A demand-side explanation of oil and other commodities’ prices

Luis F. Dumlao is associate professor of the Department of Economics, School of Social Sciences at the Ateneo de Manila University. The views presented here are his own and not necessarily those of his institutional affiliation. This article was published in the Opinion Section, Yellow Pad Column of BusinessWorld, June 5, 2006 edition, page S1/5.

The global price of oil continues to linger around US$70 per barrel, and it shows no immediate sign of going down. We explain this through two ways: supply and demand.
On the supply side, it was first suspected that oil- producing countries are not producing enough, pushing up the price. It was later argued, production is sufficient, but there is not enough infrastructure to refine the oil. But why did the level of production and current infrastructure suddenly become not enough for the world? We answer that by looking at the demand side.

The phenomenon in the oil market is not unique, as other commodities’ markets follow suit. For instance, the price of gold has increased from US$380 to about US$700 in the last two years. The price of silver is already 70 percent higher compared to the price at the start of the year. Prices of nickel and copper are at all-time record highs. Surely, each market has its unique supply side reasons. But is there possibly a common reason why all these commodities’ prices increase at the same time? There are demand-side explanations that are common to all.

The first is what most readers know—the awesome growth of two big economies that comprise much of Asia, much of the world’s economic growth, and much more of the developing economies. Because China and India grow at high rates, their oil and other commodities requirements increase. And because they are so big, world demand increases to the point of increasing prices. Undoubtedly, their economies are big enough to affect world prices.

But their growths do not sufficiently make up much of the surge of demand. Even if they have grown close to 10 percent in the past five years, the rest of the world has not grown as rapidly. For example, Japan is only starting to grow again. The US, though growing, is still not the same economy as in the 1990s. Europe’s growth is not extraordinary either. Africa continues to stagnate. Overall and on average, the world’s economy has been growing by 3 percent annually in the last three to four years. Hence, the yearly price increase of these commodities should correspond to such modest growth. But prices have been significantly increasing more than the world’s growth rate, by at a least a factor of three. So there has to be more than the demand-side explanation.

Another explanation has to do with the prevailing macroeconomic ideology of the times. That is, inflation targeting consistent with the neoclassical school of macroeconomics. The economic ideology results in a simplified discretionary policy that goes like this. First, one asks: what should be the target inflation? The answer is: The target inflation should be low enough to avoid deflation. This means inflation rates of as low as 0.5% to 1.5 percent for developed economies and about 4 percent for developing economies like the Philippines. Second, one asks: how does one hit this target? One of the most popular discretionary tools to hit such target is what economists call the Taylor rule. More on the Taylor rule later.

Third, one asks: how can one adjust targets to a more ideal inflation, say from 5% to 2%? The answer is still related to the Taylor rule. According to this rule, the central bank targets inflation by changing the expending behavior of consumers and business by affecting the nominal interest or the interest that banks quote that we see in newspapers—newspaper interest. It goes like this.

Say that the competitive market rate of return or the rate of return investors require is 2%. Say that the real interest or the actual rate of return investors get is also 2%. Say also that inflation is at a previous target of 5%. Then newspaper interest is 7%; 2% real interest plus 5% inflation equals 7%.

Suppose the central bank changes its inflation target from 5% to 1%. The policy is to increase newspaper interest to, say, 8% so that real interest becomes 3%; 8% newspaper interest minus 5% inflation equals 3%. The justification is that when real interest is greater than the competitive rate of 2%, (1) the incentive for holding on to capital savings is higher than usual; (2) economic agents expend less than usual; (3) and this pressures inflation to go down to the new target.

Suppose that inflation hits the new target of 1%. The policy is to decrease newspaper interest to 3% so that real interest once again equals the competitive rate of return of 2%; 3% newspaper interest minus 1% inflation equals 2%.

Ultimately, inflation goes down to low and stable rates that one could not have imagined in the 1970s. As a consequence, global newspaper interests also go down to rates unimaginable in the 1970s. Good things happen when interest rates are low, but bad things also happen. One bad thing is that finance capitalists transfer their money away from debt instruments.

As to where they put their money, they can put them in emerging markets like Southeast Asia, increasing the demand for financial instruments in the region, improving the performance of such emerging markets. But because the performance is due to non-fundamental things—not due to fundamentals like increase in productivity—booms happening in emerging markets would tend to behave like  bubbles that eventually burst. Remember the Asian financial crisis?

Finance capitalists can also move their funds to wealthier economies’ stock markets. Doing so increases the demand for stocks, then improves the performance of stock markets, and then contributes to what Allan Greenspan called “irrational exuberance” in stock markets.

But with the Asian financial crisis and the stock market crashes of around 2001 in mind, finance capitalists are unlikely to be as aggressive in placing their money in the same markets. So they put money in commodities markets. This so-called “investment” increases demand and increases commodities’ prices. Speculators see the increase of price, and they buy precisely because of the price increase—not because of fundamentals. It now becomes a vicious increase of price. This is a big part of the reason for the surge of prices in commodities markets.

Here now is a “caveat.” The exuberance about opening Philippine mining fields because of all-time highs in commodities’ prices like copper might be irrational: a bubble meant to burst. This is not to mention the environmental consequences.

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