Rudi's View | Jan 30 2007
By Rudi Filapek-Vandyck
Little attention has been given to the technical aspects behind the January correction in commodities and energy markets. This is remarkable given its impact on the markets in the near term is likely to be no less than significant.
Immediately after trading resumed on January 2, commodity markets were hit by professional selling orders. It was as if the world’s traders and investors had decided over the short new year break that spot prices for everything raw and material were likely to head south in the new year and it was therefore better to lighten exposure.
On top of this came the fact that two of the most publicised, and followed, commodity indices had decided to reweigh their composition forcing index trackers, often large fund managers and hedge funds, to reshuffle their assets.
As selling was followed by more selling the trend instantly became self-fulfilling. There are no official figures available, but experts at Citigroup estimated last year that short term speculators and investors accounted for more than 50% of total money flows in the oil market. While the market share of non-industry related funds in base metals markets is probably lower, it is nevertheless still “significant”.
The importance of all this is to realise that most of these professionals use mathematical models and technical analysis to direct their investment decisions. No matter how often fundamental analysts at Super Bull brokerages reiterate that market fundamentals are still supportive for ongoing price strength, if these models turn bearish money will be withdrawn from the market. And that’s exactly what has happened over the past few weeks.
All this is not to say that fundamentals no longer count in commodity markets. They do. But market signals will have to be consistent, repeated, and firmly positive before the large money flows that have just exited will start flowing back in again. Once bitten, twice shy still rules in the world of finance.
Take oil as an example. Few market watchers will deny that even only a few weeks ago, an announcement by the US president that the country would build up an extra strategic reserve, to be followed by a similar initiative by the Chinese later in the year, would have put a rocket under the spot price. In the present environment, however, oil is merely trading sideways in the mid-US$50s with experts predicting a test of technical support at US$51/barrel seems more likely, in the short term, than oil heading back to US$60 and beyond.
January’s sharp drop in the oil price has already brought out the market bears, including predictions the world will see prices below US$35 per barrel, and lower, over the next set of years. Probably of more significance is that securities analysts have started to lower their price forecasts. This means that weaker share prices have been met by reduced earnings expectations and lower valuations for stocks in the sector.
Oil specialists at Morgan Stanley concluded last year that for most calendar years consensus oil forecasts at the beginning of the year are beaten by the reality of higher prices later in the year. The more one thinks about this, the more this principle seems “natural”, maybe even deserving the label of “the way it should be”. But every once in a while comes a year when consensus forecasts have to be adjusted to the downside. The last time this happened was in 2001. Events in January suggest 2007 may well turn out such a year.
Consider that, according to a survey into market expectations by SVB Asset Management at the end of last year, global securities analysts’ expectations for the average price of oil throughout calendar 2007 ranged between US$58 and US$72 for the opening quarter of 2007. So far this means that even those at the bottom of the market will have to adjust downwards.
The SVB survey also revealed that average price forecasts for the remaining quarters of the year did not change materially, but were trending lower nevertheless with the price range for the 2007 December quarter between US$53 and US$71 for a mean price forecast of US$61.73.
In December, Morgan Stanley put the consensus market expectation for WTI crude oil at an average US$62 per barrel for 2007.
For base metals the picture is more diverse with some, like nickel, still trading at prices well above consensus market expectations, but others, including the all-important copper, suggesting consensus expectations will be adjusted downwards.
Financial news service Reuters conducts a market poll every year to set consensus price forecasts for the major metals. To determine where each of the five major base metals is at the end of January, we line up the Reuters market consensus price averages for 2007 and 2008 and actual prices on Tuesday January 30.
For copper, consensus price forecasts are US277c/lb for 2007 and US235c/lb for 2008 against a current actual price of US254c/lb (current price is 8.5% below consensus for 2007).
For aluminium, consensus is for US109c/lb for 2007 and US100c/lb for 2008. The current spot price of US127c/lb is still 16% above consensus.
For lead, consensus says US58c/lb for 2007 and US46c/lb for 2008. The current spot of US76c/lb is still 31% above the consensus average.
Zinc’s consensus expectations were for an average price of US170c/lb in 2007 and US134c/lb in 2008. The current spot price of US160c/lb is almost 6% below the 2007 average.
The absolute standout, at this point in time, is nickel with consensus price averages of US$12.00/lb for 2007 and US$9.75/lb for 2008. Nickel’s spot price of US$18/lb is no less than 50% above the market consensus for the current calendar year.
Also note that consensus expectations are lower for 2007 versus 2006 for copper and aluminium, stable for lead and higher still for zinc and nickel. All metals prices are expected to drop in 2008.
Note also that as the Australian dollar is still trading at around US$0.7730 several brokerages have started to increase their forecasts for the year. This has an adverse impact on earnings estimates for the year for most resources companies as well.
