Commodity Price Volatility to Continue
If 2011 was a wild year for energy and commodity prices, our expectation is that 2012 will be no different, as the news coming from Europe and other parts of the world should remain unsettling. One of the few exceptions to this environment will likely be that U.S. economic conditions will continue to improve and this should temper some of the volatility brought on by other economies around the world.
Recall that in early 2011 the world energy markets were shocked by the turmoil in the Middle East and North Africa in what has been called the "Arab Spring." The movement produced and will continue to produce, sweeping changes across that region of the world as regime changes continue and other, newer regimes start to consolidate. However, what will keep the region, and thus, the energy market on edge, is that the future remains highly uncertain - as the consolidation is not without its problems and the end result is far from simple. Thus, we expect the transition to be very difficult and the end result much different than what many originally thought it would be.
With the Arab Spring already on pace to change the face of the region, the biggest risk for the petroleum market remains the Iranian situation. This will likely become more and more volatile as Iran gets closer to being able to construct nuclear devices and the United States' foreign policy continues to redirect its efforts away from Iraq and toward Iran. The most worrisome scenario is the power void being created by the inability of Europe to solve its sovereign debt crisis and the implications this has for a strong European position in dealing with the Iranian threat.
Thus, we expect 2012 to be a very uncertain year for the energy markets and especially for the petroleum market, which will probably mean that petroleum prices will remain volatile until a more certain scenario develops. Of course, the continued threat of a full-blown European sovereign debt crisis has the potential to ruin the upward momentum in petroleum prices. But once this threat passes, we believe petroleum prices will remain high for the foreseeable future.
Plenty of Demand Pressure in the Pipeline
As we argued in our annual report, there are plenty of reasons for demand pressures to remain strong - for petroleum as well as for overall commodities - for the foreseeable future. As long as emerging market economies continue to grow at a relatively strong pace, the added population entering the middle classes in those countries should fuel demand for commodities and keep prices relatively high.
For example, just the transition of 5 percent of the population of the three most populated countries from the lower classes into the middle classes is estimated to add 140 million new consumers into the world economy. This is an amazing number, considering that these are all middle-class individuals, all with the potential to consume almost everything that other middle-class individuals consume in the rest of the world.
This means that as long as the current worldwide transition seen in the emerging markets continues, the prospects for commodity and energy prices will remain positive, even though we could experience some brief periods of price declines, as particular crises affect this transition. Furthermore, some of these events could actually be positive for some commodities, such as petroleum, even though it may not be great for consumers around the world.
A Crisis with Iran: Bad for the World, Good for Petroleum Prices
One impending potential crisis has to do with Iran - especially taking into consideration the fact that the United States and Iran have been at odds with one another since the Iranian revolution in 1979. But now, this threat is much greater in that Iran seems to be closer to achieving the capability to construct a nuclear device and the United States has ended its intervention in Iraq, which is going to free military resources in the event that the situation with Iran escalates.
Any indication that there could be a conflict between the United States and Iran could send the price of petroleum sky high. While any potential conflict of this nature could be temporary, it would help those countries that export petroleum and hurt consumers across the world. The biggest threat for the world economy of a potential conflict between the United States and Iran, other than the cost in human life, is that a skyrocketing price of petroleum could send the world economy into a recession as consumers across the world feel the pain of higher gasoline prices.
The most recent issue has been the Strait of Hormuz, where Iran is planning military exercises and has up the ante against the United States. These types of events could be very damaging for the world and could set the stage for what is coming in terms of U.S.-Iranian relations.
Monetary Policy Will Remain Expansive
Many have argued that one of the most important reasons why commodity prices have remained so strong over the years has been due to the expansionary monetary policy many of the world's central banks have put in place, particularly the United States and China. It is true that developed countries have engaged in very expansionary monetary policy to protect their economies from sliding deeper into recession. As the conditions that existed in the early part of this century are probably going to remain in place for many years, then we should continue to see countries around the world engaging in rather expansionary monetary policies to keep their economies from going into recessions or, potentially, depressions.
To this list we will probably have to add the Eurozone economy. While the European Central Bank (ECB) has tried to shy away from the policies that have been pursued by the Federal Reserve in the U.S. and the Central Bank of China, the current sovereign debt situation affecting the Eurozone may well convince the ECB to step in and do what other central banks across the world have been doing for some time. This means that monetary policy across the world should not tighten any time soon and will probably remain even more expansionary in the years to come.
This also means that commodity prices will probably retain the support from monetary policy across the world. While we may see some temporary weakness in commodity prices due to specific crises hitting the world economy, the current trend in commodity prices should remain in place for the foreseeable future.
Agricultural Commodities: Alternative Uses
Another important new development over the past several decades is the use of agricultural commodities for alternative uses. Two of the most important new uses is the case of sugar cane in Brazil in order to produce sugar cane ethanol for the transportation industry and the recent use of corn for the production of corn-based ethanol in the United States. These new products and processes have been developed by industry and government policies to help countries reduce their dependence on petroleum imports. This was the case for Brazil when it started developing its sugar cane ethanol project. Brazil wanted to reduce the need to finance petroleum imports with scarce international reserves and decided to subsidize the sugar ethanol industry so it could be used to power motor vehicles and reduce the dependency on petroleum imports.
For the United States, the reason was not to save scarce international reserves but to reduce the dependency on oil imports, an objective that is in vogue today as the political environment commits to reducing the linkages of the domestic economy to Arabian oil. Thus, these policies should continue to help commodity prices as these alternative uses will put pressure on the amount of commodities consumed around the world and help keep the price of these commodities elevated.
Metals: Slower Growth Means Lower Prices
Economic growth is slowing down across the world, and this is pushing metal prices down after a very volatile year in 2011. As long as the current economic conditions persist, the prospects for metal prices should remain under pressure. While there are several reasons to remain upbeat for overall commodity and energy prices, the story for metal prices is somewhat less upbeat. The reason for this is that slower economic growth means lower demand for metals, especially industrial metals - and this translates into lower prices. Meanwhile, it is well known that slower economic growth is not as bad for food products as income elasticity of demand is very small for these products, i.e., if income growth slows down, the amount of food products consumed does not go down as much or some may actually increase due to substitution effects.
Lower economic growth will be damaging for overall commodities. However, we already mentioned the caveats concerning other commodities in the current environment. For metals, the story is different as they definitely depend on demand coming from higher economic growth, especially in emerging market economies. In the end, industrial metal prices should depend on the strength of the Chinese economy. Thus, the faster the Chinese economy grows, the higher metal prices should be.
While some regions of the world - particularly the Euro region - have deteriorated, the prospects for Chinese economic growth have actually improved somewhat during the past several months as Chinese officials have started to undo some policies that were constraining growth earlier in 2011. Thus, as long as these expansionary monetary and even fiscal policies do the trick, the weakening spell for industrial metal prices may be short-lived.
For nonindustrial metals, the story is a bit different, even though they are also affected by economic growth. We believe that central banks across the globe are going to continue to keep current levels of monetary expansion in place, while some may expand upon what they already have. Meaning that nonindustrial metal prices should remain relatively high even though we have seen some correction toward the end of 2011.
Summary and Conclusions
We believe 2012 will be very similar to 2011 in that there are plenty of risks affecting the prospects for economic growth across the world. While today, the U.S. economy is recovering, albeit at a snail's pace, the Eurozone is battling one of the worst crises since the creation of the monetary union. Many, in fact, are wondering if the union is going to outlast its critics. Meanwhile, geopolitical factors are also going to make 2012 very similar to 2011, even though the Arab Spring was something of a surprise for the world economy when it started.
However, the problem in what should determine the market for commodities in 2012 is not what we know today, with some certainty, but likely what we do not know. Back in 2010, nobody expected an Arab Spring to hit the Middle East and North Africa. This means that even if what we know today could shed some light on the future for commodities in 2012, it is likely what we do not know that will determine the fate of commodity prices going forward. The only thing we are sure of is that 2012 is not going to be a boring year as there are plenty of risks stacking up around the world.
Wells Fargo Securities
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