As world growth slows, commodities have come into sharp focus. After rising for the major part of the previous decade, commodity prices have been in a slump for the last four years. Energy prices crashed last year, and the prices of base metals have been declining at a constant rate.

According to a recent report by the Economist Intelligence Unit, commodity prices will improve only marginally next year. The report states that prices for industrial raw materials (a price index of nine hard commodities with more than half of the index weighted towards metals) will rise by 3.3% in 2016 on the back of an uptick in energy prices (which, in turn, is expected to inflate production costs).

The EIU is the not the only research organization with a less-than-rosy outlook for commodities in the near-term. Earlier this year, Morgan Stanley reduced its 2015 estimate for nickel, iron ore, and coking coal by 23%, 28%, and 16% for the rest of this year. The next year is not expected to be any better, as Morgan Stanley cut its forecast for copper and nickel by 14% and 19% in 2016.

What caused the slump in commodities, and what will next year look like?

Causes of the Current Decline in Commodity Prices

To be sure, commodity markets have always been prone to supercycles, or phases of rapid growth and decline depending on world growth figures. For example, according to an NBER paper, three major supercycles started in the 1890s, 1930s, and 1960s and ended in the 1930s, 1960s, and 1990s. The paper states that a new supercycle began in the late 1990s, which is still continuing to the present day. It coincides with the emergence of a new developmental paradigm signified by the BRIC countries – Brazil, Russia, India, and China – that have mostly driven demand in commodities.

The Economist report identifies three major factors affecting current commodity prices: the plunge in oil prices in 2014, U.S. dollar appreciation, and China's attempts to transition its economy from manufacturing to services.

Even as a revolution in U.S. shale manufacturing capacity has led to a glut of oil in the international markets, Saudi Arabia, the world's largest producer of oil, has kept its production capacity intact. The result has been a glut of oil in international markets and, consequently, a reduction in prices.

Most commodities are denominated in dollars. But, the dollar's value has risen this year, making it more expensive to sell and buy commodities with respect to local currencies. As a result, emerging markets, which typically maintain competitive exchange rates with respect to the greenback, have been hit by the dollar appreciation. The result is a decline in overall commodity sales.

But perhaps the most important single factor affecting commodity prices right now is China. For much of the last two decades, growth in demand from China sustained commodity producers as a slew of infrastructure and manufacturing projects drove demand. At the same time, commodities became an instrument to circumvent capital controls imposed by the governments on bank lending. In this scheme, traders bought commodities on credit using bank loans, and sold them for a profit in the markets, earning a handsome profit on the deals. (See also: Slow Growth in China to Affect Asia-Pacific.)

Known as inventory-based financing, the practice resulted in a commodity stash in China. Prices rose in international markets as demand could not keep up with supply. In recent times, that stash has remained unused as key economic indicators ranging from GDP to manufacturing capacity (vital for growth in commodities) in the Asian country are down. This had a domino effect on commodity-producing countries, such as Brazil, whose economy entered a recession last month due to the slump in commodity prices. (See also: Brazil's Recession And Its Effect On The World Economy)

What Is the Outlook in 2016?

The International Monetary Fund has revised its July growth forecasts to 3.1%. According to the organization's World Economic Outlook report, “medium-term prospects (for global growth) remain subdued, reflecting a combination of lower investment, unfavorable demographics, and weak productivity growth.”

The EIU report forecasts an increase of 4.2% and 5.3% in 2016 and 2017 in the prices for base metals. According to the report, this increase will predominantly be driven by a price increase in aluminum prices. Weak demand from China is expected to keep copper prices down as the former metal is used extensively in infrastructure and manufacturing projects.

Although the idling capacity of U.S. oil wells has increased, there are no signs of a slowdown in oil production in Saudi Arabia. The entry of Iran, which has a substantial oil capacity, into the global oil market is further expected to complicate matters in the market. The overall effect of demand growth will be a marginal to moderate increase in prices. The EIU report estimates a gradual price increase in 2016 from US $60 per barrel from an estimated US $53 at the end of 2015. (See also: Will Oil Prices Go Up In 2017?)

Finally, the report forecasts a stabilization of prices for agricultural commodities, such as wheat and maize. The reports estimates that its Feed, Foodstuffs, and Beverages (FFB) index, which is a combination of beverages, oilseeds, grains, and sugar, will fall by 17.9% in 2015. Similar to the oil market, the decline is mainly a result of supply-side glut. Record harvests and low energy prices have contributed to four years of decline in agricultural markets.

Analysts state that fuel accounts for 10% of the variable cost in grain production, and fertilizer accounts for 40%. Prices for both have trended downwards in recent years. The plentiful supply of wheat and maize in the agricultural markets will dissuade farmers from planting these crops. Maize prices will increase, but wheat and rice prices (which are affected by consumption of grain in Asian countries, such as China) will have a delayed trajectory towards an increase. Sugar prices collapsed by 24.7% in 2015 and will have only a modest increase in prices next year, according to the report.

The Bottom Line

Commodity prices have been on a rollercoaster ride for the past four years due to economic uncertainty. Next year should see marginal increases in the prices of most commodities.

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