Feature Stories | Sep 07 2009
(This story was originally published on 17 August, 2009. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere).
By Greg Peel
“After the ‘risk trade’ trade from November 2008 to date,” suggests Credit Suisse, “we risk entering a premature ‘euphoria’ phase in our view as many equities appear to be pricing in a normalisation of the cycle already”.
In just nine months, the price of copper is up 115%. The price of nickel is up 120%. The price of oil is up 120%. The price of just about all commodities traded on an exchange are up, and up substantially. When oil peaked at US$147/bbl in 2008, it had risen in nine months by only 63%.
Currently in the US, debate is raging about commodities markets. As part of a post-GFC regulatory overhaul the Commodities Futures Trading Commission (CFTC) is seeking to limit speculative positions in commodities futures, using oil as the poster-child example. On the one side, the argument is clear: the 2008 oil price boom was driven by pure speculation. Speculators should not be permitted to create destructive price volatility in so vital a commodity. On the other side, the argument is not quite as clear, but no less emphatic.
The rise in the oil price was all about Chinese demand, suggests one argument. It was merely a reflection of a falling US dollar brought about by Fed rate cutting, goes another. Or a more fundamental argument simply notes that for every buyer there must always be a seller, and thus speculation was working on both sides – equivalently – but still there was a rally. So why is speculation to blame?
Personally, I think everyone is right.
Chinese demand for crude oil had indeed been a factor of its price rise from US$20/bbl in 2002 to US$70/bbl in 2006, then when we hit 2007, the upward trend line steepened markedly. By late 2007, the US Federal reserve begun to cut its funds rate as a response to the credit crisis and so set in train a twelve-month collapse of the US dollar. China was initially considered immune from the credit crisis, and all the market could see was more Chinese cars hitting the roads. Thus the oil price was being forced up by a combination of perceived forecast demand (call it the numerator) and a falling reserve currency (call it the denominator). The combination of an increasing numerator and a decreasing denominator provided the exponential shift in the upward swing.
But while Chinese demand was one part of the numerator story, the other was direct commodity investment. We may call the US dollar the world’s reserve currency but from a more pragmatic sense the world’s reserve currency is oil. Gold may be the traditional hedge against monetary inflation but oil can also serve that purpose while still providing consumption value. Indeed, all consumable commodities provide a direct hedge against inflation. Price inflation increases if the prices of commodities rise, and monetary inflation increases if the supply (printing) of the reserve currency rises. If you are an investor looking to hedge against inflation, why fiddle about with fiat currencies and effectively “useless” gold? Why not go straight to the source?
Prior to the mid-noughties, the “source” was largely off limits for retail investors and large mutual funds. Futures contracts, with all their inherent risks, provided the only means of direct commodity investment outside of buying shares in miners and drillers, which provide their own unique set of risks. On the speculative or inflation-hedge side, only retail cowboys and hedge funds joined genuine industry players in commodities futures markets. But with the rise of popularity in exchange-traded fund (ETF) instruments, suddenly safer access was provided. The funds took on the futures market risk, leaving all market participants with easy access to this vital market. And to make it easier still, various commodity index ETFs were introduced to provide a simple, diversified and direct inflation hedge.
The key word here is “access”. So if you add up genuine industry buyers and sellers of oil, speculators in the oil prive movement, and inflation hedging from the wider investment community, you have a powerful force to push a market one way or the other – more powerful than ever was the case before 2005.
I have put up this graph of Nymex oil futures before, but it is useful to reinforce the case:
The oil price movement is now familiar, but pay close attention to the volume bars beneath. In 2005 – when the first oil ETF was introduced – note the step jump in volume. And then note the volume growth thereafter, as more oil ETFs and commodity fund ETFs were introduced, and note that volume remains historically high to this day.
Those volumes bars represent a simple increase in market access. But then one might argue, aren’t illiquid markets more volatile? Shouldn’t an increase in volume mean less sharp movements in price?
Not when you take control of the price away from the industry players. By introducing “everyone else” to the mix you introduce herd mentality. Herd mentality provides greater market momentum. If oil is a hedge against inflation, and inflation is caused by a rising oil price, then by buying oil as a hedge one only serves to push up the price, and thus inflation, which means you need to buy more oil to hedge. That’s upward momentum for a start. Throw in speculative momentum, as in “this market’s on the move so we’d better get in”, and also throw in industry views such as that of legendary US oil man T. Boone Pickens, who in 2008 called oil at US$200/bbl, and what you have is a recipe for the chart above. Of course it all works the same way on the downside as well.
So the CFTC can argue all it likes about “speculators”, but it’s an ignorant view. And the CFTC has always supported ETF introduction.
Let’s now jump forward to 2009. Commodity prices are again on the rise, even more sharply than in 2008. But from much lower levels of course. Why this huge surge? Well it’s a combination of many factors:
(1) Commodities were oversold on herd panic on the downside; (2) record Chinese commodity imports; (3); improving global economic conditions; (4) a resumption of US dollar weakness; (5) a fear of hyperinflation as a result of excess US debt.
Some of these factors point to speculation, or speculative hedging, and some do not. By far the biggest influence on commodity prices in 2009 is without a doubt, however, Chinese buying. So why is China buying? That’s the $64 billion dollar question. Indeed, the answer to this question holds the key as to whether this recent commodity price surge has legs, or is just another bubble. Again, one can trot out a number of possible answers to the question of why China is buying:
(1) Restocking at lower prices after a period of destocking when prices were falling; (2) exploiting lower prices to build strategic reserves; (3) a realisation that parking foreign reserves in US Treasury bonds and buying commodities only as needed exposes China to the risk of a weak dollar and subsequently rising commodity prices (call it the “cut out the middle man” effect); (4) actual demand for commodities needed to supply China’s massive infrastructure stimulus program.
If you are long commodities or long resource stocks, you would really like the answer to be (4). In every other case, China is not actually consuming the commodities it is buying, implying that one day it must reach a limit. And that is the crux of the matter.
Will China shortly stop, or at least pause, its commodity buying program? As Credit Suisse puts it: “The risk of an air pocket remains high in the next 3-6 months if China pulls back in the short term”.
Chinese buying is the most influential force on the numerator of the commodity price ratio. What’s happens to the denominator (US dollar) from here is also important. Let’s have a look at a monthly chart of the US dollar index:
The trend from 2002 is undeniably down, and on a shorter term perspective the US dollar has clearly rolled over again after its brief bounce from 2008. The 2005 correction in the trend represents the Fed fighting inflation by raising its interest rate from a then historical low of 1% back to 5.25% before the credit crisis hit. The more recent correction represented the shift from US credit crisis to Global Financial Crisis, in which all world currencies collapsed relative to the dollar which had already collapsed.
The pervading global view is that the US dollar must continue to weaken in the medium term given the sheer size of US debt. At this point, the US Fed has set at timetable for the end of quantitative easing but has staunchly declared that its interest rate will be at near zero for an “extended period”. To raise rates too soon would be to derail a first attempt at economic recovery. So far the world appears still happy to fund US debt by buying Treasury bonds. So far, so good. If this attitude changes (and Lord knows every emerging market nation has declared its intention to quietly wean itself off US debt) then the Fed will have little choice but to raise its rate.
The question is, however, one of a race to recovery. China appears clearly to be winning that race, but China’s renminbi is pegged in a range to the dollar. We learnt this week that the GDPs of both France and Germany posted a surprise positive 0.3% gain in the June quarter, within a net EU drop of only 0.1%. US GDP fell 1.0% in the June quarter. The region that raises interest rates first will determine which way the US dollar will move. But when the dust settles and it appears all the world is on a path to recovery, the US fiscal budget will remaining a glaring deficit stand-out.
That’s why almost everyone is resigned to a secularly weak US dollar from here. Standard Chartered puts it this way:
“Our FX strategists maintain the view that the USD is in a multi-year downtrend, and that it will see a succession of lower highs and lows over the next few years. However, a key element to be aware of is that the current USD downtrend is forecast to be choppier than was the case from 2002-04. From a commodity perspective, this suggests fundamentals will become key differentiating factors during periodic bouts of [USD] strength.”
The fact of the matter is that global economic recovery is not going to be a smooth and seamless process. Not only is there strong risk of a spluttering period of nervous and inconsistent strength, leading to disappointing false dawns, each economic region will likely see choppy data which will lead to choppy currency relativities. Hence Standard Chartered’s forecast of a choppy USD chart from here. If the USD does bounce back periodically (rising denominator), as the analysts are suggesting above, then all things being equal we will see subsequent drops in commodity prices. Such drops might be avoided, however, if fundamental demand (rising numerator) provides the offset.
Which brings us back to our question as to whether current apparent Chinese demand is real. Because once you move away from China and other emerging markets, it’s a different story. Commodity demand from developed countries remains significantly depressed, and even though there are now signs of stabilisation, “In general, economic indicators remain weak by past standards,” noted BHP Billiton CEO Marius Kloppers at the release of the world’s largest diversified resource company’s full-year profit result last week, “and any assumption of a quick return to historical growth may be premature”.
If a secularly weak US dollar is a popular long term forecast among analysts, a short term drop in commodity prices is another. Most analysts believe that even if Chinese commodity buying is underpinned by hundreds of billions of dollars worth of infrastructure projects, record Chinese imports in the first half of 2008 in a climate of global recession suggests a lot of stockpile-building to take advantage of lower prices. Once the warehouses are full (if they aren’t already) then Chinese buying will temporarily cease.
Copper is one commodity China has been buying with gusto. Take a look at a copper chart:
Now take a look at the Baltic Dry Index over a similar period:
The Baltic Dry Index is a measure of the cost of freighting dry commodities such as copper and iron ore across oceans. Obviously freight rates rise when commodity prices rise given demand for imports means demand for ships. If you compare the period June 2008 to June 2009 on the two charts, you’ll note this relationship is clear. One interesting point, however, is that the BDI tends to just slightly lead the copper price, which (one assumes) is because ships are booked ahead of copper purchases being signed off on.
But something rather interesting happens in June. The BDI trend turns sharply downward, and now technically looks weak, while the copper price has sailed merrily on. The copper price has sailed merrily on because global economic data continue to improve and because the US dollar remains to the weak side. But the reason for the turn-down in the BDI is simple.
Chinese commodity imports are slowing.
Take China out of the mix in the short term and commodity prices are looking perilously lofty. That is why most analysts agree that a short term commodity price correction now appears inevitable.
Credit Suisse has called it an “air pocket”. The analysts at Citi suggest: “We acknowledge that the recent rally has been substantial, so we can not rule out a short term correction in risk assets as pullbacks are common during risk rallies”. National Australia Bank analysts say: “Chinese imports of base metals are expected to moderate in the short term before recovering once the [Chinese] export sector rebounds over 2010.”
Deloitte Research is more definitive:
“There is ample evidence that China has been stockpiling enormous quantities of commodities. It is likely that China is nearly done with this stockpiling and that means there is no longer going to be sustained demand for these commodities.”
Just to throw another consideration into the ring, Credit Suisse notes that the period from November to May is historically the strongest period for cyclical sector returns. (Resources is a cyclical sector.) The analysts go on to point out that “September is the worst performing month over 36 years of available data”.
We note that the Baltic Dry Index peaked in June. We note that commodity prices have kept rising into August. We also note it will be September in two weeks.
The US CFTC is currently arguing the toss over the difference between “real” demand and supply fundamentals and pure speculation. One might argue that from late 2008 China has been providing the “real” demand. China has introduced a US$586bn fiscal stimulus package, a large proportion of which is being directed towards public infrastructure works. Additionally, China has eased its interest rate, as all major economies have done, to encourage lending. But in China’s unique way, the government has not so much encouraged its banks to lend but demanded them to lend. A race is on between the competitive Chinese provinces to outdo each other on construction projects. But China, too knows a thing or two about speculation.
Benchmark metals prices are set from trading activity – both real and speculative – on the London Metals Exchange. To facilitate such activity the LME provides inventory storage warehouses across the globe. But Shanghai is also a inventory storage centre, and the vagaries of physical delivery dictate that LME and Shanghai metals prices will often diverge. Such divergence nevertheless sets up the opportunity for price arbitrage if the price being paid for metal in China exceeds the cost of importing it from elsewhere on the globe. The extraordinary surge in Chinese commodity demand in the first half of 2009 via fiscal and monetary stimulus suddenly pushed Shanghai metal prices well above LME prices at a time when the rest of the world thought metal demand was now dead in the water. Chinese metal traders sprung immediately into action, importing cheaper LME-priced metal to sell in Shanghai, or to stockpile ahead of selling in Shanghai after prices had risen further.
2009 price rises are not just a factor of Chinese demand, they are a factor of Chinese speculation.
The rest of the world has now responded to this Chinese price surge, and the LME-Shanghai price gap has begun to close. Have the Chinese metal traders bought and sold quickly, or are they still sitting on excess stockpiles in the hope of yet higher prices? Because in the meantime, marginal Chinese production of metals has again kicked into action after a period of shut-down due to uneconomical prices. Marginal producers in the rest of the world have the same idea. Supply has begun to rise to meet apparent demand.
In May 2009, Chinese copper consumption was 65% greater than in May 2008. Chinese copper consumption is up 40% in 2009 year to date while at the same time global consumption ex-China is down 20%. Yet Chinese industrial production growth was only up 9% from May to May. There is a big gap between “apparent” copper consumption as an input and actual industrial production as an output.
Credit Suisse suggested in the quote which begins this article that there is a risk we are entering a “euphoria” stage. In around six months world economic sentiment has turned from one of doom and gloom into one of fervent optimism. Share prices of global resources sector stocks, note the analysts, appear to be already pricing in a “normalisation of the cycle”. In other words, markets have now decided that despite the biggest credit market crash since the Great Depression, the world is back in business, or at least shortly will be.
Is the world back in business?
China’s own stock market has looked somewhat fragile of late, having surged some 80% from its trough in 2008. Frequent rumours suggest the Chinese authorities are about to raise interest rates in order to slow down the frantic pace of growth. Yet the view from economists inside and outside China is that this will not happen, or at least not happen yet.
The Chinese growth miracle on 2003 to 2008 was driven by an export market which represented 60% of Chinese GDP. That export market has since collapsed. Chinese authorities are hoping their fiscal and monetary stimulus policies, directed at stimulating a still immature Chinese domestic economy, will provide exactly the impetus the rest of world needs to get back on its economic feet. Developed economies have reacted to the GFC with their own fiscal and monetary stimulus packages aimed at preventing economic collapse. If the developed world has provided the floor to stop the global contraction, China is attempting to provide the impetus for actual global growth. China wants its export market back.
To that end, economists suggest the Chinese authorities will maintain low interest rates for as long as it takes. Economists also now forecast a return to global economic growth, albeit sluggish, in 2010. China is deliberately providing the rest of the world with the oxygen it needs to achieve this goal. But has a shrewd Chinese policy worked too well, too quickly?
Analysts believe that is the case. As in any natural market, an overrun has occurred. They believe the longer term prospects for global economic growth and thus commodity prices must first endure an inevitable short term correction. To reiterate the opinion of National Australia Bank analysts: “Chinese imports of base metals are expected to moderate in the short term before recovering once the [Chinese] export sector rebounds over 2010.”
In Part II: the longer term view and a discussion of the prospects for individual commodities.
