The Prices Prospects for Latin

American Export Commodities

Christopher L. Gilbert(GRADE and Department of Economics, University of Trento, Italy)

XXIV Meeting of the Latin American Network of Central Banks and Finance Ministries, Inter-American Development Bank, Washington D.C.

19-20 October 2006

1. Context and Basic Principles

Context

• The first decade of the new century has surprised by witnessing a commodity price boom – including the prices of many commodities important in Latin America.

• The boom has been far from general – energy and metals have benefited but many agricultural commodities have seen only limited price rises.

• Currently, energy prices are declining while metals remain at peak levels.

• Most commentators link the boom to rapid Chinese consumption growth. This is probably correct but makes it difficult to project how long prices will remain high.

The Standard Model

p

q

D D’ S

S’

p0

p1

Demand shifts from D to D’ leading the price to rise from p0 to p1.

Capacity is added at near the left side of the industry cost curve

shifting the supply curve from S to S’. The final price is unchanged at

p0.

New production

capacity is added

towards the lower

end of the industry

cost curve.

Is There a Permanent Component?

p

q

D D’ S

S’

p0

p1

p2

If new production (capacity) has higher costs than much existing production (capacity), the supply curve will intersect the new demand curve D’ at a higher price p2. The price rise has a permanent component.

In this case, some

new production

capacity has costs

above the industry

minimum.

Price Reversion

High prices may be viewed as • A jump in the price trend, i.e. a permanent shock – there

will be no reversion to lower levels.• An autoregressive or cyclical movement, i.e. a persistent

transient shock – there will be reversion but it may be slow.

• An outlier, i.e. a non-persistent transient shock (e.g. the effect of the first Gulf War on oil prices) - reversion will be very rapid.

In general, we should expect all three elements to be present – the issue is, what are the relative proportions.

I use a statistical model which cab isolate these three different price impacts.

2. Commodities

The Commodities

I consider a group of 8 commodities of importance to Latin America

Energy: Crude oil and coal

Metals: Copper and iron ore

Tree crops: Arabica coffee (Brazilian)

Annual crops: Maize, Soybeans and Sugar

For four of these commodities (coffee, copper, crude oil and sugar), I have been able to annual time series of consistently-measured prices going back for over 150 years.

Export Shares in Excess of 10%

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Mex

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Oil

Soybeans Copper

Sugar

Coffee

2001-04 average

Source: U.N. Comtrade Database

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CopperWTICoffeeSugar

• Note the sharp downward trend in sugar prices per-WW1. Other prices show less evidence of a trend.

• Oil prices were flat from 1880 to 1970 – the effects of the oil producer cartel.

Post-WW2 Energy and Metals Prices

The iron ore price shows a clear downward trend.

The series for coal and (effectively) crude oil are too short to be very informative.

All four prices show a sharp jump (partially reversed for crude oil) over the past three years.

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Post-WW2 Agricultural Prices

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CoffeeMaizeSoybeansSugar

Maize and soybeans move closely together.

Sugar is the most volatile of this group.

The figure does not suggest there is anything exceptional in current or recent prices.

3. The Price Trend

Time Series Price Models

The models have a common decomposition:

lnPrice = Trend + Cycles + Autoregression + Interventions

• Here xt and yt are short and long cycles and zt is an intervention.

• The interventions model permanent shifts in the price level. The copper price shifted down dramatically after WW1 because of changes in mining costs. The other interventions (coal, copper, iron ore) relate to the current price boom in metals and energy. (The coffee equation also contains 3 outlier dummies – 1864, 1977 and 1986).

1t t t t p t tp x y p z

Modelling the Price Trend

• We model dollar prices deflated by the U.S. producer price index.

• Relative to this index, coffee and copper (adjusted for the post-WW1 level change) are trendless.

• Coal and the annual agricultural commodities (maize, soybeans and sugar) all have a clear downward trend.

• We model these trends as stochastic

• Here, t is the drift, which may vary over time. t and t are disturbances.

• If t = 0 for all t the trend is deterministic. If t = t = 0 for all t (this is true for sugar), the trend is linear.

1

1

t t t t

t t t

Estimated Trends – Coffee and Copper

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AcutalTrend

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ActualTrendThe copper trend falls by 45% in

1919 and rise by 50% in 2004.

Prices trended down pre-WW1 and up post-WW2 until the mid-’70s. Thereafter the trend was negative but appears to jump up sharply from 2004.

The post-WW2 coffee trend was positive until the ’80s, but then negative.

It now appears to have flattened.

The Oil Price Trend

• On post-1970 data, the oil price appears to be a random walk with drift (4.5% p.a.).

• This implies that there is no statistical basis for forecasting anything other than a steady upward drift in the price. Prices are equally likely to rise further (relative to this trend) as to fall back.

• This does not imply that one cannot forecast price – but this must be on the basis of analysis of likely future supply-demand balances and relevant political factors.

• (A slight improvement in fit is obtained by modelling the price trend as smooth with shocks impacting the drift, i.e. t = 0 and t 0. I prefer the simple random walk model).

Trend Results

• Copper and sugar prices are seen as well above trend (41% & 30% respectively) being above trend, with coffee and maize beneath trend levels.

• The largest share of price increases over the past years is attributed to a jump in the trend price.

• This is especially true of iron ore and petroleum where there is no statistical evidence for mean reversion.

• Sugar is the only one of the agricultural commodities to have seen a rise in trend price.

• The evidence is therefore consistent with price rises being largely permanent.

• The large permanent component in commodity price changes complicates governmental decisions. Standard advice to consume ones “permanent income” is neither convincing nor useful.

2006 price (Jan- Sep)

Price trend (2006)

Price trend (2003)

Price relative to

2006 trend

2003 trend

Coal $53.72/ton $53.72/ton $39.33/ton 0.0% 36.6%

Coffee 101.4c/lb 110.3c/lb 107.5c/lb -8.0% -5.7%

Copper 300.1c/b 212.3c/lb 112.3c/lb 41.4% 167.3%

Iron Ore $77.35/ton $74.48/ton $39.11/ton 3.8% 97.8%

Maize $110.54/ton

$110.49/ton $117.52/ton 0.0% -5.9%

Petroleum $67.68/bl $67.68/bl $35.91/bl 0.0% 88.4%

Soybeans $212.82/ton

$233.98/ton $250.08/ton -9.0% -14.9%

Sugar 15.8c/lb 12.2c/lb 9.3c/lb 30.2% 69.7%

4. Cycles

Price Spectra

Cyclical shocks are transitory.

We can use spectral analysis to obtain an idea of the extent of cyclicality in the data. The advantage of spectral analysis is that there is no imposed model.

Coffee shows a long cycle at 17 years and shorter cycles at 5 and 7 years.

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Years

17 years

7 years

5 yearsCoffee

We estimate spectra for the 3 commodities for which we have long time series. Spectra are estimated on differenced series using a 4 year “tent” window.

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13 yearsCopper

5 years6 years

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Years

Sugar 9 years 4-5 years

The copper spectrum shows a clear peak at 13 years, and shorter cycles with periods of 5-8 years.

The sugar spectrum has power at 4-5 years and again at 9 years – probably a harmonic of the shorter cycle.

Cycle Models

• The cycles are modelled as

where x is the cycle frequency and x,t and x*t are two

mutually uncorrelated white noise disturbances with zero mean and common variance.

• The long cycle yt is defined in the same way.• Coffee and copper (long time series) both show

evidence of a short and a long cycle. Coal and petroleum do not show evidence of any cyclicality, although petroleum is autoregressive. The remaining commodities have a single cycle and no autoregression.

• I illustrate the analysis using coffee and copper.

,1** *

,1

cos sin

sin cosx tt x x t

xx tt x x t

x x

x x

Coffee Price Cycles

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Short CycleLong Cycle

"Coffee Crisis"

End of ICA Controls1930s Depression

& WW2

1977 Brazilian Frost Boom

Copper Price Cycles

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Growth

Reagan Thatcher Anti-Inflation

Policies

Cyclical Features

Period (years)

Average amplitude

Current state

Coffee short 3.4 6.8% -2.8%

long 20.7 39.4% -8.3%

Copper short 3.7 1.7% 5.0%

long 11.2 18.1% 32.6%

Iron ore 4.8 8.0% 3.8%

Maize 7.6 12.3% 0.0%

Soybeans 6.7 10.9% -9.0%

Sugar 7.3 13.9% 30.2%

Coffee has the most pronounced and longest cycle.

Amplitude is half the average trough to peak change.

Why are there such long cycles?

• Long cycles are evident in metals and for tree crops. They are absent in annual crop commodities.

• Mines take a long time to build (6-10 years from discovery to production). Tree crops take time to come into production (3-5 years from planting). High prices can persist over a number of years.

• Because production costs are low relative to capital costs, metals prices must fall a long way before it becomes economic for a mine to cease production. Grubbing up trees is costly, and farmers tend to devote time and inputs to other activities rather than do this. In both cases, excess supply can overhang the market for a number of years until demand catches up.

5. Speculation

Is the Rise in Oil and Metals Prices Speculative?

• Some commentators have suggested that there may be a substantial speculative component in the current level of prices. They view prices as a bubble, driven by hedge funds and other speculators characterized as having extrapolative expectations.

• The dramatic rise in futures trading over the past decade and increased volatility over the same period are cited as evidence for the claim that speculation drives prices.

• In terms of the statistical decomposition, increased speculation might imply a higher transient component in price variabilityFinance theory implies that the direction of causation is the opposite to that underlying the popular view.

a) Increased price volatility induces additional hedging demand. This drives the increased volume of futures trading.

b) Speculators earn a premium by offsetting the net hedging imbalance.

c) Speculation reduces price volatility (since speculators profit by buying low and selling high).

NYMEX Crude Oil 1986 - 2006

Gross positions (left) and the net non-commercial position (below) (from CFTC Commitments of Traders Reports).

Commercial positions, identified with hedging, have grown most.

Non-commercial positions are identified with large hedgers (e.g. hedge funds) and non-reporting positions with small hedgers (e.g. rich individuals).

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The NYMEX (Comex) copper price tells the same story – the major growth is in commercial (hedge) and not non-commercial (“speculative”) transactions.

“Speculators” were long copper futures for almost all the time from 2001 through early 2006. They have been short since April 2006.

Speculative Froth

The same pattern can be seen across the entire range of U.S. commodity futures markets:

• The major growth has been in commercial (hedge) transactions, not in speculative trades.

• Non-commercial traders (“speculators”) tend to lead the market and account for some short term price movement. However, they are no consistently on one or other side of the market, and their net position often reverses.

• Small non-reporting traders are “momentum” traders and tend to follow the non-commercials. They may exacerbate volatility in the short term, but overall probably lose money.

Speculation may be responsible for some short term market froth but cannot explain major movements of the type we have seen over the past three years.

6. The China Factor

Chinese Demand

• China is seen as the new factor in commodity markets.• Against a background of low investment in the 1990s,

Chinese demand for energy and raw material commodities is expanding at a faster rate than supply can accommodate. New mines and oil wells take 7-10 years to come on stream. This suggests prices may remain high for a significant time.

It is important to distinguish between final consumption of commodities in China and production of intermediate goods for export – only the former is net new demand.

China is not the only rapidly growing economy – simple the largest.

Shares of World Copper Consumption

China’s share of world consumption has jumped from near 8% over 1991-95 to 19% over 2001-05.

Over the same period, the Japanese share has declined from 13% to under 8%.

The net increase in Asian copper consumption is10%, little different from the increased Chinese share.

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Source: WBMS

Shares of World Oil Consumption

Changes in shares of world oil consumption show much less variation either upward (China) or downward (Japan).

This reflects the fact that the oil content is lower than the metal content of exports.

Source: BP

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China and Copper Consumption

• I have looked at this using a VAR-based model of copper consumption, production and prices. The model is estimated on annual data over 1954-2005.

• The model suggests that Chinese copper consumption has a 65% displacement ratio at the margin; i.e. for every 100 tons of copper consumed in China, 65 tons less is consumed elsewhere in the world (most significantly in Europe).

• The displacement ratio of other emergent Asian consumption is similar at 62% - but the regional impact is different (mainly on Japan).

• The headline figure for the increase in Chinese consumption therefore vastly exaggerates its actual market impact.

1991 saw an average copper price of 106.1c/lb.In 2005 values this translates to 143.3c/lb.Chinese growth has transformed a “but for” 19% real price fall into a 16% real rise.

2005 relative to 1991

(15 years)

Normal Chinese growth

(“but for”)

Fast Chinese growth (actual)

Consumption

China (m tons)

1991: 0.59

2005: 1.28

1991: 0.59

2005: 3.64

Annual growth rate 5.3% 12.9%

Consumption

World (m tons)

1991: 10.75

2005: 16.00

1991: 10.75

2005: 16.82

Annual growth rate 2.7% 3.0%

2005 price (c/lb) 116.5c/lb 166.8c/lb

The copper price has nearly doubled in 2006 relative to 2005. Comprehensive consumption data for 2006 are not yet available, so it is difficult to know how much of this increase is due to China .

7. The Future

The Price Outlook

• I have emphasized that energy, metals and agricultural commodities are all in different situations.

• It follows that there is no general commodities outlook – one needs to look sectorally.

• Except for sugar and grains (which I do not discuss), agricultural commodities are close to trend levels. There is no reason to expect change.

• Energy prices have fallen by around 20% over recent months. The market is worried about further falls.

• Metals prices remain very high, and have increased rather than declined over 2006.

Information from the Futures Markets

The structure of futures prices provides an indicator of market expectations of future cash prices.The London sugar price is seen here as falling from a current 19c/lb to 16c/lb in 2008. The premium (backwardation) is particularly sharp from Dec 06 to Mar 07 suggesting temporary market tightness.

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NYMEX (Comex) copper prices are also in backwardation (here 10/16/06) but the decline is not seen until the summer of 2007.

The price is seen to fall from an end 2006 peak of $3.50/lb to $2.90/lb in 2008. The 2007 average is $3.36/lb

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NYMEX crude oil (WTI) is in contango (10/16/06) until spring 2008, consistent with market expectations that oil prices will rise back from a current $58/bl to close to $70/bl.

Immediate supplies are plentiful, but political factors could generate a shortage in 2007.

Qualifications

• One could make these discussions more sophisticated by extracting the implied volatilities from options. This would enable the calculation of confidence bands around the prices.

• The resulting analysis places a very strong reliance on market efficiency. Few market traders have such faith – otherwise they could not look forward to making profits.

• Market illiquidity, particularly at distant dates, implies that the balance between short and long hedgers can influence futures prices. Illiquidity and high transactions costs can imply high spreads on commodity options limiting the information content of implied volatilities.

• The alternative is to use econometric models to forecast.

8. Oil

The Oil PriceBecause oil is statistically indistinguishable from a random walk, it is difficult to say anything very interesting about the likely future oil price.

A model which allows some mean reversion (even if not validated by historical data) shows prices drifting down towards $50/bl.

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However, there is substantial uncertainty: the 90% band for 2010 is $30/bl-$100/bl and the 50% band is $42-$67/bl.

Two Conflicting Pressures

Other considerations suggest that oil may be confined to a relatively narrow range by the end of this decade:

1. OPEC countries dominate unexploited conventional oil reserves. OPEC’s market share of conventional oil is likely to increase towards the end of the decade. This will keep upward pressure on the oil price.

2. High prices over the current and recent period have stimulated advances in both production and consumption technologies. This is likely to moderate consumption growth (as in the 1980s) and also to induce major increases in production from non-conventional sources (compare the expansion of non-OPEC production in the 1980s).

The interplay between these two pressures may constrain oil prices.

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Sources: BP, IEA, IMF;Oil & Gas Journal, 9/25/06

Alberta, Canada, possesses enormous bitumen reserves.

Until recently, these have been uneconomic, but the new SAGD technology allows profitable exploitation even at relatively low oil prices.

This may add the equivalent of a 5% increase in oil production by 2010.

9. Sugar

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The Sugar Price

The trend + cycle model discussed above sees the sugar cycle coming off to leave sugar prices around 14c/lb by the end of the decade.

10. Copper

How Long Can China Sustain Fast Growth?

• Since Chinese growth is seen as the important driver in the metals markets, analysts frequently ask how long this fast growth can be sustained.

• That question seems almost impossible to answer. An analogous question was posed in the 1960s and ’70s with respect to Japanese growth. Japanese growth did moderate after 1975 but rapid growth kept copper prices high and volatile over a decade from 1964. The falling off of Japanese growth was one cause of low copper prices from 1975 to 1987.

• I prefer to suppose that Chinese growth will continue but to ask how long it will take for copper production to catch up with the higher level of demand.

Copper Price Forecasts

Deterministic simulation of the copper model (i.e. ignoring uncertainty) generates a price of $2.63/lb for 2007 and $1.88 for 2008.

These prices are lower than those implied by the current futures structure.

The price falls to $1.15/lb by 2011.

Nevertheless, the 2007-08 prices remain high relative to those experienced prior to 2003.

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Uncertainty

This does not imply that the copper market has necessarily peaked.

The market sees a 41% probability that the price will average higher in 2007 than in 2006 and a 25% probability that it will rise from its current level. There is a 6% probability that the 2008 average will exceed the current price.

The 2007 average (higher than the median of $2.43/lb) is $2.63/lb.

There is also a significant probability of a price collapse in 2007: a 28% probability of a 2007 average price less than $2.00/lb.

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A Second Opinion

The 2006 edition of the IMF’s World Economic Outlook contains a nice discussion of non-fuel commodity prices.

Their model is quite different from mine (more structural) but the forecasts (here in $/ton) are very similar.

The IMF’s median for the 2007 average is $2.65/lb, against my forecast of $2.45/lb. The IMF’s central forecast for 2010 is $1.35/lb against my $1.28/lb.

Source: IMF

11. Summary

Summary: Trends and Cycles

• The commodity boom is centred on energy and metals. With some important exceptions, agricultural commodities have largely been sidelined.

• Commodity price trends, generally negative, are highly variable. It is therefore difficult to distinguish between the permanent and transient component of any price change. This makes it difficult for governments to know how much of any revenue increase they should save.

• The oil price, in particular, follows a process which is indis-tinguishable, on a purely statistical basis, from a random walk.

• Energy, metals and tree crop commodities exhibit long (10-20 years) and high amplitude (over 30%) price cycles. Both low and high prices can persist for considerable periods of time.

Summary: China

• China has been the major driver of the copper price over the past three years. It is less important for oil..

• Increases in Chinese copper consumption displace consumption elsewhere in the world, so the net increase in world consumption is only one third of the gross Chinese increase.

• Chinese growth may have resulted in a 30% real rise in copper prices up to 2005, relative to a “but for” scenario in which they would have fallen by 20% in real terms.

• It is to early to be sure what explains the dramatic 2006 price rise in the copper price.

• Speculation is not a major factor in explaining price move-ments over the past few years – it is usually only of short term importance.

Summary: Price Developments

• There is a consensus that copper prices will fall back, but this may not be until the latter part of 2007 or 2008.

• It is probable but not certain that copper has already peaked.

• The central estimate of the copper price is around $1.25/lb for 2010, around one third of its peak to date.

• Oil prices are more difficult to forecast.

• The two dominant factors over coming years will be an increased OPEC market share of conventional oil (making a return to low prices unlikely), plus new supplies of oil from non-conventional sources (making it difficult to sustain high prices). My guess is that we may see prices in the range $40-$50/bl by the end of the decade.