Global commodity focus Q2 2016
Commodity investors were stunned in 2015 as major woes continued to negatively impact on prices of all commodities, especially oil. Also assisting in this was a strengthening US Dollar and a slower Chinese economy. Looking ahead, three key catalysts for bullish surprises can be highlighted:
Surprises from geopolitical events can trigger shortages in the supply of key commodities used for energy and also influence gold and silver prices and have a bullish effect on some of the other commodities like platinum and non-precious metals like copper, lead, tin titanium and zinc to name a few. We have already seen gyrations in iron ore prices in 2016 and volumes traded, especially on China’s Dalian Commodity Exchange where volumes soared to 7.6 billion metric tonnes (76.2 million contracts) during March in the first quarter, far exceeding the previous high of 32.6 million contracts that was set in December, according to the bourse’s data.
It is only a matter of time before another disruption to commodity trade flows occur, according to many analysts who specialise in the Commodities Sector, with energy or food-related looking vulnerable in the Middle East or Russia or both. Turkey has now also joined the list of countries in dispute with Russia. Saudi Arabia is also suffering from a burgeoning population in need of jobs and the economy needs modernising in order to alleviate its dependence on oil as primary source of revenue for the government and its people.
Wahhabism is also a problem not only for the House of Saud, but for the world as a whole as it encourages the spread, not only in Saudi Arabia and surrounding lands, but internationally of this ultraconservative religious branch of Sunni Islam. In today’s world of interconnectivity and interdependence based on agreements and pacts that affect safety in homelands and internationally, and keeps track of migration and mass movement of displaced refugees, it is more important than ever to have good relations with key international partners for the west, and everyone else. Today Mohammed bin Abd Al-Wahhab’s teachings are state-sponsored and are the official form of Sunni Islam in twenty first century Saudi Arabia. Saudi Arabia is your ultimate rentier state which receives and derives a substantial portion of its national revenues from the rent of indigenous resources to external clients. The ruling al-Saud family provides all the services that a traditional government would provide in the western world, like housing, health care, education and they supply various subsidies, and this is oil funded by the substantial oil reserves.
Due to rising instability in the Middle East and the effects of the Arab Spring across the region, the al-Saud family upped the spending on social care via salary increases, public sector job creation and housing subsidies. The oil glut and accompanying global slide in oil prices and metals prices have exacerbated the economic woes for commodity dependant countries like Russia and Saudi Arabia, Brazil, and South Africa, to name a few. Of course these countries used to rely heavily on exports to China, and China is adapting with problems of overcapacity and nurturing their own consumption spending upwards to become more sustainable. Not to mention Petrobras and Brazil’s president Dilma Rousseff’s pending impeachment and whether it should be taken right to the end.
US dollar: with currency moves and gyrations notoriously hard to predict and difficult to forecast, the confident consensus of further dollar gains seems inappropriate, even foolish, especially when observing the Federal Reserve’s carefully worded statements and long deliberated consensus meetings when one word, the latest being “caution” can put a damper on wild expectations for much higher interest rates. The Fed sees inflation reaching its goal of 2% annually before the end of next year, meanwhile the market expects 10 year inflation of 1.65%.
If inflation does not reach the Fed’s required target of 2% in the next decade, it would almost be impossible to for them to raise the interest rates much at all over the same time period. Of course there are times when the market has taken a divergent view from the Fed, and this could be due to a plethora of factors ranging from measuring indices to surveys etc. But it looks like we are in a low yield, low inflation expectation era, at least for now! If the dollar starts to change direction, commodities could surge.
On Wednesday 27 April 2016 the Federal Reserve held interest rates unchanged whilst at the same time left the door open to a possible rate hike in June, although the US central bank’s policy-setting committee (FOMC) said the labour market had shown signs of further improvement despite a recent economic slowdown and it is closely monitoring inflation in line with its inflation target of 2%(as measured by the annual change in the price index for personal consumption expenditures). The overnight lending rate’s range target varies from 0.25% to 0.5%. The Fed hiked rates in December of last year for the first time in nearly a decade. The Fed expects inflation to remain low in the near term due partly to earlier declines in energy prices.
However it remains confident that inflation would rise to their 2% target over the medium term. They are however still proceeding “cautiously” in raising rates due to uncertainty in the world economy and the lack of inflationary pressure at home. Currently Fed policymakers project two rate hikes in 2016 compared to four hikes predicted back in December. This all makes a case stronger for a weaker dollar while the rest of the world plays catch-up, which can support commodity prices and possibly be the catalyst for the start of a bullish rally in commodities.
3. Supply/demand balances: this extended slide in commodities’ prices is setting up for a much needed equilibrium and return to supply/demand being balanced across a wide range of commodities. Miners and energy companies still felt the pain throughout the fourth quarter last year and the throttling of supply will likely be extended. US natural gas is a good current example of energy being produced that has recently been trading below the cost of production of even the most efficient producers. This all is in aide of a cut in the overall supply in the nearer term which can only be supportive of commodities.
Energy seems to be superficially low and suffering from bad psychology surrounding OPEC and non-OPEC members’ inability to put a freeze on output, with Iran back from the cold and the old rivalry between Saudi-Arabia and Iran not yet buried, and the US urging the Saudis to share the region with Iran, this all impacted on the psyche of oil investor and buyers. Seasonal fluctuations in temperatures being milder than expected did not help make the case to support the prices of natural gas or oil. There is however a shortage in gas starting to develop and drawdowns will eventually exceed production until the prices start to improve. On top of declining supply you have Russia-Ukraine tensions still simmering in the background all in support of gas and oil.
Base metals prices are still hugely influenced by China and what happens in China, and though there is still some woes expected in things like copper and nickel, the Chinese central government’s restructuring will see a reduction in credit being supplied to loss making overcapacity which in turn will lead to a tightening market for base metals although the individual inventories held for each type of metals will still impact the shorter term moves in prices up or down with potential downside still for copper.
Precious metals can perhaps benefit from an increase in geopolitical concerns or macroeconomic developments. Gold can benefit from sluggishly increasing inflation which, if followed by another incremental rate increase, will keep real interest rates dampened so that real rates do not negatively impact on the gold price. With real interest rates suppressed an asset like gold looks attractive as it does not have a yield per se. Platinum, of which South Africa produces 70% of global supply, have a neutral outlook due to the fact that a weak rand, caused by political woes, has delayed further supply cuts, and investor sentiment has been dented by the VW Emissions scandal, as platinum is used in the exhaust systems as a catalytic converter, coincidentally to convert toxic pollutants in exhaust gas to less toxic pollutants.
Agricultural commodities is expected to reach the bottom and start to show sign of recovery in 2016. With these commodities we can state that conditions look favourable for rapeseed, palm oil, cocoa, sugar and rubber. Although agricultural production on the major continents look set to favour the prices of these commodities, the dollar that seems range bound or weaker, also supports these commodities. Planting problems caused by droughts also mean there might be short supply in some parts of the world and that imports will be necessary. Meat prices are starting to recover after planting season droughts in large parts of the world caused oversupply, but this is expected to change to at least trade sideways if not slight recovery mode.
We have seen five years of the commodities bear market we can realistically expect bullish surprises. This could be the starter or instigator for strong recovery rallies in 2016 and after.