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Material Matters: Commodity Prices, Oil And War

Commodities | Sep 04 2012

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 – Environment remains supportive for better 2H12 commodity prices
 – QE3 in US to help, China also likely to ease policy
 – Danske Bank and Capital Economics update commodity forecasts
 – JP Morgan sees increased risk of Israeli strike on Iran
 

By Chris Shaw

While China offers a weaker outlook than had been forecast a month ago, Danske Bank suggests its analysts' existing forecasts for commodity prices for the year are largely on track. This means a more supportive environment for commodities in the second half of this year on the back of any further easing in Fed policy, some stabilisation in the Chinese economy and the European Central Bank acting as a backstop for debt-ridden sovereigns in the region.

August Fed minutes suggest to Danske a further round of quantitative easing is now likely unless economic data flow improves markedly. This is expected to provide support to risk assets including commodities in the near-term.

An improvement in Chinese economic data has yet to materialise, but with inflationary pressures in that economy continuing to weaken Danske suggests Chinese policy makers continue to have some room in terms of moving to a more accommodating policy stance.

While it may take longer than previously thought for the Chinese economy to emerge from its current slump, Danske still sees an improvement this year and expects this will be positive for commodity prices in the final quarter of 2012.

Across the commodity spectrum, Danske suggests the oil price floor is likely to move lower as the hurricane premium is taken out of the market. Geopolitical issues remain a key to prices, as does the potential for releases from strategic petroleum reserves. 

Danske expects inventory builds in oil both this year and in 2013, which implies fair value for the market should gradually move lower. Danske suggests Saudi Arabia is happy for the oil price to fall to around [Brent] US$100 per barrel, as this would dampen the current negative impact on the global economy of higher prices while still delivering solid oil revenues.

In industrial metal markets Danske notes Chinese buying has yet to re-emerge, though the market appears to be upbeat on the potential of policy moves from both the US and China to support prices. Such a boost is likely to be short-lived though, as apart from copper most commodity markets appear headed for surpluses.

The fundamentals suggest copper has the most bullish outlook in Danske's view, so while in general base metal prices should generally head lower, copper may move higher on inventory drawdowns

Capital Economics cautions that while a further round of quantitative easing by the US Fed may come as early as this month, the strength of the summer rally in some commodity prices means this may already be priced into markets. This opens up scope for attention to return to the poor economic and financial conditions that made further stimulus (if it eventuates) necessary. 

Variation in commodity price performance has been largely due to supply side factors in the view of Capital Economics, with tin and platinum benefiting from lower exports from Indonesia and mine strikes in South Africa respectively. 

For the oil market Capital Economics notes prices continue to level out as the market adjusts for the potential of official stock releases, but it is likely to be weakening demand and disappointment at the impact of QE3 that drags prices down in coming months. This is enough for the group to forecast a year-end price for Brent crude of less than US$100 per barrel.

While the increased potential for further action by the US Fed drove industrial metal prices up slightly in August, Capital Economics suggests still lacklustre economic growth in China is consistent with further price falls.

Both gold and silver have rallied in recent weeks and Capital Economics sees potential for further gains given the expectation of a renewed escalation of the eurozone financial crisis. This should be enough to bring gold's safe haven status back into the focus of investors.

Commodity price forecasts for Capital Economic are detailed below:

In the view of JP Morgan, the chance of Israel making a unilateral military strike against Iran has increased from 2-5% in January this year to 10-15% now as verbal sparring between the two sides has risen in recent weeks.

While the almost universal belief is an Israeli attack will see a large oil price spike at least at first, JP Morgan cautions the market looks ill-prepared for the potential outcome of a strong move down in petroleum prices.

If an actual Israeli military assault was to be realised within the next 12 weeks, JP Morgan suggests the reality is events are unlikely to unfold smoothly. This would significantly increase price swings in the energy market, this volatility representing the primary risk factor for global markets.

Looking at some lessons from history, JP Morgan notes mobilisation for war can in fact create unexpected momentum that results in a war that was not intended to be started. Casualties are likely to be higher than expected and expectations for a swift war are often not met.

With respect to the current situation, JP Morgan points out Israel's view is that the window for containing the Iranian nuclear weapons risk is likely to close soon. Current oil sanctions against Iran have not altered that country's behaviour with respect to uranium enrichment and Iran's possession of a nuclear weapon means an increased chance it will be used against Israel. 

At the same time JP Morgan notes there are some in global security policy circles suggesting stability in the Middle East would he increased if Iran was to become a nuclear power as it would give that nation a tool for power projection in the region.

With Syria indicating it possesses chemical weapons and with rising congestion in the Persian Gulf in recent weeks JP Morgan suggests the risk of a conflict has increased, with the potential for a draw on US or other strategic oil reserves another contributor to the increased likelihood of a military conflict.

In terms of strategy under such an environment, JP Morgan remains neutral given the potential for any Israeli military action to result in either the unnecessary release of strategic oil stocks or large damage to global commodity demand. Both have the potential to push prices significantly.

For JP Morgan the greatest value in the current environment is in options based strategies such as owning crude puts and crude call spreads and in price-neutral spread trades.
 

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