The New Alchemy: Oil and Water Into Food

This is the first part of a two-part article on the changing dynamics of oil, water and food.

The incredible rally in a broad range of commodity prices has captured the imagination of many and is creating a cruel dilemma for policy makers who need to be concerned about inflation even as economic momentum wanes. The April statement of the G7 countries seemed to recognize that the volatility of the dollar may be aggravating the move. It also prompted them to seek more stable foreign-exchange markets.

To a large extent, the G7 countries appear to have gotten what they wanted. A better two-way market for the dollar has emerged, and the implied volatility for the dollar against the euro and yen has fallen. As the month of May draws to a close, the benchmark three-month implied volatilities are below their 100-day moving averages.

Perhaps helped by talk that the U.S. Commodities Futures Trading Commission could tighten position limits in the futures market, many commodity markets have pulled back. Short-term and long-term forces seem to be at work in the commodity market.

The short-term factors, some of which are related to cyclical factors, appear to be essentially a disequilibrium of supply and demand functions, which include the increased accessibility via ETFs and other funds for money managers of both the leveraged (e.g., hedge funds, commodity trading advisors, other speculators) and non-leveraged funds (e.g., pension funds, insurance companies endowments).

'Real-World' Effects

People are responding to price changes. Car sales in the advanced industrial countries have generally fallen, and smaller-engine vehicles are being favored when purchases are made. Americans are driving fewer miles. In Paris, a new 30-minute free bicycle rental program has been launched.

Farmers are planting more grain. The world output of wheat, for example, is poised to increase by 8.2%, with the U.S. winter wheat crop (panted in the October-through-November 2007 period) expected to be more than 17% larger than last year's and the largest in almost a decade. Wheat prices are near nine-month lows. The prices of corn, rice and soybeans have fallen this month.

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Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.