Commodities Go Their Separate Ways

MAY 25, 2011   THE WALL STREET JOURNAL

By ANDREW PEAPLE

A rising tide lifted all boats, but the recent fall in commodities prices has been far from uniform. The 10% drop in the S&P Goldman Sachs Commodity Index this month, as of late Tuesday in Europe, masks a wide divergence in underlying prices, with silver off 26% and corn down just 2.8%. After years of seeing close correlation in commodity prices, investors need to become more discerning.

This strong correlation dates back to around 2006. Before 2006, the correlation between different commodities in the S&PGSCI was rarely above 20%, data from Barclays Capital show. But as commodity prices began their long bull run, driven by Chinese economic growth and loose global monetary policy, the 12-month moving average correlation increased, doubling to more than 40% for most of 2009 and early 2010. This correlation helped cement commodities as a distinct asset class in investor minds.

But during the recent selloff—triggered by fears that tighter monetary policy in China, the euro zone and possibly the U.S. will slow global growth—this long-term correlation has fallen back to around 30%. That reflects the markedly different underlying supply and demand dynamics for individual commodities that tended to be masked by the boom.

Corn and wheat prices, for example, while off their April highs, have stayed strong, reflecting concerns about global supply. The ratio of corn stocks to demand could fall below 15% this year, its lowest in four years, Macquarie forecasts, while a drought in Europe and Russia's ongoing export ban mean wheat supplies will likely tighten.

By contrast, oil prices are more vulnerable to weaker developed-country economies. Brent crude was down 11% to about $112 a barrel this month through Tuesday, and Capital Economics expects prices to fall back to $85 by the fourth quarter unless fresh geopolitical risks emerge and raise supply concerns.

Meanwhile, base-metal markets look particularly weak: Stock-to-demand ratios for zinc and aluminum are already above their long-term averages, according to Deutsche Bank data, while copper and nickel balances are climbing. Firm evidence of improving Chinese demand would likely be needed for these commodities to recoup their recent falls.

Broader correlations between commodities prices could still return, of course, but this time it may take clear signs that the global economy is slowing.

Write to Andrew Peaple at andrew.peaple@dowjones.com