Thursday 28 Mar 2024
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Following the surge in raw material prices, Wall Street firms are expanding their commodity desks. Last week, it was reported that Bank of America Corp would increase its commodity headcount by 25% and London-based Barclays would add another 6%, while Morgan Stanley is recruiting traders in shipping.

Hedge funds investing in commodities are still growing with new funds being set up. According to Bloomberg, assets under management at commodity hedge funds grew 4.3% to US$55.9 billion at the end of June from end-March this year.

The Reuters/Jefferies Index, which tracks 19 commodities, has risen 28.3% from its year’s low in March this year but it is some 36.7% away from the one-year high reached on Aug 21, 2008. 

Another dimension to the commodity trade is the return of carry trade as investors take advantage of cheap US dollars, euro and yen to buy into currencies of commodity exporting countries such as Australia, Brazil, Indonesia and South Africa. For example, investors are buying into Australian assets as the country stands to benefit from the economic rebound in China, one of its major customers. The prospect of rising rates in some of these currencies has also fuelled the return of the carry trade.   

Are commodities entering a new phase of higher prices? Credit Suisse believes so, saying commodity returns still lag behind the improvement in economic conditions and that commodity markets are now seeing the beginning of a new cycle. Standard Chartered Bank says commodity prices have been rising as risk appetites return on the back of positive economic data, especially from China, and a weaker US dollar.

While Standard Chartered says there is upside to commodities this year, especially in 4Q, it cautions that the upside is limited as expectations of rising demand have already been factored into prices. Restocking activities in China have also distorted the extent of recovery in demand while demand outside China remains weak. Furthermore, rising supplies in response to rising demand will limit the upside for some commodities. 

Crude oil has risen 43.45% YTD, trading at above US$70 a barrel. Abah Ofon, soft commodity analyst at Standard Chartered Bank, expects the West Texas Intermediate to be range-bound between US$65 and US$70 per barrel in 3Q before moving steadily higher in 4Q as demand strengthens in Asia and the greenback weakens.

“In 1H2010, a more ambivalent direction in the dollar should contain investor flows. Beyond mid-2010, we believe US dollar weakness will provide further impetus for prices to rise higher. While price spikes cannot be ruled out, some Opec (Organisation of Petroleum Exporting Countries)  members have already increased output in response to higher prices, and we expect compliance to weaken further should prices breach the US$80 per barrel,” he says.

Ofon adds that Opec’s spare capacity is currently around 5.5 million barrels per day, leaving ample scope to expand production as demand tentatively recovers. This margin will be gradually eroded as demand growth returns. However, he does not expect this to happen until beyond 2010, as it will require a recovery in developed markets.

As for grains, Ofon explains that the market is currently in the second stage of a three-stage process consisting of, firstly, the liquidation of long positions from 2H2008; secondly, tentative speculative flows; and thirdly, more broad-based fund flows into agriculture. He expects the market to now enter the third phase as investors adopt a longer-term perspective based on secular demand as well as part of their portfolio diversification strategy.

“This assumes, in the short term, that financial markets improve or at least do not deteriorate further. However, we acknowledge that potential upside in markets could be dampened as pressure is piled on non-commercial positions by the CFTC (Commodity Futures Trading Commission), which is said to be closely watching for convergence problems across a range of commodities, including soyabeans, corn and wheat,” Ofon explains in email responses to The Edge.

He adds that the possibility of deterioration in grain balance sheets due to the weather is sufficient to upset markets. This, combined with an improvement in speculative flows and greater demand from the biofuel industry, will create the strongest upside pressure for grain prices, especially in the context of a weak dollar and a possible scramble to cover short positions.

The weather factor is already playing out in sugar prices, which experienced a 23% spike over the last one month alone. Sugar cane output has declined in India, a major sugar exporter, as farmers switched to higher-priced food crops and drought hit sugar cane-producing districts. It has been reported that as of Aug 17, monsoon rainfall was 27% below the 50-year average, resulting in 256 of the country’s 625 administrative districts officially declared drought-hit. Bad weather in Brazil, another sugar-producing country, also contributed to the global sugar shortage. 

The US however, is expecting good soyabean and corn crops this year due to the seasonally cool weather, which will balance out the impact of bad weather experienced in other parts of the world on these grains, says Thomas Lee Bauer, head of food and agribusiness research and advisory Asia at Rabobank International.

Soyabean production is forecast at a record high of 3.2 billion bushels for 2009, up 8% from last year, while corn is forecast at 12.8 billion bushels, 5% higher y-o-y, according to the US Department of Agriculture’s crop production report in August.

Bauer, who does not believe in the view that the US dollar will weaken further, says going forward, the question will be whether the economy can rebound, leading to demand for higher quality foods. He agrees that the recession has not had a huge impact on food consumption, and palm oil demand has been resilient through the downturn. However, demand for higher quality foods such as high-end meats has been affected, with the exception of pork, which has been affected because of the perceived H1N1 threat.

“But that will come back. Generally, you’re going to see people eat more and eat out more, which will stimulate the food services sector, which uses a lot of beef, milk and cheese. As the global economy comes out of recession, we’ll probably see a continued upward trend in all agricultural commodity markets, driven by an increase in disposable income in Asia,” says Bauer. 

Ethanol production will remain a significant factor for corn, given the US government’s support for alternative energy while the El Nino phenomenon bears watching, given the potential impact on palm oil production, he adds.

Among the commodities, metals have done very well, with copper prices rising 95.1% YTD, nickel 60.7% and aluminium 18.3%. However, as Shanghai stocks declined last week, copper prices slid as the metal is a major beneficiary of economic activity in China, where it is widely used in the  power sector and home appliances such as air-conditioners and refrigerators.

Standard Chartered Bank’s metals analyst Daniel Smith says prices have overshot and look vulnerable to a correction in the short term. He is also expecting a correction in zinc in the near term and favours aluminium and nickel.

“In the short term, we expect both aluminium and nickel prices to keep rising on the back of robust demand in China. China has traditionally been an exporter of aluminium but its imports of primary aluminium and products have surged recently. Similarly, nickel imports have surged,” he writes in an Aug 14 report.

This article appeared in The Edge Malaysia, Issue 769, Aug 24-30, 2009.


 

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