Company News » Grain strain

Grain strain

Soaring commodity prices are putting pressure on already embattled businesses and consumers as food, oil and metal prices hit record highs. And there is no end in sight to the boom

From the vantage point of a typical company director, people involved in the
commodities business must seem like alchemists. Whether sucked out from under
the seabed, extracted from deep underground, or simply harvested off the earth,
any commodity can be instantly turned into gold.

The prices of oil, industrial metals and soft commodities such as wheat and
rice have gone through the roof over the past year. Gold, itself, has hit record
highs. The price of oil has almost doubled over the past 12 months, spiking from
$60 a barrel in March 2007 to as high as $112 in April 2008. The Economist food
price index (which includes 15 products such as wheat, coffee, coconut oil and
lamb) has risen 60% in the past year on the back of a trebling of wheat prices,
while rice jumped 30% in a single day in March.

“For the past few years the price of just about anything you could describe
as a commodity, however loosely, has gone up,” says Richard Cookson, global head
of asset allocation at HSBC.

Against the grain
While it is always nerve-jangling when prices rise, what makes it an even more
striking phenomenon is that all other assets – shares, bond yields and property
– have gone in the opposite direction. Furthermore, it has happened in the face
of a slowdown in the growth of the major western economies.

While this is odd, it may contain the answers to why commodities have risen
so much. Yes, leading western economies have suffered a slowdown, but emerging
markets have grown at a red hot pace. China’s economy has grown 11% every year
since 2005 and is on track to expand by 10% this year, according to the
International Monetary Fund. For developing Asia as a whole, the figure is
around 9%. More importantly, the make-up of growth in China and elsewhere is
markedly different from the West. China is the world’s largest importer of iron
ore, steel, copper, tin, zinc, aluminium and nickel, hence demand for
commodities has outstripped supply. Moreover, oil supplies have been restricted
by growing political unrest, guerrilla activity, wars and weather-related

Another major factor, of course, is the impact of the credit crunch. As asset
prices tumbled, capital flight saw billions shift into commodities, driving
prices further north.

Business and politicians have been quick to blame opportunistic market
speculators for the price hikes in commodities. Figures from the US Commodities
Futures Trading Commission show positions taken by non-commercial traders in
heating oil, sugar and soya beans have almost doubled over the past 18 months.
Sir Michael Darrington, managing director of bakery retailer Greggs – which is
clearly feeling the result of soft commodities’ upward trajectory – said he
thought speculation was behind the trebling of wheat prices. “It is being driven
by these commodity speculators and commodity funds which, I think, lack a degree
of morality,” he said.

Consumers pay
Whatever the diagnosis, the strength of the global economy helped businesses
pass on those price rises to consumers, says Steve Radley, chief economist at UK
manufacturers’ trade body EEF.

Official data shows the price of goods leaving the factory gate increased by
6.2% in the year to March – a 17-year high, and far above CPI inflation of 2.5%
– though that was dwarfed by a record 20.6% year-on-year rise in the cost of raw
material inputs. This has sustained producers and retailers in the short term,
but with consumers tightening their belts now for fear of recession, businesses’
good luck may now have run out. “With quite a lot of goods prices rising and
world markets going soft, it is very hard to pass on cost increases. For most
companies, it will be a hard slog,” Radley says.

Many City economists agree and see a continued rise in commodity prices
continuing, pressing hard on companies in the coming months. “Weakening
profitability is likely to weigh down on companies’ investment and employment
levels over the coming months,” says Howard Archer, chief European economist at
economics forecasting firm Global Insight.

Some companies have managed to hedge against the boom. FirstGroup, the UK’s
largest bus company, is fully hedged for oil at about $85 a barrel for its
2008-09 financial year. “That gives me certainty in planning and allows us to
set the fares and it gives people the confidence to travel with us,” says
managing director Nicola Shaw. Each $10 rise would otherwise add £4m to its cost
base. So far, the company has hedged 10% of its needs for 2009-10. “We can’t get
the prices we want to fully hedge,” she told the BBC.

Knock-on effects
Rising commodity prices may yet deliver a double-whammy to business by
preventing the Bank of England from cutting interest rates more quickly. The BoE
is concerned about second-round effects – workers responding to a higher cost of
living by demanding higher wages. “The Bank of England will not want to
accommodate oil prices as it did in the 1970s because we all know what happened
back then – and it wasn’t pretty,” says George Buckley, chief UK economist at
Deutsche Bank.

As usual, not everyone thinks commodities will go on enjoying rising prices.
Some economists, such as HSBC’s Cookson, believe commodities are about to suffer
‘reverse alchemy’.

“Whether because of fears about a reversal in the dollar, or the unwinding of
speculative excess of worries about Chinese growth, the implications could be
dramatic,” he says.

Finance directors should not count their chickens just yet. Food stocks are
at extremely low levels thanks to a spate of droughts in key agricultural areas,
demand outstripping supply and a rush by farmers to plant bio-fuels. This has
led to acreage squeeze, literally competition for land to increase farmer’s
property and simply produce more, and different types, while the boom rolls on.

“It is getting to the stage where we can only produce one at the cost of
another,” Kona Haque, commodities analyst at Macquarie Bank, says. Haque remains
bullish on the prices of all commodities for the time being. A US government
report has projected a major shift by American farmers from corn to soya beans.
Corn prices in US markets have hit record levels, while soya has dropped.

In other areas such as industrial metals, Haque says countries such as China
have embarked on self-financing infrastructure spending programmes that are
unaffected by a stricken US economy. While Haque believes food prices will
remain high for at least the next three years, she thinks prices in industrial
metals could stay high for the next decade.

What this means is planning for a commodities boom that will last and affect
companies into at least the medium-term. As EEF’S Radley says: “It is sensible
for manufacturers to plan for higher input costs for the foreseeable future.”

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