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March 09, 2009

Will commodities spike again?

In his column for the Economic Times, Ruchir Sharma argues why it would take a long time for the commodities ‘super cycle’ to revive.
Expectations of ever rising oil prices are reflected in both the forward curve and in analysts’ consensus expectations. For example, oil for delivery in three years’ time is trading at close to $70 a barrel compared to the spot price of around $45 a barrel. Meanwhile, oil analysts forecast the price to be even higher at $90 a barrel in 2012.

..However, China suffers from an over-investment problem, with an investment-GDP ratio running at a very high level of more than 40% for many years. Much of the investment is directed towards the sagging export sector and therefore Chinese investment demand is highly unlikely to revive anytime soon. China needs to reorient its economic model more towards domestic consumption and reduce its reliance on exports and investment. Japan was able to successfully make that transition in the early 1970s when its per capita income was similar to China’s current levels. Regardless of whether China takes this route or not, it’s likely the commodity intensity of its growth model will decline from the prevailing lofty levels.

For oil, where arguably the maximum residual bullishness exists, Chinese demand is not so paramount anyway. China consumes 9% of global oil production while the OECD area represents more than of 50% of world demand. The demand for oil is highly sensitive to global growth and given the expected contraction in global GDP this year, oil demand is expected to shrink by more than a million barrels a day in 2009.

It’s no surprise then that Opec spare capacity is fast rising back to 2002 levels, reducing the cartel’s pricing power. While compliance regarding production cuts by Opec members has reportedly been good so far, the incentive for producers to cheat and increase revenues remains high in the challenging global environment. Outside of Opec, countries such as Russia would obviously like to produce at maximum capacity to earn some badly needed dollars and ride out their credit crisis.
Arun Natarajan is the Founder & CEO of Venture Intelligence, the leading provider of information and networking services to the private equity and venture capital ecosystem in India. View free samples of Venture Intelligence newsletters and reports. Email the author at