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There has been a spectacular run-up in commodity prices since the early part of this decade.
Unlike in the past, when rallies in commodity prices have tended to be confined to a select few commodities, over 2003-07 prices have risen for all raw materials across the board. Indeed, metals, energy and food price (annual) inflation has averaged 33 per cent, 25 per cent and 10 per cent respectively over 2004-07.
This rally extended into the first quarter when commodity price volatility jumped dramatically and prices breached a number of new records, with oil touching $120/barrel.
The remarkable rise in oil prices has its origin chiefly in the strength of emerging market (EM) demand this decade - China alone has accounted for a third of the incremental global demand over 2002-07. But this demand surge coincided with constrained production capacity resulting from weak investment in the oil sector in the 1990s, when prices were low.
Capacity shortfalls in energy have been compounded by Opec production decisions and temporary disruptions to non-Opec output, while the investment response to sustained higher prices is being curtailed by resource nationalism in emerging markets. Separately, shortages of skilled labour have added to costs.
Forecast
The medium-term outlook for oil continues to be dominated primarily by EM demand, which is likely to stay robust despite the headwinds assailing the global economy. Price levels across all commodities are likely to remain high by historical standards over the medium term, even allowing for a delayed supply response and improvements in energy efficiency.
However, history suggests that, in the near term, commodity prices are unlikely to remain immune to the global economic slowdown that is underway, and the monotonic and sizeable increases in prices witnessed between 2002 and 2007 seem unlikely to continue. But what will this mean for the Middle East oil producing countries?
The slowdown in OECD energy demand (60 per cent of the world total) is clearly already underway and likely has further to go in 2008, not least due to a weakened US economy that is the world's largest consumer.
In addition, Fitch estimates that in 2008 growth in China - the world's second largest consumer - will be the slowest in six years. This is likely to take a further toll on global oil demand. At the same time, although investment in the energy sector has responded quite sharply to higher demand, the time lags to output are long, putting a floor under oil prices.
Fitch expects oil prices to weaken to an average $85 a barrel in 2008 and $65 a barrel in 2009.
The increased uncertainty surrounding the outlook for oil and other commodity prices is reflected in elevated levels of volatility, which are running at 10-year highs. This is complicating monetary policy management and generating more uncertain prospects for EM terms of trade.
All else being equal, were oil prices to fall by 10 per cent Fitch's vulnerability rankings indicate that they would inflict a decline in the total exports of the top 15 oil - exporting EMs equivalent to two per cent of GDP on average. However, for Saudi Arabia and its fellow GCC members, budgets use very conservative prices and a fall of this order of magnitude would be immaterial. Most GCC countries would still run budget and current account surpluses at an oil price of $55.
- The writer is analyst at Fitch Ratings Sovereign Group, London.
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