Soaring commodity prices... But will the bubble burst?

Commodities used to be the brown suits of the markets: in vogue every once in a while, forgotten at the back of the wardrobe the rest of the time.

"Like brown suits, for nine years out of 10, commodities would be out of fashion," says one trader. But now commodities are the new black.

Everything from oil to zinc is high on investors' shopping lists. And everyone from pension funds to the man and woman in the street wants a piece of the action, says Robin Bhar, a base metals analyst at the investment bank UBS: "There's hardly anyone saying 'sell' at the moment."

Most commodity prices are at record highs. Last year, copper prices jumped by half, zinc by 63 per cent, oil by 44 per cent and iron ore by more than two- thirds. The companies producing these commodities are booming too: the FTSE 350 Mining Index has risen by 85 per since the start of 2005. Mining companies and oil producers - led by the likes of Rio Tinto and Shell, which report annual results next week - now make up 27 per cent of the FTSE. But analysts and investors are fretting that we are in the midst of a commodities bubble. Are they right - and, if so, when will it burst?

Much of the growth has been due to the simple economics of supply and demand. Miners and oil producers are struggling to keep up with global demand, which is being driven by China's industrialisation. Last year, China soaked up 20 to 25 per cent of global base metal output, compared with a mere 5 per cent in the 1980s. The country was a net importer of zinc - used to make steel rust-proof - for the first time last year, as Chinese steel production grew by 25 per cent.

"The Chinese population have got to the level of wealth where durable consumer goods [fridges, cars, etc] are starting to become staples for many more of the population, rather than limited to the elite," says Gerard Lane of Morley Fund Management.

The world's fourth-biggest economy is still growing fast. Economists at HSBC predict Chinese gross domestic product will be up by 9.4 per cent in 2006 and 7.5 per cent in 2007. This follows annual average growth of 10 per cent over the past two years. In comparison, the UN predicts that the global economy will grow by 3.3 per cent in 2006.

Until a few years ago, no one, and especially not the mining industry, took China seriously. "We viewed the China story through our Anglo-Saxon eyes, and totally misjudged the scale and speed of growth," one trader says. Due to the lack of investment in new mines in the 1990s - a result of weak commodity prices and investors' desire to see quick returns - the global supply in such metals as copper and zinc has fallen significantly behind demand. Today's high cost of production has also led to the postponement of many projects.

It is a similar story for oil companies, says Jon Rigby, an oil analyst at UBS. In the 1990s, oil prices hovered around the mid-teens mark, which discouraged investment in new production. Even now, there are not many new projects coming on stream. "A lot of the easier oil has been found and developed," he adds.

Another reason commodity prices are so high is that the world is awash with money looking for somewhere to invest. All assets are in demand and prices are high. Consumers in Asia are depositing their money in banks, rather than spending it. This money is being invested in the West, snapping up government bonds and financing the yawning budget deficit of the US. As a result, yields in bonds are at historic lows. Pension fund managers and institutional investors are looking for better returns, and looking to commodities.

"Consultants advising pension funds are certainly a driver - they're saying that 5 per cent exposure to commodities should be raised to 10 per cent or even 15 per cent," says Mr Bhar from UBS.

Increasingly, investors want to invest in commodities directly, rather than the companies that produce them. During last year, Barclays Capital predicted that institutions invested $80bn in commodities, up by around one third. Most of this money has been put into commodity funds, which trade on the back of commodity price movements.

Even pension funds are becoming commodity traders, too. Hermes Pension Management announced earlier this month it would be investing £1bn of the £34bn fund of telecoms giant BT into a commodity index tracking fund. Fund managers explained that they were fed up with low returns from bonds.

Some traders admit that commodity prices are inflated by as much as one fifth but are confident there won't be a price crash.

"The bubble will deflate but it won't be the same as the dot-com boom because of the underlying supply and demand fundamentals," says Mr Bhar.

There is also an element of self-regulation, since high prices will hurt the economy and reduce demand. David Page, an economist at Investec, explains: "We expect high energy prices to inflict a toll on consumers. There could be a sharp revaluation of commodity prices as an economic slowdown kicks in."

The effect of record commodity prices is already being felt in the UK. Petrol prices are forecast to rise back above 90p a litre within the next few weeks. Businesses are suffering, too. Building material companies such as Hanson, Cemex and Aggregate Industries moved late last year to pass energy price hikes on to customers, quoting rises of between 10 and 20 per cent across a range of materials.

Doug Godden, head of economic analysis at the CBI, says that future investment in the manufacturing sector, which uses a lot of energy, is likely to fall as a result. Jobs are also at risk. "Output has not been increasing as much because of the higher costs of production. Investment is also weak."

Analysts predict that a 20 per cent slump in commodity prices could result in the profits of mining companies such as Rio Tinto and BHP Billiton falling by up to 35 per cent.

According to Mr Rigby, it may be in the oil majors' interests for oil prices to fall. "If prices stay this high, government policy and consumer patterns will shift towards lower consumption, which would be bad for the industry in the long term."

So for those planning to dust off that brown suit, you have been warned: just like commodities, it may only be in fashion this season.

Cold reality for an energy-hungry manufacturer

Ineos Chlor, which manufactures chemicals such as chlorine, uses as much electricity as the city of Liverpool.

Its electricity is converted from gas, and the bill for this accounts for over half the Cheshire company's overheads and more than the entire wage bill for its 1,400-strong workforce.

The doubling of gas prices over the past year has had a massive impact on Ineos Chlor and thrown its future into doubt. In November, its Cheshire plants operated at only one quarter of their full capacity to save fuel and keep costs down.

Andy Waring, Ineos Chlor's energy purchasing manager, is praying that the recent cold snap, which has pushed up the cost of gas again, is only temporary.

He warns that in the event of a prolonged chill, gas supplies to both homes and businesses in the UK won't be able to keep pace with the demand. Even companies like Ineos Chlor, which has signed uninterruptible supply contracts, face being cut off to keep households connected.

Mr Waring is anxious about next winter. Forward gas prices for the first three months of 2006 stand at 90p per therm, up from the approximately 50p that Ineos Chlor paid for this winter.

Being part of a group that operates chemical plants elsewhere in Europe brings into sharp focus the disparity in gas costs between the UK and the Continent. In some cases, prices are twice as high in the UK and are already "unaffordable" this year, he says.

If they go even higher next winter, Ineos Chlor would have to impose an energy surcharge on customers. But even that might just be a holding tactic. If gas prices do not come into line with the rest of Europe soon, Ineos Chlor's UK plants face closure. "Energy costs are a major issue for the group," Mr Waring admits.

Tim Webb