Wednesday, December 14, 2005

The red economy and the red metal

No one doubts that China's dramatic growth spurt over the past 4 years has been the driving force that has pushed commodity prices higher. Even though the Chinese economy is still going at full blast (industrial output is growing 16% yoy), past experience has taught us that there are limits to how much commodity prices can go up.

For one, with higher prices there are more incentives to ramp up production. In addition, price increases blunt demand, as buyers turn to cheaper alternatives (for example, according to INCO, the nickel content of stainless steel has fallen in response to higher prices for this metal).

The market for copper offers a great example of how these forces work, sometimes in a very odd fashion.

While Chinese copper demand has remained robust, in the industrialized nations it has plunged this year due to high prices, leading to an overall drop in world consumption of 1.4%, according to this forecast. According to the IMF, copper prices rose 43% last year and 38% in 2003.

Yet, despite the fact that refined supply is forecast to grow 3.1% this year, prices have risen an additional 36% (up to November).

What gives? Well, in 2003 and 2004 demand --driven by China and other emerging economies--far outstripped supply, depleting existing stocks. With latent demand very strong, the market has needed dramatic price hikes to partially close the demand-supply gap.

Obviously, it's hard to ramp up the production of minerals in the short run. But eventually market incentives lead to the expected response: in 2006, the ICSG forecasts that supply will rise 8%, surpassing demand for the first time in 3 years (although prices will likely stay high while inventories are built back up)