Persistence of commodity shocks

 Throughout history, commodities have been subjected to a multitude of shocks that could affect both demand and supply of commodities. Some shocks are permanent in nature: our research finds that this type of shock accounts for two-thirds of agricultural price variability but less than half of industrial commodity price variability over the past fifty years. Others are transitory. Base metals, for example, are most affected by economic swings because of their heavy use in highly cyclical industries. 

The nature of commodity shocks

Transitory shocks can originate from recessions, such as the 2009 global financial crisis and the 1997 East Asian financial crisis (both of which impacted a wide range of commodities), trade tensions (such as in 2018-19, and of special relevance to metals and soybeans), or bans on grain exports during 2007 and 2011. They can also arise from ad-verse weather conditions, most common to agriculture, such as El Niño and La Niña episodes or drought-related production shortfalls (such as grains in 1995 and coffee in 1975 and 1985). Transitory shocks can also result from accidents (e.g., the 2019 Vale accident in Brazil which disrupted iron ore supplies), conflicts (e.g., the first Gulf war, when Iraq/Kuwait oil production was halted), or terrorist attacks (e.g., on the Saudi oil facilities in 2019, which halted oil exports temporarily).

Shocks can also exert a permanent impact on commodity markets. For example, the shale technology shock in the natural gas and oil industries rendered the United States a net energy exporter in 2019, for the first time since 1952. The biotechnology shock of the 1990s increased crop productivity by more than 20 percent. Policy shocks can also have long-lasting impacts. Examples include government efforts to encourage biofuel production, which caused a 4 percent shift of global land from food to biofuel production; interventions in agricultural markets by most OECD countries, which put long-term downward pressures on food prices; and OPEC’s decisions to reduce oil supplies.

Shocks, especially those related to energy markets, often propagate other shocks. For example, the COVID-19 oil demand shock, which caused an estimated 10 percent decline in oil consumption during 2020, triggered a policy-driven supply shock of similar magnitude by the OPEC-plus group of a 9.7 mb/d oil production cut in April 2020. The oil price increases of the mid-2000s (driven by EMDE demand, OPEC supply cuts, and geopolitical concerns) rendered shale technology profitable, pushed up the costs of food production, and set the stage for biofuel policies. Following the oil price collapse of 2014, food production costs declined, but production of shale (through innovation) and biofuels (diverted from food commodities) appear to have a permanent character.

How much do transitory and permanent shocks contribute to commodity price variability?

Permanent and transitory shocks account for roughly equal shares. On average across commodities, permanent shocks accounted for 47 percent of price variability. Of the remainder (i.e., transitory shocks), medium-term cycles (i.e. cycles with periodicity be-tween 8-20 years) accounted for 32 percent of price variability, and business cycles (i.e., cycles with periodicity of 2-8 years) for 17 percent. Only a small portion (4 percent) of price variability is due to short term fluctuations. The large role of the permanent component is in line with the findings of research into commodity price supercycles. Furthermore, the predominance of the medium-term cycle in the transitory component is in line with recent research that finds a greater role of medium-term cycles than shorter business cycles in output fluctuations or domestic financial cycles.

Figure 1: Price variation according to type of shock

The composition of transitory shocks differed across commodities. Shocks at medium-term frequency accounted for 55 and 27 percent of price variability in energy and metals, respectively, and only 14 percent for agriculture. In contrast, business cycles accounted for 24 percent of price variability for metals. This greater contribution of business cycle shocks to metal commodity price fluctuations is in line with the strong response of metal consumption to industrial activity. Some of the commodities that exhibited the highest contribution of transitory shocks to price variability are used mainly within the transportation sector. For example, nearly two-thirds of crude oil is used for transportation, three-quarters of natural rubber goes to tire manufacturing, and half of platinum is used in the production of catalytic converters.

These averages mask heterogeneity across commodities. Transitory shocks were more relevant to the price variation of industrial commodities, while permanent shocks mattered most in agricultural commodity price movements. For agricultural commodities, permanent shocks accounted for two-thirds of price variability, for metals (including base and precious) they accounted for about 45 percent, while for energy they accounted for less than 30 percent. Precious metals exhibited the largest heterogeneity as a group, with gold prices driven mostly by permanent shocks, silver driven equally by permanent and transitory shocks, and platinum exhibiting one of the highest shares of medium-term cyclicality.

How have transitory and permanent shocks evolved?

Transitory shocks

Almost all commodities have undergone three medium-term cycles since 1970. The first medium-term cycle, which involved all commodities, began in the early 1970s, peaked in 1978, and lasted until the mid-1980s. The second, which peaked in 1994, was most pronounced in base metals and agriculture (with similar duration and amplitude to the first cycle) but did not include energy commodities. The third cycle, which again involved all commodities, began in the early 2000s, peaked in 2010, and for some commodities is still underway as of November 2020. Crude oil’s “missing cycle” reflected offsetting oil-specific shocks. Of the 27 commodities, crude oil and natural gas (whose price is highly correlated with oil) are the only commodities that exhibited two, instead of three, medium-term cycles.

Figure 2: Medium term cycle component of transitory shocks

During the period spanning the second medium-term cycle, the oil market was subjected to three shocks:

• Unconventional and offshore oil. New production from unconventional sources of oil—North Sea, Gulf of Mexico, and Alaska—resulted innovation and investment in response to the high prices during the 1970s and early 1980s, partly caused by OPEC supply restrictions.  
• New spare capacity from the former Soviet Union. Considerable spare capacity became available in the global oil market following the collapse of the Soviet Un-ion. Prior to its collapse, the Soviet economy featured both inefficient production and energy-intensive consumption.
• Substitution and demand contraction. High oil prices during the late 1970s and early 1980s led to substitution of oil by other energy sources (especially coal and nuclear energy) in electricity generation. Policy-mandated efficiency standards in many OECD countries lowered global demand for energy.

Permanent shocks

The evolution of permanent shocks differed markedly across commodity groups. For energy commodities, the permanent shock component of prices has trended upward, for agricultural and fertilizer prices downward, and for most base metals they have not exhibited any trend. The upward trend in energy prices may reflect resource depletion, and the largely trendless nature of long-term metals price movements may reflect the opposing forces of technological innovation and resource depletion. The downward trend in permanent shocks to agricultural prices is consistent with low income elasticities of food commodities. Commodities with a history of widespread policy interventions (cotton) or subjected to international commodity agreements (cocoa, coffee, crude oil, cotton, natural rubber, and tin) followed a highly non-linear path.

Annual agricultural price trends are highly synchronized and differ from those of other commodity groups. The contribution of permanent shocks to annual agricultural price variability (68 percent) is the highest among all six commodity groups, and these permanent shocks have evolved in a similar manner across annual agricultural prices.

Figure 3: Permanent shocks

 

This similarity reflects diffusion of shocks across commodities due to input substitutability, consumption substitutability, and agricultural policies, which are similar across most crops:

• Input substitution. Annual agricultural commodities tend to be farmed using the same land, labor, machinery, and other inputs. As a result, reallocation be-tween different annual crops from one year to another prevents large price fluctuations in individual crops. The impact of the restrictions in soybean imports by China from the United States in 2008, was short-lived due to land reallocation and trade diversion. Separately, despite a policy-induced increase in demand for maize, sugarcane, and edible oils over the past two decades, price increases in these three crops were in line with those of other annual crops (e.g., rice and wheat) as land was reallocated.
• Consumption substitution. Since annual crops have overlapping uses, substitution in consumption can dampen price fluctuations in any one of them. In the example of import restrictions on soybeans discussed earlier, soybean meal was substituted by maize for animal use in China while soybean oil was substituted by palm oil for human consumption.
• Policy synchronization. Policy interventions for agricultural markets tend to apply to the entire sector and stay in place for several years, even decades, with few or no changes. For example, agricultural policies in the United States and the EU, the world’s largest producers in several agricultural commodity markets, are renewed every few years and apply to the same crops.

Policy implications

The heterogenous behavior of shocks suggests a need for policy flexibility, especially in commodity-exporting countries. Countercyclical macro-economic policies can help buffer the impact of transitory shocks. Countries that depend on exports of highly “cyclical” commodities that are buffeted by frequent transitory shocks may want to build fiscal buffers during the boom phase and use them during the bust period in order to support economic activity. In contrast, in countries that rely heavily on commodities that are subject to permanent shocks, structural policies may be needed to facilitate adjustments to new economic environments.
 

^{1. The blog is based on the Special Focus section of the Commodity Markets Outlook, October 2020 edition.}