Commodities | Sep 14 2006
By Greg Peel
Ripples of concern have spread through the market that commodity prices are about to take a big dive. Analysts are beginning to warn of a correction to come – none of this piddling May-June stuff, but a REAL correction.
But then analysts have been talking correction all the way up the commodity bull run. Super-cycle or no super-cycle, commodity prices have just not followed the rules. Rules that imply reversion to mean prices, rules that suggest cycles within cycles, rules that say prices simply cannot go higher.
About a year ago most resource analysts threw their rule books out the window.
Part of the problem was that they were serially undervaluing resource stocks. Or at least their resource stock valuations began to look pretty silly compared to traded share prices. They really had no choice but to get on board. As spot prices continually shifted up, so did analyst forecasts.
Only this week and last week have we seen the latest round of forecast increases. But commodity prices have now begun to weaken. Are resource analysts wrong again?
No, it is not implicit that they’re wrong. In fact most forecast increases still reach levels notably short of spot and short-date prices, and longer dates (with the exception of gold which has a natural contango) tend to fall steeply. In some cases any shorter date contangos in base metals have been completely ignored.
And analysts are again rolling out the correction argument. Arguments were strong around April-May last year, and sure enough a correction ensued. The market was seriously overbought, said many, and they were right. Newfound investment instrument euphoria had definitely delivered a bubble situation.
But as far as corrections go, it wasn’t much. Such it was that by August we found ourselves back at May levels once more. Why?
Respected UK analysts Sucden have provided quick recap of why commodity prices are where they are:
(1) Many years of chronic underinvestment in mining leading to a lack of new projects and new skilled personnel; (2) Unforeseen supply-side disruptions due to pushing existing infrastructure too hard, and due to labour strikes predicated on a (not unreasonable) objective to share in some of the spoils; (3) Everybody has underestimated Chinese demand (a lot of this was underestimation of the domestic infrastructure boom as opposed to just manufacturing for export consideration); (4) As a result of 1-3, inventories have fallen to historically low levels; (5) New financial products have encouraged previously unknown direct fund investment in commodities.
Add to the above: Post 9/11, world central banks were determined to increase liquidity in order to avoid economic stagnation, resulting in a wealth of speculative carry trades into more lucrative assets such as commodities (notwithstanding Japan’s already zero rates).
When you look back, it really isn’t all that surprising. So what’s happening now?
More recently, central banks have begun to tighten monetary policy all over the world. Carry trades are looking increasingly less attractive. The reason why central banks have been tightening is due to inflation fears brought about by the inflated prices of exactly the commodities those with cheap money have piled into, and those which China has been sucking up fast – oil being the major commodity.
For along time inflation was a concern, but not a problem. The reason is that China was countering commodity inflation with export deflation. By utilising the seemingly endless supply of workers willing to work for next to nothing, China was importing up all the raw materials and exporting manufactured products at lower and lower prices.
In this way inflation was masked. But it couldn’t last forever. It’s one thing to buy a cheap TV, but China could not export cheaper petrol prices, nor cheaper food. That bubble had to burst. And it did so finally when suppliers of everything realised that fuel prices were just not going down, and so they began to pass on their costs into prices.
In the meantime, China is itself now an inflationary bubble set to burst. Growth mania has produced an oversupply of manufacturers, all vying for same thin margins. The explosion had been fuelled by cheap credit and artificially controlled exchange rates. While China is not about to simply let overextended manufacturers go under, it is addressing the speed of its growth through financial controls.
In other words, China is trying to slow its economy. This would put a brake on commodity prices.
The US economy is also now slowing, and more rapidly than most thought. US housing was expected to pullback, but only with a soft landing. It now appears it may be in for a very hard landing. This flows through to consumer sentiment and consumer spending. And ultimately, to commodity prices.
Six months ago all the talk was that the economies of Europe and Japan had finally awakened from their slumber, and that viably alternative growth regions were in the offing to provide relief from the China-US dichotomy and its related imbalances. But inflation has posed too much of a problem, and those economies appear to be stalling again. Once more, this is not bullish for commodities.
Were there to be global recession, then commodity prices surely must fall. Ironically, as oil prices have fallen (for now) fears have been tempered, yet falling oil prices are bringing down commodity prices with them. This brings us neatly to the overbought scenario.
Sucden suggests market sentiment could be the crucial factor in short term market direction. Say the analysts:
“We forget how long people have been calling for a correction in metal prices. Almost throughout the market’s rally there have been almost continuous calls for a correction of anything from 20% to as much as 50%. We have recently firmed in our belief that a major downside price move could still emerge…All commodities currently seem to be becoming deserted by bulls, at least by those prepared to establish new long positions or significantly add to existing ones. And yet on the LME [London Metals Exchange] a really big “wash-out” has not been experienced, just two minor down-side attempts have been seen.”
JP Morgan has weighed into the argument. Morgans’ analysts increased their commodity price forecasts only this week, but as explained earlier, this does not necessarily render them bullish in their view. In fact, Morgans has just released a report suggesting “The weight is against base metals”. The analysts have provided four reasons for this view.
Firstly, the fall in the oil price. Energy represents 72% of the Goldman Sachs Commodity Index futures basket, and so a fall in this index has a negative effect on the other commodities in the basket.
Secondly, the “roll return” has turned negative. The roll return is a phenomenon that appears in commodities bull markets where the immediate availability of a commodity is under pressure – thus forcing short-date prices up – while supply down the track is expected to improve – thus keeping long-date prices low. By shorting the short-date and buying the long-date a speculator can pick up a carry in an instrument that doesn’t otherwise pay dividends or coupons.
The large positive return that has existed recently in base metal markets has begun to dissipate and in some cases turn negative. Morgans suggests the implication is that the market sees supply-demand heading for rebalance soon.
Thirdly, and as mentioned previously, global economic growth is slowing.
Lastly, short term supply factors that have greatly influenced the market now have an end in sight. With Escondida in particular nearing resolution, such supply disruptions have been accounted for and are now no longer a surprise.
JP Morgan is recommending an Underweight position in the resources sector. Conversely, the equity analysts continue to recommend Overweight positions on BHP Billiton (BHP) and Rio Tinto (RIO).
How badly would a major commodity price correction hurt BHP and Rio ? Well a look at day-to-day trading would suggest a lot. Both fly up and down on daily metal price changes. However, one needs to consider the more macro picture.
BHP is increasing its production everywhere. One of the reasons commodity prices have been so high is the inability of miners to even get the ore they have onto the market due to limited infrastructure capacity (rails, ports, etc) and smelter capacity. Capacity in both areas has been increased and is increasing. This means the likes of BHP will be selling ore at lesser prices, but will potentially be selling more of it. A lower level of comfort in price will need to be found, but the developing world is not just suddenly going to stop developing.
Rio ‘s growth is not so exciting, which is why some analysts have turned negative on the stock. Or at least they favour a greater weighting in BHP.
Those analysts calling for a correction are not calling the end of high commodity prices as we know it. There is still a super-cycle. The only difference is that, as long has been expected, prices need to cycle back to more realistic (but still historically high) levels.
Says Sucden:
“Our gut feeling is that an imminent large downward price move remains a high possibility. But should it occur, it would remain a corrective move with prices recovering later this year at the very least to challenge the all-time highs – and quite possibly to surpass them – perhaps by some margin.
“Therefore, should the correction emerge, which could represent a fall of as much as 25% from current prices, then we would view such a move as a buying opportunity in both the short and medium term.”
The one proviso Sucden puts on this view, however, is watch out for the fund money. If sentiment is frightened into very negative territory, and prices break technical levels (particularly moving averages) there could be some short term carnage.
Credit Suisse agrees with the above. The analysts point out rather wryly: “If some of the speculative or diversification-oriented financial buyers decide to take profits, the meaning of downside risk may become abundantly clear.”
Credit Suisse is among the fraternity calling for a correction. CS notes that over the last five years the CRB Index has seen the biggest real jump in its history. Bigger than two world wars and the 1970s. “Did someone say overbought?”
CS is not expecting this downturn to be devastating either. The analysts do not expect it to turn into a recession. They do, however, see an “almost certain” global recession in 3-5 years, impacting on Chinese growth just as all the new supply finally catches up.
That’s a long way off yet.
Citigroup has an interesting take on the matter:
“This commodity-resources super cycle is a very good one. But the China/USA growth-demand combination today is NOT better than Japan/USA combination in the 50s and 60s. China is about where Japan was in the mid 1950s in terms of size and contribution to commodity demand.
“However, real commodity prices are back to their 50s and 60s levels—so the market is factoring in that China will do as well as Japan went on to do in the 1960s, i.e. rising to be almost half the US economy. China may well do this, and the world may well keep growing in a strong low inflation way to accommodate this. But it will need to do this to justify current real commodity price levels. Hence we believe we are coming to the end of rapid nominal increases in commodity prices—the momentum slows from here.”
Citigroup wrote this in early May. While you could say the analysts got it very right, given the May correction, you could similarly say they were wrong, given that by August we were back again. However, this view is more than just a six-monther. Arguably, and as commodity prices slip once more, the view is still a very pertinent one.
After the May correction, many analysts forecast a move forward but at a slower pace. A positive trend, but a less excitable one. Yet China kept growing and supply kept being disrupted. That’s changing. Maybe now the May view has come to fruition.
