whether mainland demand for other commodities can continue to grow at the rates seen in recent years. Analysts at Capital Economics note that over the last decade, prices for industrial metals have tended to rise only when the mainland's growth rate has exceeded 10 per cent. When growth has fallen below that, notably in late 2008 and early 2009, metals prices have collapsed.
With the mainland's overall growth expected to ease to around 8 per cent next year as fixed asset investment growth slows, metals prices could well fall rather than rise in 2012.
Finally, there is the role of the US dollar. With commodities universally priced in US dollars, at least part of the increase in prices over the last decade can be attributed to the American currency's weakness.
But with the US dollar likely to strengthen against most major currencies next year thanks to safe haven flows and the effects of European bank deleveraging, commodity prices will struggle to make gains in US dollar terms.
As a result, the commodity bulls may be forced to take a breather in 2012. So if anyone tells you that the recent fall in prices offers a compelling buying opportunity, remember that that opportunity could yet become a lot more compelling over the next 12 months.