Commodities Rally: Can It Continue?

Along with the upturn in equities markets from the March lows, commodities prices have spiked.  Oil is above $60/barrel, copper and other base metals have lurched higher due to China’s renewed demand on the heels of its stimulus spending, and grains have soared as well.  Analysts at RGE Monitor recently questioned whether this move in commodities is sustainable.  Their comments are as follows:

Commodity prices seem to be getting ahead of fundamentals again. As of May 13, 2009, the Rogers International Commodity Index rose 7.6% since the start of 2009 on the belief that putative ‘green shoots’ around the world validated a V-shaped economic recovery in 2009. However, these ‘green shoots’ might still be a signal of the stabilization of economic activity at low levels, rather than a return to trend growth. Even if GDP growth around the world has bottomed, growth may continue to be negative or sluggish until 2011. As such, commodity price gains might reveal a false sign of economic recovery – and so might the recent spate of bear market rallies in stock markets and inflows into emerging markets. The strong uptrend in commodity prices since February has been propelled more by technicals (investment demand, opportunistic stockpiling at low prices) than fundamentals (real growth in physical demand and production). Commodity prices could snap back to reality before resuming a more moderate uptrend in line with a U-shaped global growth path.

Base Metals

Base metalsposted the strongest rebound among the commodity groups. The S&P GSCI Industrial Metals sub-index rose 21.1% ytd as of May 13, 2009. Copper led the rebound as it had the smallest surplus (as a percent of supply) and China’s copper imports reached an all-time high in March. China’s import rebound was driven by strategic reserve buying and the re-stocking of depleted inventories to take advantage of low prices – not to reflect (as yet nonexistent) strong growth in global manufacturing or consumption.

China’s infrastructure-heavy fiscal stimulus will provide some support to commodities as will the nascent stabilization of the property market, but other private demand may continue to be weak, suggesting that China’s commodity demands may level off at somewhat lower levels than recent trends. Although China’s PMIs are the first and only ones globally to indicate expansion in the manufacturing sector, with external demand weak, they have a long way to go just to return to mid-2008 levels. Elsewhere, bankruptcy in the U.S. auto sector, dismal auto sales among Europe and Japan’s carmakers and weak housing markets have obviated metal stockpiling. Non-precautionary metal demand has been flat globally, leaving the metal price uptrend without any real economic backing.

Seasonality may also have beefed up metals prices temporarily: base metal demand tends to spike up in the spring as refiners stock up before metal producers – primarily in Europe – take their summer holidays. The opening of mines and refineries in Asia and Latin America have alleviated some of this precautionary demand for metals, but the ‘spike’ remains – albeit in milder form. For example, demand for aluminum by beverage makers rises in the spring in anticipation of higher demand for canned beverages in the summer.

After restocking ends, base metal demand will likely dip into a summer lull. Not even infrastructure-heavy fiscal stimulus packages may offset the fall in private sector demand for industrial metals. Already, some metal prices have begun to retreat as early as late April as physical buying waned and further pressure is likely. However, fundamentals may drive metal prices down only briefly before lower prices again attract opportunistic stockpiling and speculation. Metal prices may also be lifted by investor demand for metals as a hedge against the potential inflationary effect of quantitative easing or a weaker dollar. But technicals aside, metals will be hard pressed for a fundamentally sustainable rally until consumer demand growth revives. Moreover, higher average commodity prices might lead some of these green shoots to wither.

Iron & Steel

Meanwhile, contract bulks remain in limbo. Negotiations have already passed the April 1st start of the 2009 contract year yet benchmark iron ore contracts are still to be settled. With steelmakers demanding drastic price cuts (40-60% y/y) back to 2007 levels, sellers have been stalling for time in hopes that the market will improve. Negotiators plan to conclude negotiations by June 2009. Until then, major producers have offered iron ore in the spot market at temporary prices 20% below the 2008 contract levels. Iron ore spot prices have increased slightly since the start of 2009, but on higher freight costs not higher demand. As of May 15, 2009, the Baltic Dry Index was up 228% since the beginning of 2009.

Iron ore contract prices will most likely end up lower than last year due to the global demand contraction. Analysts expect a 35%-65% correction. Steel contract prices should follow suit with one leg already down – the 2009 contract prices for metallurgical coal (a major steel input) have settled 60% lower than in 2008. The World Steel Association forecasts the world’s apparent steel use will be lower in 2009 than in 2008. It expects only India to see an annual increase, thanks to construction for the 2010 Commonwealth Games.

Precious Metals

Gold is a special commodity in that the fundamentals of physical supply and demand are minor influences on its price. Gold’s price is most often driven by speculative demand for a hedge against inflation or economic uncertainty. Many investors see gold as a substitute for fiat currencies. Consequently, gold prices sometimes track changes in central bank holdings of gold.

Gold markets largely ignored China’s surprise revelation that it had increased its gold reserves as much of this had already been priced in by speculators. Moreover, China produces its own gold. The increase in China’s gold holdings is just a mere drop in the bucket of its total $1.9 trillion in foreign exchange reserves. Gold’s share in China’s foreign exchange reserves remains much lower than the global average and well below the U.S. share. But China’s interest in gold is consistent with its taste for real assets to gradually diversify from its U.S. bond-heavy portfolio. If other central banks followed suit, gold demand could increase sharply.

IMF gold sales will likely have little impact on gold prices if it sells its gold to central banks rather than the free market. The European Central Bank Gold Agreement’s expiration in September 2009 may have more impact. The signatories are likely to renew the agreement and continue limiting central bank gold sales. Fears that monetization of rising public debts will erode currency values may spark demand for gold as an inflation hedge.

Agriculture

The commodity group trading closest to fundamentals has been agriculturals. S&P GSCI Agriculturals registered a small 1.77% ytd increase as of May 15, 2009 – a reasonable price gain in line with the subtle inflection in global consumer demand. Intra-group price performance has largely reflected differences in supply-demand situations: Sugar and coffeehave outperformed grains, meat and dairy. Supply deficits due to cane crop failures in India and weather damage to coffee in Colombia have kept sugar and coffee prices at multi-year highs. According to the S&P GSCI, the sugar price has risen 19% ytd as of May 15, 2009 and coffee 10%. Grains (wheat, soybeans, corn) on average have fared less well, rising only 1% ytd as of May 15, 2009, commensurate with their looser supply/demand balance.

Meat prices have fallen with the reduction in meat demand due to falling incomes around the world. The swine flu outbreak exacerbated the decline in pork demand and prompted bans on pork imports in Russia, China and other places. Dairyprices seem to have bottomed at the pre-boom levels of 2006 and stabilized at this lower balancing point for supply and demand.

Oil

WTI crude oil futures have risen sharply since March, touching $60 per barrel May 15 2009, despite the weak demand outlook. Preliminary data and economic forecasts suggest that 2009 will mark the second back-to-back annual oil demand decline since the 1980s as industrial and residential demand slows and commercial inventories are high around the world. As such, spot and futures prices are likely to face further pressure along with a return in risk aversion.

OPEC’s cuts have contributed to tightening supplies somewhat but have yet to lead to much of an erosion of stockpiles, particularly in the U.S. where crude oil inventories are just off the highest levels since 1990 and well above the 5-year average. In Europe and Japan the supply overhang is less pronounced but stockpiles remain well above average levels, indicating no supply shortage.

In the U.S., demand for gasoline has held up better than other fuel products as prices per gallon are well below year-ago averages and miles driven by Americans are on the increase on a year-on-year basis. However, with gas prices having inched up this year and the U.S. consumer under pressure, summer driving season may not add as much significant demand for gasoline as in the past. Meanwhile demand for crude oil products as a whole continue to fall sharply from last year, with the most recent data from the Department of Energy suggesting an 8% drop from early May 2008, with the decline in air traffic contributing to double-digit declines in jet fuel demand.

Meanwhile, as with its metal demands, China’s increase in oil imports in late Q1 and early Q2 might not be sustainable – reserve refilling and stockpiling may account for part of the increase. With the increase in refinery capacity, including a new refinery in Fujian which can process heavier, sour crude, China may also try to ramp up refined fuel exports without a short-term increase in fuel demand domestically. Moreover as energy prices rise, China- a price sensitive buyer- may well reduce purchases.

OPECmeets again at the end of May, but further cuts seem very unlikely now that oil prices have returned to a range where more OPEC members are fiscally comfortable (most GCC countries can balance their budget in the $50-55 range). In fact data suggests that OPEC production has actually increased in April, with quota compliance falling to 77% down from the 81% from February of 2009. Compliance could well worsen. Meanwhile, non-OPEC production declines, especially from Russia, are reinforcing OPEC cuts. With a freeze on investment in most countries, supply shortages are a risk in the coming years, suggesting more volatile prices ahead.

Natural Gas

The reduction in industrial demand and ample supply contributed to record buildup of natural gas inventories in North America and in Europe, pushing down on prices. As such, natural gas has been less infected by the renewed appetite for commodities. However with natural gas drilling activity having fallen sharply, there is a risk that the current glut could be followed by a supply shortage. With the manufacturing sector weak, industrial demand in advanced economies may be particularly slow to recover, limiting the revival of demand.

Macroeconomic Implications

There are several macroeconomic implications of this recent increase in commodity prices. Commodity exporting economies and their currencies are, like commodities, vulnerable to a reversal of risk appetite. The green shoots which prompted the in rush into commodities have likewise prompted inflows to commodity exporters like Russia, South Africa as well as Australia and other commodity exporters. The U.S. dollar’s weakness has contributed to strengthening of both G-10 and EM commodity currencies. However, with global exports weak, the upward pressure on currencies is not particularly welcomed and some emerging market economies like Russia are intervening in foreign exchange markets, adding to their reserves. At current oil prices, the outlook and liquidity conditions are improved in many exporting economies, many of which like Norway, Saudi Arabia and Chile are deploying their past savings to meet current spending needs. However, even the current improvement in revenues may do little to avert the consumption slowdown in many of these economies.

The generalized increase in commodity prices across the board and in transportation fuels in particular poses the risk of choking off any global economic recovery. And although current production cuts and delayed investment may have only limited effect on prices in 2009, they could raise the risk of a significant price shock in 2010 which could send the economy back into weakness. Swift increases in commodity prices as we saw in 2008, tend to exacerbate recessions as well as worsen external balances in the U.S. and key oil importers and adding to the amount of capital needed to finance fiscal and financial support packages.