Natural gas prices were down about 20 per cent in 2010 making it one of the worst performing commodities in a year in which most commodities posted significant price increases. The problem with natural gas has been the huge amount of supply that has come on in recent years and the supply pressure does not seem to be abating as we enter 2011. In the face of a very harsh winter in both North America and Europe, natural gas has not reacted and now seems very hard pressed to push through the US$5 per mmbtu mark. If it fails to push through these levels over the next few weeks then the outlook for the rest of the year is for prices to remain at depressed levels based on current market dynamics. This may not be good news for T&T but it is what it is and so we have to play with the cards in our hand.
Crude oil seems to be a different story altogether. The first thing that investors should note is that there two benchmark prices for crude oil. There is heavier Brent crude and the lighter (better quality) West Texas Intermediate (WTI). The price that is often quoted and followed in T&T is WTI which has been trading around the US$90 region for the past few weeks. Traditionally Brent crude trades at a discount to WTI yet as we saw in 2008 and again today in 2011 Brent crude is in the US$98 region. The differential in price between the two benchmarks is usually around US$2 in favour of WTI, however, today we are seeing as much as a US$12 differential in favour of Brent crude which is effectively a US$14 reversal from the norm.
Such is the vagaries of the oil market that there are many and sometimes conflicting reasons for this disparity. The main reason put forward is that there is surplus supply of WTI in the US. The surplus of WTI is not reflected elsewhere and Brent is more reflective of global prices. The fact is that oil prices have been up 14 percent over the course of 2010 and the sentiment remains for higher oil prices.
The fundamental basis for higher prices rests with the global growth story backed up by positive economic numbers coming out from the US. Setting aside all the rhetoric and innuendo appreciate that oil prices ran up to US$147 and then fell to US$30 before rising again to the US$70. These moves took place in a matter of months so it should be clear that demand and supply are not the only factors influencing price as global demand did not fall from 90 to 45 million barrels per day during the height of the financial crisis.
Commodity Price Inflation
The oil price dynamic should be of concern today as it was back in 2007 for the simple reason that 2007 was the precursor to the economic collapse that took place in 2008. Recognise that the key input in any level of economic growth is energy and the key input in energy is oil. As oil prices rise so too will the price of gasoline, heating oil, and every other by product that is consumed. These increased prices are either passed onto consumers, which then reduce disposable income in other areas, or they are absorbed by companies that then see a reduction in their profit margins, which is then reflected in the share price. Some analysts have suggested US$120 oil as a tipping point. We will wait and see.
A key side effect of rising oil prices is its impact on food prices. Higher oil prices increases the cost of fertilisers, the cost of running mechanical farm equipment and the cost of transportation and storage. In addition there is the substitution effect where corn, soya and sugar are used to produce bio fuels instead of being brought into the food chain. Severe and abnormal weather patterns presents another issue that has and will continue to impact food prices. In 2010 there were brush fires in Russia that impacted wheat prices. There were floods in Pakistan and most recently Australia. Supply and demand are not the only factors that impact the price of commodities. Commodities are priced in US dollars and the "price" of the US dollar relative to other currencies are directly impacted by the actions of the US Federal Reserve. The Federal Reserve's decision to introduce US$600 billion into the market up to June 2011 as part of a monetary stimulus program caused the US dollar to fall. It has also pushed money flows into stocks, commodities and emerging market economies.
This has fuelled strong inflation pressures in the emerging market economies; a definite problem for these countries. While the official inflation rate in China is 5.0 per cent. Two increases in the minimum wage in one year the latter over 20 per cent suggests a much more dire circumstance. Recognise that in poorer countries the amount of money spent on food and basic commodities is much greater than in more developed countries. As a result inflation pressures coming from higher commodity prices will have a disproportionate impact on these countries very often requiring a political response.
The average age of the Indian population is in the mid 20s. That represents huge growth potential for the Indian economy in years to come but appreciate that such a young demographic is also ill equipped to handle the impact of sharply higher inflation levels. This is a scenario that could easily derail the global growth story; especially where it is taken for granted that emerging market growth is all but guaranteed. There is currently a worrying undercurrent of activity that is covering the globe and this must be addressed before it is too late.
Global Unrest
Over the past two months there have been protests in Chile over higher gas prices, riots in Algeria over increases in basic food prices, the ousting of the Government in Tunisia on the back of high unemployment and rising food prices, similar riots have now spread to neighbouring Egypt as this article is being written. There is also unrest in Morocco and Yemen. There have been sparks of protest in Jordan and Lebanon. The risk of protest spreading across neighbouring North African and Arab states is something worth monitoring. Recall the impact of the overthrow of the Shah of Iran in 1979 on global markets. India with 18 per cent food inflation last month has had to deal with some unrest and Bangladesh faced similar to the point where their stock market was shut down.
Price controls on various food items have been introduced in Ethiopia, Sri Lanka, Russia and India while South Korea have sought to impose a freeze on electricity and gas prices in an attempt to curb inflation.
Add to the list the continuing restless in peripheral European countries on account of austerity measures to deal with mounting deficits. The coalition government in Ireland seems to have collapsed; the UK coalition will have their time in the sun when they start to introduce their proposed cuts. To piece it all together you should recall last year when discussing the willingness of Governments to engage in running huge deficits and subsidies I warned of the risk of social unrest down the road. Add to that the further impact of higher prices due to inflation and investors should recognise that this is a situation that needs careful monitoring.
What makes the situation more complicated is the argument that had it not been for the actions of the US Federal Reserve the US could have been facing a risk of deflation and even with global inflation a concern the US is recording a very tame sub 1.0 per cent inflation rate. Overall this means that the policy responses of different countries are likely to be at odds with each other. During the financial crisis of 2007/08 a key element in managing the risks was a coordinated approach that basically spanned the entire globe. Going forward such cooperation is unlikely to be repeated but the level of interconnectedness of the global financial system remains in tact. The 2007 version of the global financial crisis started with the rather mundane issue of sub prime loans in the US. Today we have a number of isolated hot spots with different risks. Note I am not predicting another crisis, not yet anyway, but there are enough issues around the globe to require vigilance.
Ian Narine is a broker registered
with the SEC