Eriko Takahashi (JPO)
1st July, 2009FASID
Development Assistance Survey Unit (DASU) Study Group Meeting
Conducted Jointly with the World Bank Tokyo Office
The World Bank and FASID jointly held a seminar on 15th June, 2009, inviting Dr. John Baffes, Senior Economist
at the World Bank, as the speaker.

Dr. Baffes gave an informative presentation on recent trends in commodity

markets and where they will be heading in the long-run.

The presentation was followed by an active discussion

amongst the participants, which included government officials, representatives from various development
organizations, embassies, academic institutions and private companies, and students.

1. Date: 15th June, 2009 @ 13:00-15:00
2. Venue: World Bank Tokyo Office - Large Conference Room
3. Speaker: Dr. John Baffes (Senior Economist, Development Prospects Group, World Bank)
4. Theme: Commodities at the Crossroads
5.1 Today’s presentation
Since the turn of the century, especially after 2003/4, global commodity prices soared, peaking inmid-2008.

Issues regarding commodity price development, which in recent years had been considered a topic ofglobal interest, seem to have been put on the back burner following the September 2008 financial crisis.
However, commodity price-related concerns are still present, and for many developing countries in particular, theyremain an important issue.
The objective of the presentation is to identify the factors that fueled the commodity price boom of thepast few years, and to predict where commodity markets will be heading in the long-run.

Characteristics of Different Commodity Groups in the Post-WWII Period

Metals – Prices steadily increased until the early 1960s, reflecting postwar reconstruction in many countries.
Interestingly however, prices gradually decreased for the next forty years, by a yearly average of 1.4-1.5%. In
early 2002/3, metals showed the most abrupt boom compared to other commodities.
Energy – Prior to the 1973 oil shock, energy prices were stable, due to the fact that crude oil prices were handledby oil companies that negotiated agreements with countries for which they extracted the oil.

The first andsecond oil shocks of the 1970s caused oil prices to soar, and in the mid-1980s they went down again.

Energyprices increased dramatically in the recent commodity boom.
Agriculture – Agricultural commodity prices have generally shown a downward sloping behavior in the post
World War II period, apart from three specific periods when prices boomed distinctly; during the Korean War, theconsecutive oil shocks and the recent commodity boom.

Key Characteristics of the 2003/4-2008 Commodity Boomz

Previously, different commodity prices had followed different paths; however, in the most recent commodity
crisis, all commodity prices increased and decreased in tandem, showing similar behavioral trends, unlike
previous booms.

zComparing the Manufactured Goods-Unit-Value (MUV)-deflated world prices in dollars to the CPI-deflated
prices in domestic currencies of the three commodity groups (i.e. accounting for effect of the real exchangerate), it is evident that prices in domestic currencies of developing states increased much less than world
prices.

zMonth-to-month absolute percentage changes in agricultural commodity prices over the past twelve months
have demonstrated, on average, three times the amount of price volatility than that of the past 25 years;
similar results were obtained for other types of commodities

Factors behind the Recent Commodity Boom

There are many factors that have been identified as the key elements in driving the recent commodity
boom, including strong and sustained growth particularly in developing nations, underinvestment in the past in
extractive commodities, a weak dollar, fiscal expansion, investment fund activity, adverse weather conditions andother geopolitical reasons. Although it has been argued by analysts that all of these aspects have contributed tothe price boom, there have been exaggerations and misrepresentations.

On the other hand, the fundamental

causes of the 2008 price spike are not fully understood.
☆Increased Income and Dietary Changes in Developing Nations (e.g. China & India)

For the most part of last 40 years, the majority of commodity demand has increased, on average, at arate higher than the population growth rate and lower than the GDP growth rate, suggesting that as long as such
trends continue, we will not suddenly run out of commodities in the near future.

Furthermore, regarding theglobal consumption of different commodities (energy, industrial metals excluding precious metals and food)adjusted by GDP, it has been confirmed that the intensity of commodity demand has been declining

with GDP

growth, particularly for energy and food, suggesting that technological progress has increased the efficiency ofcommodity use.
A popular notion thought to be a key factor behind the recent food price boom has been the increased
demand for grains by China and India for consumption purposes.

However, when the grain consumption for thethree main types of grains, rice, maize and wheat, are combined for China and India since 1995, although an
upward trend can be confirmed, there is no significant difference in the trend before and during the commodity
price boom.

Moreover, when the grain consumption of the two countries is taken as a share of global grain

consumption, interestingly, it actually demonstrates a decreasing trend in the past couple of years, hence thisrefutes the idea that the grain absorption of the two countries are causing prices to increase. The decline ofglobal grain stocks to levels as low as mid 1970s’ standards has been identified as a key factor that contributed tothe grain price boom.
☆Decline in Yield Growth and the Increased Production of Biofuels

There is discussion that the rates of yield growth have been declining since the green revolution,
especially in food commodities, causing food prices to increase.
but yields for cotton and maize have in fact increased .

This is true for most agricultural commodities,

The large-scale adoption of genetically modified cotton

by China and India has caused yields to double, and as for maize, there have been intensive inputs of the crop tomeet high biofuel demands, especially in the U.S.
The idea that the substitution of food commodities for biofuels production caused the boom is subject todebate.

Of course, the diversion has contributed to the boom, but not to the extent that it has been reported byanalysts and economists.

For example, when the land used for the production for U.S. ethanol is taken as a shareof U.S. corn production area, it accounts for almost 30%, which seems relatively high; however, when expressed
as a percentage of U.S. grain area, it goes down to 8-9%, and as a percentage of world grain area, it accounts for
only 1-2%. Therefore, it is important to keep facts in perspective and consider both their short and long-term
effects on commodity prices.
☆Escalating Energy Prices and the Drying-up of Extractive Resources (e.g. Crude Oil)

Escalating energy prices have been identified as a key contributor to increased agricultural commodity
prices, since agriculture is an energy-intense industry. The long-run price transmission elasticities from energy
to non-energy commodities based on OLS estimates show that agricultural commodities have a reasonably highelasticity of almost 0.3, implying that a 10% increase in energy prices leads to a 3% increase in agricultural prices
in the long-run.
From the late 1980s until the early 2000s, investment in oil and gas by major U.S. multinational
companies was low, but the expected correlation of high prices was not observed until after this period.

The

crucial question to fundamentally understand the causes behind the commodity boom is why did it take so long forenergy prices to pick up, given the extensive period of low investment in such commodities?

There are threemain reasons for this.
1.

The global crude oil consumption has been declining, and corresponding to this decline, the share of nuclear
energy has increased, going from 1% in 1970 to 7% in 2000.

This implies that crude oil consumption isslowly being substituted by nuclear energy, in other words, nuclear energy has taken away some of theenergy demand of crude oil, thus leading to the underinvestment in extractive energy commodities.
2.

The excess capacity of crude oil with the collapse of the Soviet Union was another factor which contributed
to the underinvestment in energy commodities. After the oil crises of the 1970s, there was a huge sparecapacity of crude oil.

However, due to inefficient production and consumption, which implied that oil

prices did not reflect market forces, this capacity remained unutilized. When the Soviet Union collapsed in1989, although prices were properly reflecting market forces, the income within Former Soviet Union
countries declined, so crude oil consumption became inefficient.

3.

The chain of financial crises of the 1990s (e.g. South America, East Asia, Russia etc) brought the real GDP
growth rate of both developed and developing countries down in the early 2000s and an explosion of growth
immediately after.

The amount of known reserves of world crude oil suggest that despite the fast rising demand for oil
consumption, known reserves have grown just as rapidly.
The problem with the measurement of reserves is that some countries report reserves that were measured
in earlier years and simply make adjustments to the statistics, which leads to small spikes appearing when middle
income countries make alterations. Consequently, the U.S. Geological Survey has attempted to modify the databy making two major adjustments.

Firstly, according to scientists and analysts, when an oil field is developed, it

is often the case that the initial estimates of the oil reserves by regional geologists are 30-40% lower that theactual oil extracted; therefore, the U.S. Geological Survey took this factor into account and included a new term
“expected reserve growth” in their survey from 1996.

Secondly, they made amendments to the bureaucratic

estimates of oil reserves by mapping the regions in question with data based on both bureaucratic estimates andscientific estimates by geologists and engineers, and revised the data.

Taking the two major adjustments intoconsideration, the U.S. Geological Survey predicted that 76% of total crude oil resources is still existentunderground, which is another indication that the world is not going to run out of resources abruptly.
The issue does not lie in the amount of oil reserves, but rather in where the supplies are coming from.
Data for the last 25 years on global crude oil production reveals that the share of offshore sources (i.e. deep sea,high cost areas, etc) is increasing.

This suggests that the oil consumed in the future will be more expensive thanin the past, which justifies the reason as to why we have shifted to a new equilibrium of energy prices; it isestimated that we will probably have an equilibrium oil price of perhaps 3-4 times higher than what weexperienced in the 1980s through the 2000s.

Five Types of Speculative Activities in the Recent Commodity Boom

Excessive speculative activities have been blamed by several analysts and economists to have attributed
to the recent commodity price boom; such activities have been categorized into five different types and are listed
below.
1.

Speculators in future exchanges

2.

Speculators who “corner” markets

3.

Hedge funds in search of short term returns

4.

Speculators holding stocks

5.

Investment, pension and wealth funds
In Dr. Baffes’ opinion, the last type of speculation may have been one of the main causes of the recent

boom, especially the 2008 spike.
affected commodity prices.

Investment by pension funds, wealth funds and other funds has evidently

In recent years, most equity and bond markets have started to co-move, and thecorrelation amongst them have become much stronger than before (e.g. Asian equity markets affect Europeanequity markets, which in turn affect U.S. equity markets).

Since investing in highly correlated assets can incur

high risks, investors needed to diversify their assets, and commodity markets were a class of assets that were notcorrelated with existing classes of assets.

Although for such funds, allocating 2-3% of their portfolio tocommodities was a minor investment, their actions affected commodity prices significantly.

Commodity Markets in the Long-term – Projections and Forecasts

Apart from polices and technological changes, the increased link between energy and non-energy
commodity prices, biofuel mandates and subsidies, intensified investment fund activity, economic growth
especially in developing countries and changing weather patterns will become the dominant forces that will shape
the long-term outlook of commodity markets.

In real terms, commodity prices are expected to average about

50% higher than those in the late 1980s until early 2000s. In terms of crude oil, prices are estimated to increase
to about $70-75 a barrel in current terms, about three times that of the 1980s.

Q & A Session
Why the Metal, Energy & Agriculture Markets Moved Together in the Recent Boom

The three commodity markets are believed to have moved together because of demand forces fromdeveloping countries that acted on metals and energy commodities but not on agricultural products.
Agricultural commodity prices adjusted later due to the energy and non-energy commodities link.

Implications of Increased Market Demand

There is certainly a high demand in the metal and energy markets.

However, as for agriculturalcommodities, the demand has not increased significantly subsequent to the latest boom in comparison to theprevious decade.

Put in economic terms, it is a demand issue for metals and energy, but rather a cost issue for

agriculture alongside the diversion to biofuel production. There is still a need to investigate the link between
energy and non-energy commodities, but if it is the case that with higher energy prices there is a stronger
correlation between the two types of commodities, whatever price behavior we may see in energy markets may bereflected in the price behavior of agriculture markets in the future; further econometric analysis on the relationshipbetween the two commodity groups is essential for forecasting the long-run prospects of commodity markets.

Means of Improving Food Production Efficiency

We have to think to ourselves whether we are actually facing a food shortage issue.
diversion from food to biofuel production is occurring.

It is true that aHowever, looking at the rice market for example, stocks

were in fact lower 3-4 years prior to the recent commodity boom, and there does not seem to be a supply issue atpresent.

In poor areas like in African countries, it is more of an income issue – it is not that they are sufferingfrom a shortage of agricultural products, but rather that they cannot afford such products.

Comments on Commodity Market Forecasts and Future Policies

It is expected that although commodity prices will eventually stabilize, we will probably be facing
higher price volatility than before the recent boom.

With regards to the prospects of stock holding as a pricestabilization mechanism, it is doubtful that this will work given all the past failed attempts.

Prospects of Introducing a Taxation System

It may be possible for a taxation system to be introduced as a means of stabilizing commodity markets
in the long-run, for example, the Tobin taxation system or maybe a minimal transaction tax that could impose abehavioral constraint for large transactions, especially in the futures markets.
system may also be potentially effective in stabilizing commodity markets.

Imposing a progressive taxation

However, policymakers will need toconsider associated issues upon the introduction of such taxation systems, for instance, how imposing constraints
in one area will lead to people making transactions in another area, or how the tax will be collected and allocated.

Additional Informationz

Most of the presentation material has been reported in “Global Economic Prospects 2009: Commodity
Markets at the Crossroads” (www.worldbank.org/prospects/gep2009/)

z

The latest Global Economic Outlook update was released on June 22nd, 2009(www.worldbank.org/prospects/)z

For more details, please contact Dr. John Baffes at jbaffes@worldbank.org