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The Gravity of Free-Falling Prices

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By Peter G Hall
Vice-President and Chief Economist Export Development Canada

What goes up must come down. What holds in physics is also true in economics, evidenced in recent commodity price plunges. Although crude oil floods the media headlines these days, similar tumbles have come to characterize other industrial commodities as well. What can Newton teach us about commodity prices?

Lots. In the lead-up to the 2008 financial crisis, the price of West Texas Intermediate (WTI) crude oil skyrocketed to USD 145 per barrel. Economic collapse felled prices to USD 30 before year-end. Then, worldwide public stimulus sparked a price surge of 270% over the next two and one-half years. Traders were convinced that supplies were tight, keeping prices high. However, in 2014, WTI began a 65% plunge, which took it as low as $38 in August. For its part, copper climbed from USD 0.80 a pound in January 2000, to USD 4.34 in January 2011, before slipping to USD 2.33 in August 2015. So what gives?

The massive and unprecedentedly coordinated public policy response to the crisis is an often-overlooked driver of commodity prices during the most recent cycle. Apart from the impact that fiscal stimulus had on demand, central bank asset purchases, first in the US, then in the UK, EU and Japan, injected a vast pile of liquidity into the system. Access to cheaper credit spurred emerging market growth and demand for commodities. Stock-piling became common. China’s share of global consumption for commodities across the spectrum is now at least one-third of the global total. In addition, investors funneled stranded cash into commodities in a search for yield, artificially boosting prices.

But as it’s said, there’s no cure for high prices quite like high prices. In 2000, US production averaged about 5.8 million barrels per day, falling to a low of 5mb/d in 2008. High prices then boosted investment, and US crude production shot skyward. In fact, by 2014, the US became the world’s top crude producer, thanks to increased findings and higher well productivity. Shale oil became more economical by employing techniques similar to those developed for shale gas, lifting proved reserves to over 48 billion barrels in 2014. Horizontal rigs now drill multiple wells, some in 11-kilometre stretches. Offshore rigs have moved further out, drilling to depths of over 12 kilometres. Not to be left behind, steam technology helped Canadian crude production climb by over 1mb/d this past decade.

Natural gas production has also benefited from unconventional technologies. The US has known for years about its shale gas potential. Proven reserves in 2005 stood at 5 trillion cubic metres, but thanks to the perfecting of techniques like fracking and horizontal drilling, shale gas has become more economical. Proven reserves ballooned to 9.8 trillion cubic metres by 2014, and US production climbed from 511 to 728 billion cubic metres. Once avidly pursuing imports, the US is now seriously considering gas exports.

Meanwhile, advancements in technology have simultaneously tempered demand for energy. Universally, countries require less than one-half of a barrel of crude oil today to produce $1,000 of GDP, compared with almost one barrel in 2000. Consequently, US consumption has slipped by about 1 million barrels per day since 2007.

On the copper side, producers seeking to cut costs have resorted to recycling. Since the metal is fully reusable, about one-third of the global copper supply is now made up of recycled material. As a result, the world has mined less than 15% of known resources to date. For their part, builders have cut the amount of copper pipe used in the average two-story North American home by 150 pounds, over the past 30 years, by substituting it with cross-linked polyethylene pipe.

The bottom line? Quantitative easing boosted commodity prices, and a consequent wave of investment, together with a surge in recovery-enhancing technology created the supply-demand imbalances that undermined prices. Consumers reacted to higher prices by conserving or substituting. At the same time, anticipation of a large-scale withdrawal of QE will shrink the liquidity that fueled the re-surge in prices. The interplay of these forces has caused prices to fall hard, from which point they’ll rise modestly through the medium term.


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