Boom times can’t go on indefinitely

Commodity prices have surged as the Chinese economy has emerged as a major consumer of resources. This has been beneficial for Western Australia – a major commodity exporter.

We caution, however, against assuming that the commodity boom will continue indefinitely. The evidence suggests that, as with all booms, it will give way to a downturn at some stage.

Commodity prices have enjoyed a boom in recent years. The CRB commodity price index has increased by 18.5 per cent over the past year and has jumped by more than 40 per cent over the last five years. This boom is not unprecedented, however.

Commodity prices are very cyclical and booms have come and gone over the years. For example, we saw metal prices boom from 1975 to 1979 as well as 1986 to 1988. In these and many other examples, the boom in commodity prices was followed by a slump. Accordingly, it is appropriate to ask whether the boom will be different this time. Our expectation is that it probably won’t be.

Much of the rise in commodity prices has been driven by strong demand from China, as its economy continues to grow rapidly. China is now the second largest economy in the world and the fastest growing consumer of commodities. For example, China is currently the world’s biggest consumer of steel, zinc and copper, as well as the second largest consumer of oil, behind the US.

Global demand for oil has increased steadily, at around 1.5 per cent a year over the past 20 years. At the same time, Chinese demand has increased at a 6.7 per cent annual rate such that China now consumes 8 per cent of the world’s oil production, up from 4.7 per cent a decade ago.

Looking at commodities other than oil, low stockpiles have boosted prices.

However, as prices rise, supply increases as new projects come on stream and older ones, which are uneconomic at lower prices, are revived. As evidence of this, the Australian Bureau of Agriculture and Resource Economics notes that a record number of domestic minerals and energy projects have recently been completed and that there are record numbers currently committed to or under construction. This is expected to add significantly to Australian commodity production.

Replicate the same situation globally and it is easy to envisage the supply response that will ultimately lead to a normalisation of prices. Indeed ABARE is currently forecasting prices to decline over the coming 12 months for a number of key commodities.

It is often the case in such booms that, by the time the increased production becomes available, demand has already waned in response to the higher prices. In these circumstances, the market moves from excess demand to excess supply and prices retreat significantly; that is, the boom is over.

In the current environment, there is also a risk that the China story is being overplayed. Although China’s economic growth has averaged 8.6 per cent over the past decade and the long-term outlook for the Chinese economy remains healthy (and Australia is well placed to supply resources to China), there is a short to medium term risk that momentum in Chinese economic growth and demand could slow.

Market sentiment at present suggests that any slowdown in Chinese demand for commodities would be felt acutely on global commodity markets and hence could have a significant negative effect on prices.

The commodity price boom has its fundamental basis in above-average global growth (led by China) and low stockpiles. Higher prices will, however, bring forth additional production over time. At the same time, there is the possibility that demand will cool of its own accord. Either of these factors alone could cause commodity prices to retreat. If both occur at the same time, prices could decline substantially. For this reason, amid the current good news for the mining and resource sectors, we caution against the assumption that the boom is here to stay.

• Steven Milch is chief economist at St George.