How Long Will Low Commodity Prices Last?

Commodity Returns

Commodities as an investment haven’t done well in recent years, but this year has been especially bad. They’ve been the worst-performing asset class in 2014, with a return of -16% year-to-date. Barring a rebound in the next month and a half, that would be their worst performance since the financial crisis in 2008. So is the pain now over for investors with exposure to commodities? The answer depends on the key factors that have driven down commodity prices.

Perhaps the most important factor affecting commodities is the pace of global economic growth. Stronger economic growth translates into more demand for commodities, but the global economy has slowed as growth in emerging markets declines and the European economy continues to stall. While the global economy grew by more than 5% per year in the mid-2000’s prior to the financial crisis, it’s only averaged around 3% growth per year since 2012.

The good news for those hoping for higher commodity prices is that the global growth rate may partially bounce back. The International Monetary Fund projects that the global growth rate will increase to around 4% per year over the next few years, powered by stronger growth in the United States and emerging markets. There are a number of ways that such a potential rebound could be thrown off-course, however, such as a sharp slowdown in the Chinese economy.

The outlook for commodities is also affected by factors affecting supply rather than just demand. In recent years these supply factors have particularly hurt the prices of energy commodities (such as oil and gas), which are largely responsible for the poor performance of commodities so far this year. Techniques such as hydraulic fracturing (or “fracking”) have led to increased energy production, especially in the US. Supply could increase further as technology continues to improve and makes energy production more profitable.

Over time, however, commodity prices have a self-correcting aspect: lower commodity prices themselves help reduce supply by making commodity production less profitable. This process doesn’t occur instantaneously, which is why commodity prices sometimes move up or down dramatically. But it does suggest that as commodity producers adapt to lower demand, prices are unlikely to keep falling for too much longer.