The commodities boom: is the best yet to come?

George Lucas takes a look at the commodities market and asks if 2011 will see the sector flourish.

As senior Australian executives trooped home from Davos, there was a sense they were returning with a far more optimistic attitude than when they left for the annual talkfest at the Swiss resort.

Quite clearly there was a positive note sounded at Davos about global growth in 2011 that would have seemed misplaced even late last year. Even Europe is offering a silver lining.

If that optimism proves prophetic, then commodities – of the soft and hard variety – could enjoy one of its strongest years since World War II. In short, the coalescing of a recovering US, rising demand for coal, iron ore, base metals and oil, and tightening demand and supply balances in agricultural commodities all suggest a commodities bull market in 2011.

The US Federal Reserve kicked off the year with its Beige Book report, taking its cue from business leaders across the country.

It’s an increasingly bright, if cautious, picture. Critically, for a commodities-based economy such as Australia, the Fed’s manufacturing contacts were the most optimistic about a US recovery in 2011.

A re-emerging US economy, which is still the largest economy, will also be the antidote to the measures Beijing and other Asian economies may take this year to slow their economies because of inflation fears – although compared with developed economies, a ‘slow’ 8.7 per cent growth rate for China, as predicted by the World Bank, remains quite respectable.

A recent article in The Economist put it bluntly – commodities are “partying like it is 2008”. Oil prices are now trading around US$100 a barrel and are the highest since October of that year.

World food prices are back to their peak of July 2008, as is copper.

And the story is the same for iron ore – predictions of prices setting an all-time high in 2011, beating the 2008 record.

According to a recent report, the average annual spot market price for iron ore this year will rise to US$153-154 a tonne of iron ore finds with 62 per cent iron content, delivered to China – exceeding the average US$150 price in 2008.

The rise in commodities prices is in line with and confirming the increase in global economic growth and is not just confined to energy and agriculture.

About US$100 a barrel now, oil has been predicted by Goldman Sachs, JP Morgan and other investment banks to keep on rising through 2011, simply because demand is greater than supply as the global economy recovers. Some forecasters are predicting oil reaching US$150 a barrel by October.

One important factor that could deflate the figure over the year is if the US dollar makes a strong recovery and keeps the price of crude at its current level.

If the oil price does make its expected recovery, then supply and demand pressures will flow on to alternative fuel sources, such as ethanol, leading to rising prices in sugar, corn and other ethanol sources.

Then there is food and other soft and agricultural commodities, such as cotton, which is reportedly hitting prices not reached since the American Civil War.

In recent months, agricultural commodity prices have risen sharply in everything from coffee to natural rubber.

These higher prices have had an impact on the margins of producers, who in turn will be passing them on to consumers.

Indeed, food – and food security – has become a hot issue in the past few weeks, starkly illustrated by the riots in Egypt and the annual food price rises of 14 per cent in India and reported shortages of staples such as onions and lentils there.

Recent floods in Australia and Brazil, as well as droughts during 2010 in Russia and Argentina, only add to the scenario that demand for food from a tightening supply line will cause hefty rises in agricultural commodity prices.

It will now be a key topic at the upcoming G20 meeting.

Weather – and commodity – watchers will be keenly scouring the northern hemisphere ahead of its spring planting season and looking for any unseasonal weather patterns that could disrupt food and mineral production akin to what Australia has suffered in the past couple of months.

Like a perfect storm, it appears the stars are in alignment for a bumper year for commodity investors.

George Lucas is the managing director of Instreet Investment.