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Commodity fall fuels deflation fears

LONDON (Reuters) - Commodities’ fall from grace in recent months has been fast and furious and further losses cannot be ruled out as the economic and demand landscape deteriorates over coming months.

This will add to deflation fears, but not for long because many commodities are expected to soon hit a floor as output cuts curb supplies. The notable exceptions could be copper and oil.

“Just as the market was irrational on the way up, it will be irrational on the way down,” Ian Morley, a director at fund manager Quantum, said.

“We’re probably not too far from the bottom, but it doesn’t mean oil can’t fall further, another 20 percent is possible.”

That could take crude to around $40 a barrel, a drop of about 70 percent since a record above $147 a barrel in July.

Some analysts say strong rhetoric and production cuts from oil producing group OPEC, which controls about 40 percent of the world’s supplies, could slow the descent to that level or even drive a swift rally if OPEC cuts output too deeply.

But Michael Lewis, global head of commodities research at Deutsche Bank, said cuts by the Organisation of Petroleum Exporting Countries OPEC.L could take around a year to feed through.

“We’re looking for a low of about $30-$35 a barrel by the end of next year,” he said.

So for now, with falling prices, central banks slashing interest rates and recession a reality in major economies from Japan to Germany, deflation remains a danger.

After hitting highs just a few months ago, inflation is falling in all industrialised economies as growth falters.

“We all know headline inflation rates will probably touch the zero line by the middle of next year,” Klaus Wiener, head of research at Generali Investments, said. “Raw material prices will start rising again, but it won’t happen in 2009.”


The mood in the grains market is also sombre. Prices of the benchmark December U.S. corn futures contract have more than halved to around 350 U.S. cents a bushel since July.

“Demand for meat appears to be waning ... This will weigh on corn demand with over 65 percent of corn being used as feed in an average year,” UBS said in a recent note.

The Swiss bank expects to see corn prices average at 450 cents a bushel this year and 400 cents in 2009.

Some industrial metals could also fall further. Prices of copper, at $3,600 (2,345 pounds)a tonne are near marginal costs or highest costs of production estimated at above $3,500 a tonne.

Average costs of production for the metal used in power and construction are estimated at between $2,000 and $3,000 a tonne, and depend partly on whether they include the revenue from byproducts such as steel material molybdenum.

Some expect to see copper hit $2,800 a tonne, a drop of nearly 70 percent since an all-time high of $8,940 in July.

“Prices are well above costs for many producers. We have not had significant enough cuts in copper production to move the market out of being in a surplus next year,” Catherine Virga, analyst at CPM Group, said.

Analysts expect the copper market to show a surplus of 100,000 tonnes this year and 900,000 to 1 million next year.


But in the long term, fund managers say infrastructure spending plans and growing demand for commodities from fast growing countries such as China could mean the next upswing after 2009 could be sharper and much more inflationary.

They say the world could be facing a shortage of raw materials more acute then previously thought, partly because many companies are shelving expansion plans.

“We have growing scarcity of natural resources with fast-growing countries like China and India demanding more,” Generali’s Wiener said.

A series of government stimulus packages around the world could help kick-start demand. In China provincial government plans will add an extra 10 trillion yuan to a 4 trillion yuan plan announced by central government earlier in November.

President-elect Barack Obama has talked about a two-year plan to revive the U.S. economy. In October he called for a $175 billion stimulus measure.

“New bridges, new roads and new power stations will all require more in the way of resources,” Andrew Cole, director of asset allocation at Baring Asset Management, said.

“We’re worrying more about long run inflationary pressures then we are about short term deflationary pressures.”

Additional reporting by Barbara Lewis, Humeyra Pamuk and Barani Krishnan; editing by Sue Thomas