The Brave New World of Supply and Demand

One of the most basic tenets of economics is the relationship between supply and demand. Higher demand means tighter supply and the result is generally higher prices for a limited supply of goods. As the economy collapsed through the “Great Recession”, prices for basic materials such as aluminum, copper and steel followed suit. End market demand essentially disappeared and prices fell precipitately. Copper that had traded as high as $4.00/# in September 2008 could be had for $1.25/# six months later.

 

The economy began its recovery in March, 2009 and commensurate with that recovery, copper prices have now gone full cycle and are back to around $4.00/# this week, some two and a half years after the fall.

 

Over a shorter term, we have experienced quite a spike in material inflation. Hot rolled steel that was $565/ton last August has recently priced out as high as $850 per ton. During that same timeframe aluminum ingot rose from $1.00 a pound to a recent high of $1.37/#. These materials are tracking at annualized inflation rates of over 50%.

 

For those of us mired in a still moribund construction market, however, you might rightly wonder: Where’s the demand? Why are we seeing price increases in a market where there appears to be so little demand? This article will address some of the factors behind this phenomenon.

 

The U.S. no longer leads in demand for basic commodities

 

In the good old days, the U.S. economy set the pace for global demand. This is no longer the case. Demand from China, India, Brazil and other emerging markets now lead the way. U.S. capacity for steel production is a little over 100 million tons per year. Chinese steel capacity is now 400 million tons per year and most of that was added over the last decade.

 

Emerging economies require much in the way of infrastructure and construction of infrastructure means demand for basic metals. Going forward, the supply/demand cycle for these materials will be established offshore. This could have either an inflationary or deflationary effect on the U.S. economy. A slowdown in China could mean a boatload of foreign material being dumped in the U.S. The point is, we no longer control events.

 

Metals are a hedge to the dollar

 

Aluminum and copper are commodities traded on the London Metal Exchange. As traded commodities, they are financial products and therefore can provide a useful hedge to movements in the currency markets. Quite simply, aluminum, copper and other traded commodities are a straight up hedge to the dollar.

 

A weak dollar means higher metal prices. A strong dollar means lower metal prices.

 

The easy money policies and low interest rates of the Federal Reserve Bank have been good news for U.S. manufacturers. The weaker dollar that has resulted has tended to be a boon for manufacturers and in fact the manufacturing sector has led the U.S. in this recovery. The backside however means higher material costs and as the economy recovers, we are certainly seeing that.

 

Steel is now emerging as a new trading product on the London Metal Exchange. Trading levels are still pretty thin but as this product emerges, you can be certain that hedge funds and commodity funds will quickly move to include steel, one of the most basic of commodities, in their trading basket.

 

Exchange-Traded Funds

 

Exchange-Traded Funds (ETFs) have emerged as an attractive new means for trading everything from stock indexes to particular industries to specific products. It is necessary, for example, that an ETF for oil be backed up by physical inventory of that oil. A $100 million Oil ETF must physically possess $100 million of oil. Similarly, a $100 million aluminum ETF must be backed by $100 million of aluminum. There were no aluminum ETF’s until a little over a year ago.

 

Why does this matter? This is essentially a brand new market for aluminum producers – one that is not backed up by any growth in end-use manufacturing demand. The end-use demand in this case is purely financial. Think of it like manufacturing aluminum simply to store it in Fort Knox.

 

The result of the development of these funds remains to be seen. It could mean more volatility or it could mean less but it is something new and it will have its effect.

 

Conclusion

 

These are just some of the drivers in the Brave New World of material costs and they are by no means limited to metals. From a positive perspective, we now have more transparent markets and increasing liquidity in these tradable markets. On the downside, we now must be cognizant of many more inputs in the way we make purchasing decisions. We hope this article has been helpful in improving your understanding of this changing marketplace.

 

 

Mike Petersen
President, Petersen Aluminum Corporation

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