Financial Markets

Daniel Campana

[RISING COMMODITY PRICES

AND THEIR EFFECTS ON THE
CAPITAL FORMATION
PROCESS]
This report examines the current commodity bull market and its effects on manufacturing

and retail companies, consumers, and the capital formation process. Sharp increases in

commodity prices over the past several months have had far reaching effects on the global

economy. Rising foods prices have sparked uprisings in the middle-east that have already led

to the demise of one country’s leader. Concern over increasing food prices in Asian countries

has prompted speculation of government-funded food subsidies. Meanwhile on Wall Street,

companies such as Kraft Foods and Ford Motor Company have cited rising input costs as the

cause of recent declines in profit margins. Consequently, these companies’ stock prices have

declined. A careful analysis of the conditions and factors that have contributed to rising

commodity prices is needed to understand how the capital formation process will be affected.
 Rising Commodity Prices and Their
Effects on the Capital Formation Process
By Daniel Campana

Introduction

The term “commodity” is used loosely to refer to the raw materials that are used in the

production of goods and services. These materials include, but are not limited to, energy

products, agricultural products, and metals (Commodity Basics, 2006). Commodities are traded

on several exchanges through financial instruments such as futures contracts and options.

Participants in commodity markets include hedgers, who produce commodities or require

commodities for their business, and speculators, who provide liquidity and efficiency for the

market with the hopes of making a profit (Block & Hirt, 2008, p. 395).

Rising commodity prices have been making headline market news for several months.

Among the most popular topics have been the soaring prices of metals, oil, and agricultural

products. Gold contracts are currently trading in excess of $1400, up from a decade ago when

they traded around $260. Copper is currently trading at all time highs of over $400. Copper

contracts traded for around $75 a decade ago (“Back with”, 2011). Crude oil is currently trading

at over $100 per barrel--prices not seen since 2008. Since the beginning of 2010, corn, soybean,

wheat, and cotton futures prices have risen approximately 92%, 44%, 68%, and 162%,

respectively. It’s easy to see how these dramatic increases in prices can threaten manufacturers,

retailers, consumers, and the economy as a whole (Pleven, 2011).

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 In order to fully understand the potential effects of rising commodity prices, we must

first examine current and past commodity market conditions. Next, we must analyze how

businesses and consumers will manage higher commodity prices. We will be able to use this

information to help us understand how the commodity market may affect the capital formation

process.

Commodity Market Conditions

As discussed in the introduction,

commodities of all classes have been subject

to higher prices. The Economist’s

commodity-price index has surged 49%

during the past year (“Back with”, 2011).

What is not widely discussed today is that

the rise in commodity prices actually began

in 2002. This trend can be seen in a chart of

the CRB Index, which tracks the average price of a diversified basket of commodities. Between

2002 and 2008, CRB trended upwards, which is indicated by the upper trend line. CRB began

free-falling during the second half of 2008 until it bottomed out in the first half of 2009. Once

bottomed out, CRB quickly regained its footing and continued its trend upward. The lower

trend line indicates that the overall trend between 2002 and 2011 is still up.

The remarkable drop in the CRB index during the second half of 2008 can be attributed

to the financial crisis that caused a global recession. During this time, the global economy

shrank as fear and uncertainty swept the world’s financial markets.

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 A combination of several factors explains the rise in the CRB index and increases in

overall commodity prices. Among these factors are increased demand for commodities,

decreased supply of commodities, and loose monetary policies of the U.S. government (Tuxen,

2011). It should be noted that many economists agree that these factors will remain in place

during the next several years (Derby, 2011).

Increases in demand cause prices to rise, as buyers become willing to pay more to secure

their purchases. The Organization for Economic Cooperation and Development (The OECD) is

preparing a report on commodity prices for the next G-20 meeting in April. In this report, The

OECD cites increases in global demand for commodities as the primary factor that is driving

commodity prices higher (Di Leo, 2011). Danske Research estimates that approximately 75% of

global growth is driven by emerging markets, such as China and India (Tuxen, 2011). China

and India are already among the world’s most highly populated countries. As their economies

grow at accelerated rates, so do their populations (Di Leo, 2011). Consequently, demand for food

and energy commodities increases in response to this growth in population. The development

and growth of these economies also brings higher demand for raw materials used for building

infrastructure and manufacturing goods. As these economies continue to expand, demand for

commodities of all classes will increase (Tuxen, 2011).

Decreases in supply, relative to demand, cause prices to rise, as scarcity forces buyers to

bid against each other to secure their purchases. Several events occurred during the past year

that have temporarily shocked the commodities market. Unusually dry weather in Russia, the

Black Sea Region, and South America led to poor crop harvests in 2010. During this same time,

Australia experienced flooding that wiped out many its crops (Tuxen, 2011). In recent weeks, oil

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prices have soared over supply concerns arising from turmoil in the Middle East (“Back with”,

2011). Despite being temporary obstacles, these events have had far reaching effects on the

commodities markets.

The recent events that have driven commodity prices higher have disguised underlying

structural headwinds facing the commodities markets. According to Joseph Glauber, the

USDA’s chief economist, U.S. farmers would need to plant eight to ten million additional acres

of corn to restore average corn stockpiles. Glauber claims that farmers would need to plant an

additional three to four million acres of soybeans to restore soybean stockpiles. Any significant

increase in crop harvests would require additional land. Unfortunately, there are only limited

amounts of idle land that can be brought into production immediately and preparation of new

farmland can take years (Pleven, 2011). Similar obstacles are faced by other commodity classes,

such as oil. Although there is spare capacity in current global oil production, oil producers are

often hesitant to increase production. Oil production and exploration is a costly and timely

endeavor. Strict regulations further complicate matters. Until these structural issues are

addressed and supply reaches equilibrium with demand, commodity prices will continue to rise.

(Tuxen, 2011).

Monetary policy and the value of the

U.S. Dollar (USD) have also played a large

role in rising commodity prices. Commodity

prices are measured in USD’s. As the value

of the USD depreciates against other

currencies, the price of commodities rises.

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In other words, there is a degree of negative correlation between the value of the USD and the

price of commodities. This relationship can be seen when we plot changes in the USD index

against changes in the CRB index. Trend lines are used to to further emphasize the negative

correlation between the two indices.

Although a variety of factors affect the value of the USD, U.S. monetary policy

contributes significantly to the strength or weakness of the USD. Monetary policy refers to the

positions that The U.S. governement takes to control the money supply (Block & Hirt, 2008, p.

104-105). The most recent major monetary policy decision has been to engage in quantitative

easing, where The Federal Reserve holds interest rates low by purchasing government securities

in the open market. In order to fund the purchases of these these securities, The Federal

Reserve essentially prints new money, resulting in increased supply of The USD. This in turn

causes the USD to weaken against other currencies. As uncertainty and fear linger in the U.S.

economy, the U.S. government will most likely continue taking monetary policy stances that put

downward pressure on the value of the USD (Kemp, 2010).

Effects on the Capital Formation Process

Commodities prices affect the financial markets in a variety of ways. The immediate

effects of changes in commodity prices are felt by manufactureres and retailers. These

companies may pass these changes on to consumers. These changes, if significant, may affect

the consumers demand for various products. Through a feedback loop, this change in demand

will ultimately affect companies’ abilities to generate profits. Through this cycle, commodity

prices have various effects on the capital formation process.

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 Rising input costs affect companies in a variety ways. If companies are not able to pass

rising input costs on to consumers, their profit margins deteriorate. The Wall Street Journal

reported that as of February 14, 2011, 25% of S&P companies that reported earnings for 2010

posted lower margins in the most recent quarter. S&P reports that average operating margins

for S&P 500 companies is down from 8.95% to 8.68%. Companies such as Ford Motor Company

and Kraft Foods beat analysts estimates of revenues and profits, yet saw their stock prices decline

due to lower operating margins (Cheng, 2011). As commodity prices continue to rise,

companies will be forced to raise prices or operate less profitably.

As commodity prices continue to rise, the likelihood of consumers paying higher prices

for goods and services also rises. To avoid deteriorating profit margins, companies may raise

their prices. Whirlpool and Electrolux recently announced that they will be raising the prices of

their washing machines by eight to ten percent. The price of steel, which is a primary input in

the manufacturing of washing machines, has jumped 20% in the past year. Hanes is currently

talking of raising prices on their cotton garments by up to 30%, to cope with the rapid rise in

cotton prices. The decision of whether or not to raise prices often hinges on the price elasticity

of companies' products. Manufacturers and retailers of consumer staples are usually in better

positions to raise prices than manufactures and retailers of discretionary products. This is due to

the fact that consumers require staple products to survive. Companies that offer premium

products with high consumer demand may also have an easier time passing prices on to

consumers. As commodity prices continue to rise, the profitability of many companies may be

determined by how well they can pass rising input costs on to consumers (“Everyday Higher”,

2011).

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 Consumers are already being affected by increasing commodity prices. Rising oil prices

have forced U.S. consumers to pay over $3.00 for a gallon of gasoline. As consumers are forced

to pay higher prices for various products and services, their discretionary income erodes. This

means that consumers will have less money to spend on products such as electronics,

automobiles, and luxury items (Derby, 2011). Consequently, manufacturers and retailers of

discretionary products will post lower earnings and may even be forced to downsize. These

struggles will wreak havoc on many companies, as their stock prices fall and their credit ratings

are downgraded. As conditions worsen, increasing commodity prices may begin to put a drag on

the global economy and financial system as a whole (“Back with”, 2011).

Conclusion

Sharp increases in commodity prices over the past year have raised awareness of the

potential for looming price increases in products and services throughout the economy. These

sharp increases are part of a long-term trend in the commodity market that began in 2002. An

examination of current conditions in the commodities markets illustrates hows supply and

demand, along with loose monetary policy, have driven commodity prices higher. Although the

future remains uncertain, this examination suggests that recent trends in the commodities

markets will continue. As commodity prices continue to rise, manufacturers and retailers will

be forced to pass rising costs on to consumers and cope with shrinking profit margins. This will

mark the beginning of a vicious cycle in which discretionary spending begins to deteriorate and

many manufacturers and retailers are forced to change the ways they conduct their businesses.

As this series of events begin to unfold, fear will tear through the global economy and financial

systems. This will ultimately change the course of the capital formation process.

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Works Cited (APA)

1. Back with a vengeance. (2011, January 20). The Economist. Retrieved from
http://www.economist.com
2. Block, S. B., & Hirt, G. A. (2008). Investment management (9th ed.). New York, NY:
3. Cheng, J. (2011, February 14). Threat builds on the margins. The Wall Street Journal.
Retrieved from http://online.wsj.com
4. Commodity basics: What are commodities and why invest in them?. (2006, July). Pimco
Investor Educations. Retrieved from http://www.pimco.com/pages/commodities
basics.aspx
5. Derby, M. S. (2011, January 31). Will commodity prices pass through to the core?. The
Wall Street Journal. Retrieved from http://online.wsj.com
6. Di Leo, L. (2011, February 27). OECD sees real demand driving commodity prices. The
Wall Street Journal. Retrieved from http://online.wsj.com
7. Everyday higher prices. (2011, February 24). The Economist. Retrieved from
http://www.economist.com
8. Kemp, J. (2010, October 29). Quantitative easing and the commodity markets. Retrieved
from blogs.reuters.com/great-debate/10/29/quantitative-easing-and-the-
commodity-markets/
9. Pleven, L. (2011, February 17). Outlook for food prices:high. The Wall Street Journal.
Retrieved from http://online.wsj.com
10. Pleven, L., & Wirz, M. (2011, February 3). Companies stock up as commodities prices rise.
The Wall Street Journal. Retrieved from http://online.wsj.com
11. Shipman, J., & Vigna, P. (2011, January 24). Protecting profits at a price. The Wall Street
Journal. Retrieved from http://online.wsj.com
12. Tuxen, C. (2011, February 9). Global inflation scare: Overview. Retrieved from
http://danskeresearch.danskebank.com
13. Tuxen, C. (2011, February 9). Global inflation scare: Commodities super cycle resumed.
Retrieved from http://danskeresearch.danskebank.com
14. All charts are courtesy of stockcharts.com

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