Longer-term outlook for commodities is less certain, writes Fiona Reddan

OVER THE past six years, the price of commodities has boomed, and while global equity markets may be in freefall due to the credit crunch, commodity indices are up by more than 70 per cent over the past year.

Crude oil, silver, lead, uranium, cattle, cocoa, corn and gold are all at or near record prices. The price of copper has trebled in half a decade and the price of zinc has doubled. But with global economies in recessionary mode, can the boom continue or should investors look to divest their commodities holdings?

Simon Barry, senior economist with Ulster Bank Capital Markets, says that supply is struggling to keep up with demand and this imbalance is keeping an upward pressure on prices.

"Although economies in the developed world have slowed, emerging markets are still performing very strongly, with growth in China expected to be in the double digits for 2008," he says.

The exceptional price increases experienced by commodities have been driven in large part by an increasing demand for raw materials from economies such as China, where rising incomes have led to a massive increase in demand. As it can take years of research and development to find new oil fields or to mine precious metals, supply is simply not keeping up with demand.

The depreciation of the dollar has also increased demand from non-dollar buyers, while continued population growth and rising incomes are also driving demand. The world's population is predicted to rise from 6.7 billion in 2007 to 9.1 billion by 2050, and it has been estimated that Brazil, India, China and Russia will then collectively need more oil, aluminium and copper than the entire planet used in 2006.

Moreover, the price of most commodities is heavily linked to the oil price; as oil prices continue to reach new records, it is no surprise that commodities are experiencing an exceptional boom period. But can this last?

Renowned commodities trader Jim Rogers says commodity bull markets typically last about 18 or 19 years, so just six years in, it looks like this bull market may still have life left in it.

Although commodities can perform differently, they share a number of characteristics, including how they can protect a portfolio against inflation, because their value tends to go up when inflation goes up. They also have an insurance-type characteristic, says Ciaran Bristow, chief investment officer with Irish Life Investment Managers. Thus, when a major global event such as a terrorist attack happens, every asset class falls in value except gold and oil.

Commodities also typically perform best when equities perform worst and this year has been no exception.

Over the 12 months to the end of June 2008, the SP GSCI, the benchmark commodity index, grew by 76 per cent, while over the same period the Iseq index fell by 44 per cent.

One of the most talked-about commodities is oil. From a low of $18 per barrel after the September 2001 terrorist attacks, oil has had a spectacular run, surpassing $140 a barrel for the first time in June. And it's unlikely that the price will fall anytime soon, as demand continues to grow, buoyed by emerging markets such as China, India and the Middle East.

One of the better-performing commodities has been gold. It reached an all-time high of $1,033.90 (€651.10) on March 17th, but expectations are that it can continue to rise.

A survey conducted by financial information provider Bloomberg among 28 traders, investors and analysts around the world on June 26th and 27th revealed that three-quarters of those surveyed recommended buying gold.

Analysts say that, in real terms, gold is still far off its 1980 peak of over $2,000, and with ongoing fears over global economies, gold is seen as the perfect hedge against inflation.

"We've seen a pick-up in demand in the past week or two," says Mark O'Byrne, managing director of brokerage Gold and Silver Investments Ltd in Dublin.

"Given the confluence of so many bearish factors for bond and equity markets, we remain firm in our belief that gold will reach $1,200 per ounce before the end of 2008."

Agricultural commodities have also been booming, due to increasing demand from countries such as China, combined with the increasing price of production due to the rising cost of oil. The World Bank predicts that world grain production will have to rise by 50 per cent to meet demand by 2030. Moreover, recent floods in Iowa and Illinois, which usually produce one-third of all US corn and soybeans, sent commodity prices to record highs.

Irish Life's commodity fund is already up 17.8 per cent in the year to June 27th and Bristow expects commodity prices to continue to rise, as he believes that prices have only gotten in line with where they should be, and that seven or eight years ago, oil was "extraordinarily cheap" at $20 a barrel.

"It is still hard to know if oil should be priced at $140 a barrel or $200 a barrel. In many ways, it's only reaching the levels of previous oil crises now," he says.

Simon Barry says the degree to which increases in commodities are driven by speculative demand may be overstated and that fundamental factors remain strong. "The increases we've seen in oil prices have been complicated by the fact that you can't simply turn on an extra supply of oil," he says.

In the short term, he thinks commodities are a good bet for investors, but long-term, he expects the market to respond to signals, and over time expects prices to be pulled back from the level they're at as supply is increased and people begin to change their behaviour.

"In the US, people have already started to change their car-buying behaviour as the price of gasoline reaches $4 per gallon, and are moving away from buying gas-guzzlers," he adds.

Barry also expects the price of food-related commodities to ease back due to the unwinding of adverse conditions such as the drought in Australia.

"It will take repeat adverse supply shocks to keep prices soaring," he says. Food commodities have already shown how volatile they can be. Wheat prices were up by 60 per cent in the first quarter of 2008, but fell right back in the second quarter.

Such indicators mean that, for Bristow, the "days of the easy money are over".

"Although there are good structural reasons as to why commodity prices are going up, that doesn't mean that it isn't still showing elements of being a bubble," he says.

"Most booms start out for good reasons. For example the housing boom in Ireland was due to demographic reasons, but it grew and grew until it became a bubble."

In the short term then, commodities can be expected to continue to perform strongly, but longer-term the outlook is uncertain, as supply begins to catch up with demand.