If It’s in the Ground, It Can Only Go Down

This bullishness is misplaced. The world is now in the biggest growth slump since the Great Depression, and the era of exceptionally high global growth that led to a surge in demand for commodities from 2003 to 2007 is unlikely to return any time soon. Yet for the most part, analysts, no matter what their view on the global economy, agree that commodity prices will rise. Optimists say a revival in consumer demand will drive up oil and other commodity prices, while pessimists are buying commodities as a hedge against a feared outbreak in inflation, given all the money central banks are printing across the world.

Both scenarios ignore history, which shows that only one commodity rises in an inflationary environment: gold. Other commodity prices tend to bloom only during the mature stages of a boom when the global economy overheats and demand briefly exceeds supply. At the moment, supply for nearly all commodities far outweighs demand, and likely will decline for at least the next couple of years.

The hopes of producers could also deepen the slump. The oil men, copper miners and steel barons clearly expect the recent price declines to be temporary, because they are making only short-term cuts in factory output, rather than taking more permanent steps like closing factories. A case in point is the steel industry, which has slashed production by 40 percent worldwide since September, leaving mills operating at 65 percent of capacity, down from 95 percent last year. However, steelmakers are not closing plants, which means mills will run at partial speed for the foreseeable future, leaving producers with little pricing power.

The dynamics are similar for other metals. Despite the recent fall in prices, many commodities still trade well above their cost of production, so prices need to come down further before producers feel the kind of pain that forces plant closings. Instead, inventories for most commodities have risen to five- or, in some cases, 10-year highs, even though spot rates are still well above prices of a decade ago. That implies prices will have to decline as the excess inventories need to be cleared out.

The only reason the fall in oil prices hasn't been deeper already is that many people expect a continuing boom in China, driven by Beijing's aggressive stimulus plans. These days any hint of good news out of China—even a slowdown in the decline of manufacturing—can unleash whoops of joy in the oil trading pits.

They come too early. China suffers from an overinvestment problem. It has been investing at a rate equal to 40 percent of GDP for nearly a decade, a level unprecedented in the history of economic development. Much of the money goes to export industries, which are sagging in the global downturn. Investment demand is not likely to revive soon, nor should it. China contributes 10 percent of global economic output, but has been consuming 25 to 50 percent of most industrial commodities, a pace that can't be sustained. The pace should slow in coming years, as China moves to reduce its reliance on exports and investment, and to build an economy driven by local consumers. Beijing is also working to create more-efficient factories that run on less energy and require fewer raw materials. Meanwhile, in nations other than China, demand for commodities is falling at an annual rate of 30 to 60 percent, which will put intense downward pressure on prices.

China's impact on oil prices is greatly exaggerated, anyway. China consumes 9 percent of global oil production, while the rich nations of the Organization for Economic Cooperation and Development consume more than 50 percent. Demand for oil is highly sensitive to global growth and the IEA expects it to shrink by 2.4 million barrels a day or 2.8 percent as the world economy is now estimated to contract by 1.4 percent in 2009.

That will greatly reduce the power of the oil cartel to raise prices. OPEC has always found it difficult to dictate price trends when its spare capacity exceeds 5 percent of total demand, and right now it is at 8 percent and rising. The cartel has ordered three production cuts in the last six months, and while its members are now meeting 80 percent of the targeted cuts, the incentive to cheat will only grow.

At some point, of course, commodities will spike again, but only temporarily. To date, the centuries-old slide in prices has been marked by long bear markets and short bull runs. Data from CSFB shows that the average bull market in oil has lasted from four to nine years, and the average bear market from 11 to 27 years. The bull market that ended last summer saw prices rise tenfold over nine years, mirroring the duration and magnitude of the previous bull market, which ended in 1979. That was followed by a bear market that lasted 20 years. If history is any guide, we're only at the beginning of another long one.