What has driven the recent correction in commodity prices? Does this signal an end to the super-cycle?
The March correction was a broad one; affecting energy, precious metals, industrial metals and agriculture. In light of global economic issues, debate over whether the current bull run is taking a breath, or drawing to a close, has certainly intensified.
However, we believe the recent correction is more the result of factors outside supply and demand fundamentals. Investors unwinding speculative long positions to take profits or exiting existing positions to cover margin calls elsewhere are the main cause.
This unwinding effect has probably been most severe in the agricultural complex, where investors have put on the most aggressive long positions and where price declines have exceeded 20%.
Rather than signalling an end to the cycle, this investor positioning phenomenon does not derail what we see as bullish fundamentals, most notably in the agricultural and precious metals sectors, and also within parts of the industrial metals complex.
In particular, we forecast prices across the agricultural complex to bounce back strongly, reflecting high underlying demand as the fight to feed people, cattle and cars intensifies against a backdrop of global land and water constraints. Inventory to consumption ratios for agriculture are at or close to multi-decade lows and likely to remain this way in the medium term.
Are there more corrections to come? What impact will a US economic slowdown have on commodity prices?
Commodities are at risk from further corrections which could extend into the second quarter. This includes a pocket of US dollar strength, which naturally places downward pressure on USD-based commodity prices, particularly energy.
Another relapse in global equity markets could also have an effect on industrial metals prices, which have shown strong correlation to the S&P500. Considering the index has declined around 13% since its peak in October last year and that the average decline from peak to trough over the last 10 US recessions since 1948 has been 25%, a recession in the US could spell further pain for this sector.
However, any correction will be short-lived in our view. We believe underlying fundamentals across the industrial metals complex, specifically for aluminium and copper, remain strong.
The rally in agricultural commodities also appears to be in its infancy. Our research shows that compared to previous bull cycles, which were not backed by such significant demand drivers as China and India, prices in real terms are still a long way from their highs. Sugar, coffee, cocoa and corn are particularly cheap.
To what degree has speculative buying influenced recent price movements?
There has been much discussion over the past few years regarding how investor activity affects price, term structure and volatility across the commodities complex. In 2005, the discussion was focused on the distorting effect the rapid inflow of money tracking commodity indices were having on the crude oil forward curve, which had flipped from backwardation to contango.
Since roughly two-thirds of index money was estimated to be tracking the S&PGSCI index, which had an allocation of at least 70% to the energy complex, the speculative community was an easy target to be held responsible for the shift in the WTI forward curve. However, such claims were seriously flawed in our view. Taken to its extreme, it would imply the crude oil curve will be perpetually in contango not least given the surge in funds tracking commodity indices since 2005.
While financial flows can have an effect on price, curve and volatility across the commodities complex at a certain point in time, we believe underlying fundamentals are the ultimate drivers. For example, the sudden move in the crude oil curve from contango to backwardation last year has its origins in the steady reduction in OPEC and specifically Saudi Arabian crude oil production. As Saudi Arabia withdrew oil from the market, physical fundamentals tightened and contributed to the forward curve moving back into backwardation.
This year, the discussion has shifted from the effect investors have had on the forward curve to their effect on price. We agree that commodity index returns have been buoyed in 2008 by a new wave of risk capital entering the commodities complex and have been particularly surprised by the strong recovery in copper prices, which we had expected to occur later in the year. These gains have been all the more remarkable since it has occurred in an environment where the S&P500 has remained depressed.
However, we believe any possible disconnect that drives commodity prices away from underlying fundamentals will not be able to persist indefinitely. While investors can certainly amplify price movements in commodity markets, suppliers and consumers ultimately drive prices.
What is driving increased investor participation in this asset class, particularly with regard to agricultural commodities?
Commodities have been a clear winner in terms of out-performance this year, offering powerful diversification benefits when added to a portfolio of bonds and equities. Not only does back-testing show extremely convincing results, commodities have also weathered the sell-off in global equities and credit distress extremely well over the past 12 months. Since the start of the year, we calculate that commodities have returned 12.2% up to 20 March, compared to 2.9% for bonds and -11.7% for equities.
Indeed, we believe the strong performance of commodities against a backdrop of sub-prime and global risk reduction is fundamentally based, rather than simply fund flow or speculatively driven. While the demand side of commodities might suffer from the US or even a global economic slowdown, we believe ongoing supply side constraints across many commodity sectors will keep the outlook bullish.
Investor concerned about a weak US and global economic outlook and skittish global equity markets are increasingly looking at agriculture indices, which tend to be resilient to US recessions, global equity market weakness, the course of US monetary policy and the ebb and flow of the US dollar.
How do you see commodity prices developing over the medium-term?
We believe prices across the agricultural complex will bounce back strongly after the recent sell-off. This reflects the strength in underlying agricultural demand and inventory to consumption ratios at, or close to, multi-decade lows.
We are also sustaining our medium term bullish outlook towards the precious metals complex. Not only is the platinum market balance forecast to remain in deficit until 2009, but, additional dollar weakness has not been exhausted in our view. Indeed during four of the last five US recessions, the US dollar trade weighted index has declined by an average of 9% from peak to trough.
Given our house view that the world economy will escape severe recession and the persistence of emerging market growth patterns, we remain positive across most of the industrial metals in 2008 and 2009. The overarching themes of extraordinarily tight market balances and uncertain energy supply will continue to support an elevated price environment.
For oil, supply and demand fundamentals continue to be relatively tight. Even with a significantly slower global economy, world oil demand is expected to grow by at least one million barrels per day in 2008. With non-OPEC supply forecast to rise by circa one million barrels per day, OPECÆs market share (after correcting for NGLs and inventory) is not expected to change substantially.
Although there could be a rebound in non-OPEC supply growth in 2009, the global economy should be doing better then too and that implies higher oil demand and yet another year with minimal pressure on OPECÆs quota system. Meanwhile, we believe the oil producers are becoming more accustomed to higher prices and our review of the extremes in oil valuation suggests that prices would have to rise much further in order reach excessive levels. In our view, $70 per barrel of oil is cheap, $130 per barrel of oil is expensive, and $100 per barrel of oil is the centre of the trading range in the near-term.
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