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Wednesday, July 29, 2015

Causes and consequences of lower commodity prices – a guest post

Globally, prices of various commodities have been on a downward spiral. Prices of oil, gold, steel, copper, aluminium have reduced considerably. That should be good for the Indian economy – as India imports significant quantities of oil and gold.

Reality is a little different. Lower oil prices have shrunk our current account deficit and benefitted oil marketing companies, but not oil explorers like ONGC and Cairn. Lower metal prices have hurt banks that have large exposures to the metals sector, and producers like Tata Steel and Hindalco.

In this month’s guest post, Nishit assesses causes of lower commodity prices and their consequences. Small investors should benefit from this analysis, as it lends perspective to the commodity cycle and would enable them to fine tune their investments.

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Commodity prices are collapsing all over the world. Gold is at a 5 years low, crude oil is very near its lows. Metal prices are tanking. Why is this happening and how can we benefit from this?

First of all, commodity cycles are long drawn out affairs of over 10-12 years between peaks and troughs; which means, prices are not going to rise in a hurry. There may be some corrective spikes but prices would continue to correct over a period of time.

All these years, China was consuming and stockpiling huge hoard of resources building steel and concrete cities which fuelled a real estate boom. China also set up huge capacity of Steel production. All these led the commodity prices many times higher. Now the Chinese economy is floundering; the real estate sector has no buyers and the stock market in China is collapsing.

China has created so much capacity - what does it do with it? Obviously, it cannot be left idle. So, it is now exporting steel priced very close to the cost of production of steel in India. The Government is doing its bit by adding some anti-dumping duties. Overall, the prices remain depressed.

China was accumulating gold reserves and that was the reason price of gold was going up. Now they have started selling some gold leading to lower prices.

Now the bad news. Commodity cycle related companies like steel industry in India will be in doldrums for some time to come. Banks have huge exposure to these companies. These companies make profit equal to just about the interest payment on their loans. Forget about repaying principal amounts.

In India, people rush to buy gold at every price drop. If they buy now they will have to hold it for at least 5-6 years or maybe even longer.

Lower crude oil prices will help the Indian economy. These will also continue for some time to come - at least for this year 2015.

Having an understanding of why commodity prices are correcting will help us capitalise on them.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan. You can reach him at nish.stockid@gmail.com)

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