Commodity Talk: Riding out the storm

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In general, commodity prices continue to struggle as global economic indicators deteriorate and signs of recovery are few and far between. With the global economy in a significant downturn this year, and the prospect of a mild recovery at best in 2010, the general demand outlook remains bleak.

The resurgence of steel prices in China earlier this year has been choked off by rising supply and a lack of any real evidence (yet) of a rise in end-use demand. Freight rates have sustained their rally, but a further move higher seems unlikely in the absence of a real improvement in steel demand and output which, in turn, hinges on the implementation of China’s infrastructure plans.

Supply cuts have been significant, paving the way for recovery. In practice, however, supply cuts — particularly across the metals and energy markets — have been significant.

Once expectations for global economic performance bottom out, we believe commodity markets will begin to see a recovery, driven both by fundamentals and a subdued rekindling of investor interest. To the extent that this coincides with weakness in the US dollar and rising inflationary expectations, the environment could be very supportive for commodity markets.

Near term, however, perhaps with the exception of sugar and palm oil — where supplies are in question — persistent weakness is likely across the commodity market spectrum in 2Q2009.Recovery, when it comes, will likely be selectiveThe key question is timing, and recovery, when it comes, is likely to be selective, given contrasting fundamentals. We favour crude oil over industrial metals, which will, in general, be weighed down by substantial inventory and capacity overhangs. This has been evident in China over the last couple of months as steel producers quickly increased output as domestic demand rose, choking off the recovery. The demand growth largely came from dealers in anticipation of renewed demand for infrastructure projects from mid-year. In practice, any resumption in steel demand is more likely to favour raw material costs than steel prices as spare capacity is so high.

Opec is likely to take its cue from observed inventories. This contrasts with the crude oil market, where we believe the medium-term prospects for a price recovery are more positive. Near term, crude oil prices continue to be driven by the conflicting pressures of falling demand growth and significant Opec supply cuts. Prices seem to have found a floor at above US$40 a barrel in the last few weeks despite continued poor economic data, and have strengthened to the mid-US$40s in recent days ahead of Opec’s meeting on March 15.

There is little market consensus on whether Opec will announce a further cut to its production target. Indeed, estimates of the level of compliance also vary wildly. Latest IEA estimates put Opec-11 (excluding Iraq) output at 26.7 million barrels per day (mbd) in January, 1.8 mbd adrift of the 24.9 mbd target, but compliance has continued to strengthen over the last month. A recent Reuters survey puts February output down a further 0.6 mbd at 25.6 mbd, and estimates from consultancies tracking tanker movements suggest cuts might be even deeper than this. For instance, Petrologistics estimates that February output was just 25.3 mbd.

Assuming an output of 2.3 to 2.4 mbd from Iraq, this suggests Opec’s output of 27.6 mbd, which is substantially below our projected call of 28.7 mbd in the second quarter, and rising to 28.8 to 29.5 mbd in the second half of this year.

However, given the huge uncertainty surrounding both demand and supply estimates and forecasts, Opec will likely take its cue from observed inventory levels when making its output decision. Inventory data from the US has at last begun to show crude oil stock levels falling. While this indicates a more balanced market, Opec is likely to at least call for greater compliance to existing targets ahead of the seasonally weaker second quarter.

While economic data continues to deteriorate, it is unlikely that the oil market will gain much traction. Once things bottom out, however, we believe the substantial output cuts will pave the way for a recovery.

While Opec’s margin of spare capacity is in essence a “capacity overhang”, the likelihood is that the organisation will be slow to re-open the taps once demand recovers and prices begin to rise. Comments from Opec ministers suggest that members would like to see prices at US$60 to US$70 a barrel, suggesting that they will be slow to increase output as prices rise. Meanwhile, in an industry where extensive investment is required even to keep production constant, investment plans have been scaled back as prices are now well below marginal costs for many regions. We continue to highlight the risk of a sharp snapback in prices once demand has been rekindled.Gold’s rally stalls, but we remain bullish longer termThere was a significant rally in the precious metals sector in February, although gold was hit by a sharp correction in early March. The initial driver was the panic buying of safe haven assets as equity markets slumped and worries about the banking sector intensified. Strong inflows into exchange traded funds (ETFs) were recorded for all markets through the middle of February. However, this rally was founded almost entirely on risk aversion, with gold jewellery demand notably absent. When ETF buying dried up, prices fell back once more.

Despite this, gold should find a floor soon and we continue to look for prices to head higher in the second half of this year, particularly once the US dollar weakens beyond mid-year as we expect. High levels of scrap supply, particularly in India and the Middle East capped the recent rally, but much of this material will have now been washed out of the market for this price level, and the next rally beyond US$1,000 per ounce should consequently prove more sustainable. Helen Henton is head of commodity research at Standard Chartered Bank. Comments: [email protected]

This article appeared in The Edge Malaysia, Issue 746, March 16-22, 2009