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Time to revisit the commodity market

Recent price corrections bring opportunities Time to revisit the commodity market

Most commodities are trading close or below their marginal cost of production, with platinum, nickel, oil and grains the most striking examples. While in the short-term companies and mines can continue to produce even if prices are trading below marginal costs, it is not sustainable in the long term.

Unprofitable operations will have to be shut down or downsized, reducing production to contain costs. We expect the recent correction in commodity prices to be short-lived and believe commodities are attractively valued at current levels. Most of the factors that have hit commodity prices over the past month are temporary, and we believe the price correction creates tremendous opportunities for medium to longterm investors.

The state of play

Concerns about European and Chinese growth, markets digesting higher US rate expectations and US dollar strength, bumper grain crops, and adjustments to oil supply and demand expectations have been the main drivers of the poor commodity performance in 2014 (Figure 1). We believe a number of the increased supply price drivers will be transitory and that the recent period of softer global growth will prove short-lived.

US dollar strength should not hinder a price rebound as dollar strength is being driven by expectations of improving US demand. As China eases policy to boost growth, the US economy recovers and years of gradually tightening capacity start pushing up inflation, commodities should recover from current beaten down levels.

Metals

Investors focussing on global risks prompted a volatility surge across asset classes, which resulted in a sell-off across cyclical assets. Global equity benchmarks led the correction, prompting prices of several metals to fall below their marginal cost of production. Prior to the price weakness in September, industrial metals had staged a striking recovery in 2014, with a 6.4% rise in the first eight months of the year. While we believe most metals are attractively priced at current levels, we think platinum, palladium and nickel offer interesting opportunities at the moment.

Platinum and palladium markets were plagued by a 5-month long strike in South Africa at the beginning of the year that took over 1moz of platinum and 700koz of palladium off the market (equivalent to 14% of 2013 total production of platinum and 8% of 2013 total global production of palladium). As palladium is extracted as a by-product of platinum in South Africa and of nickel in Russia, it will only be produced as long as it is convenient to extract platinum and nickel, respectively. At the moment, platinum is trading 9.3% below its marginal cost of production (Figure 2) while nickel is around 18% below its marginal cost of production (Figure 3). Indonesia is the biggest nickel producer with 21% of global supply.

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The metal ore export ban that began in 2014 remains in place and Chinese producers of nickel pig iron, a lower-quality substitute for refined nickel, have since turned to the Philippines, the 2nd largest global producer with 14% of supply, to keep their industry well supplied.

However, seasonal rains are set to disrupt nickel mining and seaborne transportation of the metal in the Philippines. Disrupted production should start to reduce elevated stockpiles, in turn buoying prices.

While the aluminium price has also fallen below its marginal cost of production and the industry has undertaken considerable steps towards a more balanced market, we believe its price is not yet ripe for a recovery. Despite recent efforts to discipline aluminium supply and the market ex-China being in a deficit, we believe further cuts will be needed to compensate for the build-up in capacity coming from China and for prices to be pushed substantially higher.

Agriculture

While wheat, soybeans and corn are all trading at multi-year lows on the back of expectations for record crops this season, Arabica coffee has rallied over 70% since the beginning of the year on supply concerns.

With grains priced for perfect growing conditions, any small setback in weather in major producing countries or an escalation in trade restrictions in Russia or Ukraine could drive a price rally. The whole grains sector is trading below total cost of production (Figure 4), and because of the seasonality of production, there is likely to be changes in what and how much is grown in coming seasons because sustained weak prices could prompt producers to switch to more profitable crops or use of their land. A decrease in next year’s expected crop should lead to a drawdown of stockpiles and help support prices, which have just begun to stage a rebound.

While the International Coffee Organisation envisages only a slight recovery for coffee in the 2014/2015 season, as a devastating leaf rust disease is likely to prompt switching to other crops, we believe the recent rally was excessive as there is no immediate shortage of coffee and prices remain well above marginal costs of production (Figure 4).

Energy

Weak global demand for oil and distillates combined with ample global supply of crude sent both Brent and WTI prices to the lowest since November 2010 for Brent and June 2012 for WTI. The geopolitical risks in some OPEC countries and the sanctions on Russia have so far very limited impact on global oil supply and failed to provide support to oil prices against market expectations. In the meantime, the OPEC members entered a price war in October, selling their oil at a discount in order to increase market share in Asia, putting further downward pressure on both oil benchmarks. The key to greater support in oil prices lies with OPEC. With oil prices hovering below most major oil producers’ budget break-even levels (Figure 5), we believe it is a matter of time before OPEC start to reduce supply. While the IEA has indicated that most oil produced is still economic at US$80/barrel, the majority of OPEC countries are estimated to require oil prices of at least US$90-US$100/barrel to balance their government budgets. While different oil fields have different breakeven costs, it is generally alleged that US shale oil, which accounts for most of oil production growth over the past few years, has a breakeven price ofUS$60-US$80 (Figure 6).

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ETF inflows put a break on gold price decline

ETF inflows put a break on gold price decline. Energy: Brent would appear to have stabilised at $105 a barrel, and is embarking upon a moderate recovering. The same is true of WTI, which has risen to $98.5 a barrel this morning. When compared with last week’s major losses, though, today’s upturn is modest. For some days, the market focused entirely on ample physical supplies, but they now seem to be paying more attention to the supply-side risks again. The situation in Iraq remains unclear. It is alleged that Kurdish fighters, supported by the Iraqi airforce, have retaken some areas held by the Sunni extremists Islamic State. At the weekend, this faction captured two smaller oilfield and the biggest Iraqi dam. In the light of this news, it is hardly surprising that oil exports from northern Iraq are still at a halt. According to the Iraqi oil ministry, exports from the south of the country amounted to 2.44 million barrels a day in July, slightly more than in June. However, according to shipment details, oil exports still amounted to an average of 2.52 million barrels a day up to 23 July, which points to a sharp dip in the final week of the month. In mid-July, Iraq was still assuming that exports were reaching 2.6 million barrels a day. Libya’s oil output currently amounts to 450,000 barrels a day, compared with 500,000 barrels a day a week ago. With hostilities there continuing, Libyan oil supplies can be expected to shrink even further, even though the oilfields are safe according to the state oil company NOC.

Precious metals: Gold is still trading below the $1,300 mark, apparently supported latterly by ETF inflows: In July, the ETFs tracked by Bloomberg on a monthly basis recorded a net inflow again for the first time since March. The 15.7 tons registered constituted the largest monthly quantity since November 2012, but one swallow doesn’t make a summer. Over the year so far on balance, there has still been an outflow of some 30 tons of gold from ETFs. In view of the headwinds presented by additional demand components, the ETF inflows will probably merely have slowed down the price decline in recent weeks. While the present negative factors remain – a strong US dollar, weak physical demand in Asia, and weak coin sales in the west – we do not envisage any serious price gains. In addition to modest coin sales in the US, Australian coin sales too, for example, dipped sharply month on month in July to 25,100 ounces.

Demand from the automobile industry for platinum and palladium remains robust. There were 16.4 million vehicle sales in the US in July, measured on a seasonally adjusted annual basis. While this was down slightly on June, when the highest figure for almost eight years was recorded, it was nevertheless up 4.5% on a year ago.

CHART OF THE DAY: Diverging development of corn prices in the US and China

Base metals: Indonesia’s trade deficit rose again in June to some $305 million, owing mainly to a drop in commodity exports. The first-half deficit amounted to $1.15 billion on account of the country’s new mineral resources policy introduced in mid-January. This is no doubt one reason for the government’s announcement yesterday that the export tax on ore concentrates would be cut to 0-7.5%. The original tax was on a progressive scale starting at 20%, but the reduced rate applies to mining companies who have made a commitment to build smelting plants in Indonesia, and is linked to construction progress. According to a government authority, the mineral ore export ban and the export tax together have resulted in at least 50 projects for the construction of smelters in Indonesia being launched, with a total value of over $31 billion. They are to be realized in the coming years. Consequently, we could soon see more supply from Indonesia on the global market again, with the situation on the nickel, bauxite and copper markets easing. Copper producer Freeport-McMoRan, which reached an agreement with the Indonesian government just over a week ago, will according to its own information be exporting copper concentrates again as of tomorrow. Since the rise in nickel prices this year in particular was due to the Indonesian export ban, we see scope for correction here in the event of higher exports.

Agriculturals: While corn is trading at a four-year low in Chicago, prices in China are soaring. Corn has risen 10% so far this year on the Dalian spot market to hit a new high. On the futures market, contracts maturing in September are trading at a multi-year high. Some of the country’s major cultivation areas, amounting to 4 million hectares, are suffering a drought. This brings a threat of a lower yield, especially in the central Chinese provinces Henan, Shaanxi and Hubei.

However, forecasts are still predicting a record corn harvest in China. The USDA, for example, raised its forecast in July by 2 million tons to 222 million, which it expects to match consumption. The International Grains Council has not amended its estimate of 220 million tons. Chinese official forecasts too give a figure of 223 million tons, as higher output is expected in the northwest of the country. Even in the event of a lower crop, therefore, China would probably only have to import a little more corn, especially since it has been building up inventories on a generous scale in recent years, and is highly restrictive with imports of genetically modified varieties. While imports have been high by past standards in recent years, in absolute terms they have been low at a maximum 5.2 million tons in 2011/12, as the country is still adhering to a policy of being as self-sufficient as possible. The USDA envisages imports of 3 million tons in 2014/15.

Oil Supply Risk Drives Energy ETF Flows in June, Europe Reacts to ECB

Oil Supply Risk Drives Energy ETF Flows in June, Europe Reacts to ECB – European ETP Highlights

Oil Supply Risk Drives Energy ETF Flows in June, Europe Reacts to ECB As of the end of June 2014, global ETP assets approached $2.49 trillion (€1.82 trillion) rising by $75.9bn for the month of June. European ETPs received +€4bn of cash inflows. Equity exposed ETFs benefitted most by gathering +€3.5bn, while fixed income products had yet another positive month collecting +€0.9bn of cash inflows. Commodity based ETFs listed in Europe saw modest outflows of -€0.3bn.

Energy ETFs in demand on Iraq crisis

The Iraqi insurgency led by the Islamic State of Iraq (ISIS) has dominated the media throughout May and June. Major cities in Iraq were captured as ISIS solidified its grip in Northern Iraq. Baiji, Iraq’s largest oil refinery, was also captured which led to concerns on global disruption of oil supply from OPEC’s second largest producer of crude oil. In June we have noticed significant investor attention and inflows to Energy ETFs on expectations of a spike in oil prices with over €63mn entering an Oil & Gas ETF listed in Europe.

ECB announcement
After the ECB announcement in early June, which provided a range of stimulus measures to counter the threat of deflation and boost the Eurozone economy, ETFs exposed to the broad European equity markets reacted positively and received healthy inflows of €1.4bn. Whilst the upbeat tone from the announcement was dampened towards the end of the month due to less positive data from Germany, these inflows remain sticky and we are yet to witness cash being withdrawn from these products.

Dividend ETFs steadily accumulating healthy inflows

As the economy begins to turn, high yielding dividend paying stocks become more attractive as payments to shareholders previously deemed unsustainable in the long term start to look quite the opposite. In addition to this, investor expectations of the ECB announcement on stimulus measures may have created greater attraction to high yielding equities in the near term. Coinciding with this view it was noted that dividend focused ETFs have seen significant inflows from April’14 to date at over +€1.2bn.

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