Commodity prices to benefit from global wealth

Tobias Merath of Credit Suisse predicts a strong year for commodities.
Gold glitters: Credit Suisse is bullish on the prospects for the precious metal
Gold glitters: Credit Suisse is bullish on the prospects for the precious metal

The last few weeks were mainly marked by the recovery of commodity prices following the sharp correction right at the start of the New Year. As a result, the major commodity indexes are now trading significantly higher again than in mid-January. Since its low point for this year on January 9, the Dow Jones AIG Commodity Index (DJAIG Index) managed to regain more than 8%. Over the same time, the Goldman Sachs Commodity Index (GSCI Index) even recovered more than 9%. While those numbers seem impressive, the YTD performance of commodity indexes remains poor, given the correction during the first two weeks of 2007.

The recovery of commodity indexes also masks the fact that the price trends in the individual commodity categories are still quite disparate. Energy commodities have been hit hardest by the correction at the outset of the year. However, they also led the subsequent recovery. The Dow Jones AIG Energy Index now stands at a higher level than on January 1. Base metal prices were also strongly affected by the correction and unlike energy, had a harder time recovering. Only in late February did price dynamics pick up. In soft commodities, price movements have been limited so far this year. While the sector was barely affected by the correction, it also failed so far to break its sideward trend sustainably to the upside. The only commodity category which has seen continuous price increases since the outset of the year is precious metals.

Given the fact the global economy is still in a state of slowing growth, in particular in the US, the price trend across the individual commodity classes should remain disparate, depending on the sensitivity of the individual categories to the business cycle. In that context, some risks remain for industrial metals and energy, while our outlook for precious metals and soft commodities is 48 Spring 2007 favourable. Only when growth of global industrial production starts to pick up again later that year, would we expect more sustained price increases across the different commodity classes. This outlook also has implications for the attractiveness of broad-based commodity indexes as well as for our investment strategy for individual commodity classes.

What to expect for commodity indexes

Despite the recent recovery, the YTDperformance of the major commodity indexes remains subdued for several reasons. First, growth in global industrial production is still slowing, especially in the US, and also in parts of Asia. Prices for energy commodities and base metals in particular tend to react quite sensitively to fluctuations in economic growth. Therefore, downside risks still prevail for these commodity categories. Since energy commodities and base metals account for large portions of the performance of the major commodity indexes, the outlook for index performance remains subdued even when we take into account our positive view for soft commodities and precious metals.

The second factor which affects index performance negatively is the contango situation in many markets. Contango is defined as a situation where longer-term future contracts are more expensive than shorter-term contracts or spot prices. Most commodity indexes track the performance of front month futures contracts. Shortly before the delivery date, these contracts need to be rolled over, meaning the expiring contracts are being sold and the proceeds are invested into the subsequent futures contracts. In a contango situation, these subsequent contracts trade at higher prices than the expiring ones, ie a positive price performance is already priced in. If the actual spot price performance falls short of this pricedin performance, rolling costs arise which weigh on index returns. Currently the markets for energy commodities, precious metals, most soft commodities and the market for copper are in contango. Together with the current slowdown of economic growth, this should limit the performance of commodity indexes in the months ahead.

However, the situation should brighten up, once we see a re-acceleration of global economic growth. Since we believe that such a pick up in economic growth will only materialise later in 2007, we are still cautious regarding the short-term outlook for broad-based indexes. However, there should be some upward potential in the second half of the year.
The oil price will depend very much on the outlook for the global economy
The oil price will depend very much on the outlook for the global economy

Where to invest in the commodity universe

As a result of the subdued short-term outlook for broadbased indexes and the differing trends in the individual commodity categories, a tailor-made investment strategy for each commodity category is needed.

In the energy sector, oil prices should consolidate after the recovery since January 19. As the heating season slowly comes to an end, developments in the gasoline sector become increasingly relevant for oil prices again. However in the US, gasoline inventories rose to significantly above-average levels over the last couple of months. Together with the current growth slowdown in global industrial production, this should limit further upside potential in the weeks ahead. So while we expect oil prices to exhibit a sideward trend over the short- to medium-term, renewed concerns about political tensions in important oil producing countries such as Iran, Nigeria and Venezuela should lead to increased volatility during the next months. However, later this year, oil prices should start to increase again more sustainably. Already now, OPEC production cuts are starting to affect crude oil inventories in the US. While inventories are still above average, they are currently converging towards it. Together with the expected pick up in economic growth this should lead to renewed price increases over the more medium-term. Our 12-month forecast for WTI prices is accordingly $60-66.

In base metals, the situation is a bit different. While nickel and tin prices are reaching new all time highs due to combination of robust demand and severe production outages, others such as copper have seen a strong correction. Since base metal prices are highly sensitive to changes in the business cycle, risks still prevail as long as economic growth is still slowing. In the current situation, we prefer metals with a conservative risk/return profile such as aluminum. Only later in the year, when global growth starts to pick up, metals with a moderate risk/return profile such as copper and zinc should start to look attractive again.

For precious metals, the investment outlook remains constructive. Precious metals are less dependent on the cycle of global industrial production. Their price development hinges on investment demand and demand growth from the jewelry industry, which mainly emanates from India, China and the Middle East. For all three of 50 Spring 2007 these regions, we forecast strong GDP growth which should underpin precious metals prices. Gold remains our favourite market in the precious metals sector. Demand for gold remains strong. Physical demand emanating from the jewelry industry as well as investment demand is currently underpinning prices. The latest data reveals constant inflows of money into physically-backed ETFs in addition to the futures market. At the same time, the supply side remains tight on the gold market. Gold sales by European central banks so far this year have noticeably lagged behind the levels seen in 2006. Moreover, recent data shows that gold mining production in South Africa was down 12.4% y-o-y in December 2006. Nevertheless, due to negative seasonal effects which can be expected during the first quarter, we anticipate some market turbulence in the coming weeks. Given the strong fundamentals of the physical market, investors should nevertheless use price dips to add to their positions.
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