The Unassuming Economist

From Vox by Rabah Arezki, Adnan Mazarei, and Ananthakrishnan Prasad

As a result of the oil price plunge, the major oil-exporting countries are facing budget deficits for the first time in years. This column goes through the evidence, suggesting that the low price environment is likely to test the relationship between governments in oil-exporting countries and their sovereign wealth funds, at a time when spending is going up.

As a result of the oil price plunge, the major oil-exporting countries are facing budget deficits for the first time in years. The growth in the assets of their sovereign wealth funds, which were rising at a rapid rate until recently, is now slowing – and some have started drawing on their buffers.

Figure 1. Brent crude price, 2014-2015 (US dollars per barrel)

In the short run, this phenomenon is not cause for alarm. Most oil exporters have enough buffers to withstand a temporary drop in oil prices. But what will happen if low oil prices persist, and how will policymakers react? We explore here the fallout from low oil prices on sovereign wealth funds in oil-exporting countries and find that that they have important domestic implications. The impact on global asset prices will depend on the extent of unwinding of the sovereign wealth funds of oil exporters that will not be compensated by portfolio adjustment in other parts of the world that will in turn depend on their economic prospects.

Figure 2. World’s biggest sovereign wealth funds, 2015 estimates

The rise of sovereign wealth funds

In the early 2000s, high oil prices brought about a massive redistribution of income to oil exporters, resulting in current account surpluses and a rapid buildup of foreign assets. Governments established new sovereign wealth funds or increased the size of existing ones to help manage the larger pool of financial assets. The total assets of sovereign wealth funds are concentrated in a few countries. As of March 2015, it is estimated at $7.3 trillion, of which $4.2 trillion are oil and gas related. While there are large differences across sovereign wealth funds, available information on their asset allocation points to a significant share in equities and bonds.

By IMF colleagues: Rabah Arezki and Akito Matsumoto

“It was the best of times, it was the worst of times.” With these words Charles Dickens opens his novel “A Tale of Two Cities”. Winners and losers in a “tale of two commodities” may one day look back with similar reflections, as prices of metals and oil have seen some seismic shifts in recent weeks, months and years.

This blog seeks to explain how demand — but also supply and financial market conditions — are affecting metals prices. We will show some contrast with oil, where supply is the major factor. Stay tuned for a deeper analysis of the trends in a special commodities feature, which will be included in next month’s World Economic Outlook.

Metals matter

Base metals — such as iron ore, copper, aluminum and nickel — are the lifeblood of global industrial production and construction. Shaped by shifts in supply and demand, they are a valuable weathervane of change in the world economy.

There is no doubt about the direction of the prevailing wind for metals in recent years. Prices have been gradually declining since 2011 (chart 1). While oil prices have also dropped, the decline is more recent (prices peaked in 2014), and more abrupt. That said, in both cases the downward pressure on prices result broadly from abundant production from the era of high prices. This is now coming to roost with lower demand from both emerging markets and advanced economies. There are importance nuances however in the relative strength and nature of those forces.

Appetite for production

In the early 2000s, demand for metals shifted from advanced economies in the West to emerging markets in the East. China, by far the main driving force, now accounts for half of global base metal consumption (chart 2). Compare that with China’s more modest consumption of 14% of the world’s oil which is almost exclusively used for transportation.

It is therefore no surprise that metals prices are heavily influenced by demand, and the needs of one economic giant in particular. India, Russia and South Korea have also increased their metal consumption, but remain far behind China. The slower pace of investment in China in the last few years, however, compounded by concerns over future demand amid the sharp stock market decline and currency devaluation this summer, have been exerting downward pressure on metal prices.

Oil supply glut

Oil prices tell a different tale. Our view is that supply factors are playing a bigger role than demand. See also our blog from last December. OPEC’s decision to maintain its level of production and strong shale oil production in the United States — in addition to the large production capacity from earlier investment — have contributed to an unprecedented supply glut.

“Norway’s half century of good fortune from its oil and gas wealth may have peaked,” according to an IMF report. “Oil and gas production will continue for many decades on current projections, but output and investment have flattened out, and the spillovers from the offshore oil and gas production to the mainland economy may have turned from positive to negative. Thus far, economic policy has needed to focus on managing the windfall, and Norway’s institutions have been a model for other countries. Going forward, the challenges will become more complex. The problems of managing “Dutch disease” are not gone, but they will abate, particularly if the recent drop in oil prices is sustained. However, they will be replaced by the difficulties of managing a transition away from what has been an increasingly oil- and gas-dependent mainland economy.”

By Bob Samuelson [The Washington Post]:

First was the dot-com bubble, then the housing bubble. Now comes the commodities bubble. We don’t fully understand the stock market’s current turmoil, but we know it’s driven at least in part by a bubble of raw material prices. Their collapse weighs on world stock markets through fears of slower economic growth and large financial losses.

All bubbles share similar characteristics. There’s a strong, enthusiastic demand for some object (whether stocks, homes, oil or tulips). High demand pushes up prices, which inspires more demand. Prices ultimately reach unsustainable levels so that when spending slows, the bubble implodes. Commodities have now traced this familiar path.

As the Economist reminds us, raw material prices respond to different influences. Weather affects crops; technology (a.k.a. “fracking”) affects oil recovery. Still, despite these variations, prices of many commodities — not just oil — have followed roughly similar trajectories in recent years. They have dropped steeply, according to figures from the International Monetary Fund.

Here are declines for five commodities from 2012 through July 2015: oil, down 48 percent; iron ore, 60 percent; copper, 31 percent; palm oil, 39 percent; and wheat, 37 percent. Many commodity prices have continued to fall.

The bubble formed on hopes that China’s rapid growth would feed an ever-expanding appetite for raw materials, says economist John Mothersole of the consulting firm IHS Global Insight. Demand and prices would remain high indefinitely. Although prices fell after the 2008-09 financial crisis, China’s huge “stimulus” package — intended to offset the crisis’s drag — sent them up again, says Mothersole. China’s demand seemed destined to stay strong, as economic growth would stabilize at a high level.

It didn’t. In 2010, China’s economy grew 10 percent; the IMF expects 6.8 percent in 2015 and 6.3 percent in 2016. Other economists think growth could be lower. As a result, much of the added production capacity — mines and the like — to supply China isn’t needed. “There’s a new commodities era,” says economist Rabah Arezki, head of the IMF’s commodities research. “Everyone was rushing to invest. Now they have to adjust to a new lower level of demand.”

Continue reading here.

Workers carry pipes to install an irrigation line in a coffee farm in Santo Antonio do Jardim, Brazil, last year. (Paulo Whitaker/Reuters)

The study “(…) suggest that while limited exports capacity would result in output losses over the medium term, the potential output gains from a full market access of Canada’s energy products could reach about 2 percent of GDP over a ten year horizon. Actions can be taken on a number of fronts to resolve transportation constraints and address domestic market segmentation. These include diversifying international export markets for Canadian energy products, which would require building pipeline and export infrastructure to facilitate access to non-U.S. markets. Energy integration between Canada’s western and eastern provinces can be strengthened further, and recent initiatives in this direction are welcome. More generally, there appears to be an important scope to increase inter-industry linkages across Canada that would lead to wider sharing of benefits from the energy sector.”