Commodities | Nov 16 2010
By Chris Shaw
With QEII adding liquidity to markets investors continue to be attracted to commodity markets, as evidenced by record highs for copper prices and gold pushing through US$1,400 per ounce at one point in recent sessions.
RBS suggests the attraction of commodities can be attributed to a number of factors, including fears of a possible debasing of fiat currencies or upside inflation surprises, which is driving investors to real assets.
As well, RBS points out further economic stimulus measures mean interest rates in developed economies are likely to stay lower for longer. This has the effect of allowing non-yielding commodities to remain competitive versus cash and other lower risk investments.
The final factor in RBS's view is commodities at present are an attractive way to play what is still a fragmented global growth outlook. Even if developed markets add little to commodity demand growth over the next few years, strong consumption in Asia should keep commodity markets tight and so deliver further price gains. By playing commodity markets, investors can gain exposure to these markets and economies.
While prices are elevated at present, RBS takes the view ongoing market deficits and falling commodity inventory levels will mean significantly higher base metal prices by 2013/14. If these price gains come faster than this, RBS sees some potential consequences, which would delay any move to deficit markets. This in turn would make base metal prices vulnerable to price corrections.
Factors to look out for, according to RBS, include any rapid restarts of idle capacity, something the broker suggests is most likely to impact in nickel and zinc. Price gains could also see a surge in marginal supply, as China for example has announced an additional US$4.48 billion in spending on exploration to reduce that country's reliance on imports of copper and iron ore.
Liquidation of unreported or strategic Chinese base metal stockpiles could also occur, RBS noting there has been some possible evidence of this already as sales of private sector copper stockpiles potentially contributed to weaker Chinese imports in October.
In terms of how to play the commodities sector at present, RBS suggests investors ride the wave for now but be prepared for sharp corrections over the next 12-18 months. Beyond this timeframe, RBS expects improving fundamentals will underpin further price gains through to 2014.
Given the importance of Chinese demand to commodity markets, any changes in expectations in this regard could have a significant impact on prices in the sector. Having been of the view commodity prices would be supported in the second half of this year thanks to an acceleration of Chinese demand as economic policy eased, JP Morgan notes recent economic data and official announcements are now challenging this view.
According to JP Morgan, there are two reasons to expect this trend could continue – firstly, JPM notes Chinese macroeconomic policy stance has been expansionary from a credit growth perspective, so it seems too early to anticipate authorities seeing the battle as won and adjusting policy accordingly.
This reflects a view if policy had been loosened as some in the market expected, the message to speculators would have been to simply wait out a modest pull-back before enjoying the next run up. In JP Morgan's view, this would have made containing the next upswing even more difficult.
Secondly, the broker notes both residential construction and infrastructure spending face near-term headwinds, as a build-up in inventory is putting some pressures on project starts. On JP Morgan's estimates, 2011 is likely to be the slowest year for the private housing sector in the last decade.
At the same time, JP Morgan suggests infrastructure spending is likely to be affected by what are currently high debt levels among local authorities, which the broker expects will make the next round of borrowing and spending lower than what occurred in 2009/10.
Even allowing for this, JP Morgan retains a positive view on the Chinese market, as those sectors of the Chinese economy most exposed to credit conditions have priced in the policy risks. This suggests a limit to any potential downside.
In contrast, JP Morgan suggests resource stocks have not yet priced in these policy risks, so it is adopting a more conservative stance. This is particularly the case at the smaller end of the Australian resources market, where share price performance has been good against a background of modest Australian dollar commodity price rises and cost inflation.
JP Morgan's recommendation is to reduce risk in the Australian resources sector, the broker's preference being for the larger, more diversified stocks.
Macquarie has also looked at Chinese demand with respect to copper, noting it hasn't slowed as much as the market had expected in recent months. This has kept momentum high in the copper market and leads the broker to suggest prices are going to rise further in 2011.
This is based on Macquarie's view the copper market will be in deficit in 2011 to the tune of around 420,000 tonnes. Physical Exchange Traded Funds (ETFs) are likely to widen any deficit and the broker suggests these could at least partially offset any increase in the rate of metal substitution or demand destruction stemming from higher prices.
What should also be supportive for the physical copper market, in Macquarie's view, is while China is currently de-stocking concentrate, scrap and refined copper it will need to return to the market early next year.
There remains scope for corrections in coming months given the current level of prices, but Macquarie continues to see scope for the copper price to trade as high as US$12,000 per tonne over the course of next year.
Copper prices averaging such a level for all of next year is less likely according to Macquarie, as such elevated prices are likely to attract more scrap and increase the levels of both thrift and demand destruction in the market.
With respect to aluminium, Macquarie is bullish on a two to three month view, expecting the metal will outperform as the Chinese market is tightening quickly thanks to strong demand growth and falling supply.
Further de-stocking is likely in the early part of 2011 in Macquarie's view as Chinese supply will take some time to ramp-up in the New Year and this offers an extra potential boost for prices.
Turning to the thermal coal market, Deutsche Bank notes prices here have also been strong in the past month, rising by around 13%. In the broker's view, the gains reflect restocking ahead of the northern winter.
Such seasonal buying is generally significant, Deutsche Bank noting Chinese thermal coal demand from power plants has risen by an average of 16% in December when compared to the annual average. This year the trend has been exacerbated by fears the coming winter could be a particularly cold one.
This year is a La Nina year, which supports the concerns of an unusually cold winter, so Chinese power plants have also been buying as a precautionary measure. The view of Deutsche Bank is the weather factor could potentially make thermal coal the best performer of the bulk commodities in 2011, as demand from key regions such as India and China should remain resilient.
As well, Deutsche expects a continuation of infrastructure issues in China and constraints from key seaborne suppliers such as South Africa and Australia. From a forecast US$98 per tonne for the 2010 Japanese financial year (JFY), Deutsche expects prices for contract thermal coal will rise to US$110 per tonne in JFY 2011 and to US$120 per tonne in JFY 2012.
