Commodity markets have witnessed extreme price action during the past 12 months, from historic highs to price reversals driven by a weakening global economy and investor risk aversion. While some optimists are forecasting the start of a recovery, the opaque global economic outlook still poses many questions for commodity producers and consumers in Asia. Simon Grenfell, head of commodities for Asia at Deutsche Bank, shares his views on the challenges facing the region and the broader development of commodity markets in Asia.
What has been the reaction to recent rises in commodity prices?
Sparks of optimism have supported a sustained rally in financial markets over recent months, with suggestions that the worst of the financial crisis may be over. However, debate over what is driving the rally continues; is it liquidity-driven or are markets correctly predicting a turnaround in the global economy?
If we presume an economic recovery is the main driver, the rise in oil prices to $70 per barrel was clearly supportive, although we have since seen this ease to $60. Freight rates, a measure of the expectation for global trade activity, have risen strongly with the Baltic Dry Index up 413% from its low in December 2008.
However, looking at the overall economic climate, of which demand for commodities is dependent, then the fog surrounding the recent rally becomes more entrenched. US unemployment, while slowing, was at 9.5% in June. Unemployment in the Eurozone hit 9.5% in May. China's exports fell 26% year-on-year in May. The fall in global stock markets caused by the World Bank's downward revision to its global economic outlook on June 23 showed just how fragile the rally is.
Forecasts by the International Monetary Fund and the Organisation for Economic Cooperation and Development (OECD) point to a weak recovery to global growth in 2010. Our strategists forecast the global economy will contract by 1.5% in 2009, returning to growth of 2.5% in 2010. China, a key source of demand for global commodity markets, is expected to see growth of 8.3% in 2009 and 7.8% in 2010.
While these data leave many questions as to the sustainability of the current rally, it is clear that volatility will likely remain a key factor at least until the end of the year. As such, we have seen renewed interest from producers and end-users in ways to manage a potentially wider trading range for commodity prices in 2009.
Longer term, the threat of inflation re-emerging as the world comes out of recession, coupled with capacity cuts across all commodity sectors, may cause a strong bounce in prices at some stage; perhaps even surpassing the levels seen at the beginning of 2008.
As the volume of carbon credits sold by Asian projects continues to grow, how do you see Asia's contribution to the global carbon market developing?
Asia's carbon market has developed strongly over the past couple of years and we are now seeing it mature into its next phase. Until recently, the focus was very much on the early stages of the market's development. This involved introducing clients to the Kyoto Protocol mechanisms and the European Emissions Trading Scheme to help them lock-in cash flows for projects that lower carbon emissions. This typically involved the abatement of industrial gasses, improving energy efficiency or constructing renewable energy projects. These efforts continue to form an important part of the market, particularly in China, where we have been helping companies monetise the carbon credits issued to their projects.
However, as the scheme matures in Asia, the number of issued certified emissions reduction credits (CERs) being sold by project owners in the region is growing significantly. These flows represent CERs that have been issued to operational projects. An important step in monetising these credits is finding a partner from an industrialised country to participate, which is a requirement under the Kyoto Protocol, and a role we have been increasingly active in filling.
So while the market has seen a reduction in primary deals, we are starting to see some meaningful flows of issued CERs from Asia into the European market. With more carbon trading schemes being designed and implemented around the world, the Asian carbon landscape has the potential to develop significantly. Specifically, the potential to see domestic carbon markets develop in countries like New Zealand and Australia, as well as renewed interest from Japan, bodes well for the future of the global carbon market.
However, as these alternative schemes shape up, it is clear that Asia will remain a key source of carbon credits for companies.
Although a new market to Asia, freight futures grew in popularity as shipping costs spiked during the last economic cycle. Has this interest been sustained and how do you see this market developing?
From queues of laden vessels blocking Australian harbours on their route to China, to images of empty container ships bobbing in the Malacca Straits, the global shipping industry has witnessed extreme changes in fortune over the past 12 months.
To put this in perspective, the Baltic Dry Index fell precipitously in 2008, from a high of 11,793 on May 20 to a low of 663 on December 5. Wet freight rates saw a similar decline. These falls were largely caused by an expectation that global trade would seize as the credit crisis permeated through the global economy. A sustained ship-building boom in previous years, with many vessels expected to come on-line this year, was also viewed as increasing global shipping capacity to levels that many saw as unsustainable.
However, the recent rally has fed through to freight markets with freight futures across the board rising consistently since March. This in part reflects the extreme sell-off seen in the fourth quarter of 2008, but also large deliveries of iron ore into China between October 2008 and April 2009. A belief that global trade may begin to recover somewhat quicker than anticipated has also contributed.
Chinese demand for raw materials will remain a key driver of global freight rates. The large-scale public infrastructure spending announced in response to the crisis may help sustain dry bulk rates in the short term; perhaps even long enough to see a broader recovery in global trade.
Freight futures, or forward freight agreements, are still part of a very young market globally. However, given that shipping costs are an important variable for local exporters, I expect this market to play an increasingly important role in corporate liability management in Asia.
What do you see as the most significant change in terms of trading in today's market versus trading conditions prior to the credit crisis?
Unsurprisingly, liquidity has diminished across the entire commodities complex. This is in part due to the pull-back in risky assets, but also to uncertainty about the real value of the US dollar. The textbook relationship of US dollar weakness leading to commodity strength has been the most common trend over time. Because commodities are priced in US dollars, if the dollar weakens the value of commodities should rise to maintain their value in global trade.
However, this relationship has broken down at various times; the most recent example being the rush to US Treasuries in the second half of 2008. This led to a sustained rally in the US dollar and a fall in commodity prices as money shifted away from risky assets.
Lately, dollar weakness and a commodity rally have again coincided, bringing this inverse relationship back. However, what is different this time is the driver of US dollar weakness; the medium-to-long-term effects of quantitative easing and the unprecedented levels of liquidity being injected into the global financial system are still very much unknown.
Combined with lower levels of liquidity, trading conditions have therefore become extremely tentative and I think this uncertainty will continue until the implications of Fed policy on the value of the US dollar become clearer.
Corporate flows will remain fairly tight until we see a clear bottom in global export demand and inventory levels become more subdued. The ensuing demand effect will allow manufacturers to exert pricing power back onto consumers and see their participation in commodity futures markets increase as hedging activity picks up. In addition, the 'flight to quality' movement when choosing counterparties has also modified the competitor landscape in Asia and globally. The fallout from the Lehman bankruptcy has seen many corporates take a much more pro-active approach to managing their counterparty risk and increasingly understand that price alone is not the only reason to choose a trading partner.
Have you seen investor interest in commodity markets return since the start of the rally?
The popularity of commodities as an asset class perhaps reached its peak in the first half of 2008. Most strategies at that time focused on directional plays, with the expectation that commodities would continue to rise as a result of acute supply and demand shortages. However, commodities have a history of volatility and the head-and-shoulders performance by commodities in 2008 was no exception.
Given the declines in valuations in the second half of 2008, the reliance on directional trades saw commodity markets become a less popular source of returns. Volatility has since ensured these strategies remain the domain of more nimble and sophisticated investors for the time being.
However, commodities offer a range of market neutral trading opportunities that can provide returns independent of price direction. Given some investors' reluctance to make directional calls in today's market, commodities are again featuring in investors' portfolios. Strategies that play the arbitrage between various points on commodity futures curves are an example. Investor interest in these trades saw us recently launch our Commodity Harvest index to retail investors in Singapore, which uses a market-neutral strategy to try and provide returns regardless of market direction.
Banks around Asia have also been actively promoting simple commodity trades based on the dual currency deposit structure. Popular with retail and private banking clients, this involves the short-term sale of call options on gold. An investor will deposit gold for a set period of time, say one or three months, and receive a premium in return for a promise to pay a counterparty a pre-determined amount should the price of gold reach a certain level. The depositor will obviously have a view that gold will not increase in value dramatically.
Inflation concerns, driven by the massive injections of liquidity by central banks into global markets since the start of the financial crisis, have also boosted interest in various commodity structures to hedge against future inflation risk. While this is likely not a short-term issue, the consequences of the unprecedented measures being taken to reflate the global economy are very much unknown. I expect this theme will become more dominant as we head towards a sustained recovery in the global economy.