Commodities | Oct 18 2011
– ANZ suggests commodities are oversold
– Barclays revises its sector order of preference
– Issues in oil and steel markets
– Price stability needed for palladium's fundamentals to dominate
By Chris Shaw
Having reviewed September quarter performance and market conditions ANZ Banking Group's October Commodity Call suggests commodity markets look oversold, but while there is uncertainty in financial markets prices are unlikely to rebound strongly.
The current uncertainty means investors appear to have priced in an emerging market contagion, a risky call in the view of ANZ. This leads the bank to suggest as financial conditions settle somewhat, investment funds should return to buy what remains a strong Chinese demand story.
The weakness in commodity markets over the past few months has been centred in the exchange-traded base metals and oil markets, ANZ noting these markets are larger and have more liquidity so are easier for investors to move in and out.
Downside in steel, iron ore and coal has been limited given the contract-based nature of these markets, while ANZ suggests the recent weakness in agricultural markets has been cushioned somewhat by heavier selling earlier in the year.
Demand fundamentals still appear solid, with ANZ noting business sentiment in the key demand market of China remains strong. As well, the December quarter tends to seasonally be a stronger period as the northern hemisphere holiday period passes and re-stocking gains momentum.
In the view of ANZ, commodity prices appear close to a bottom and should start to improve as investors turn their focus from developed market concerns to emerging market opportunities. In support of this view, the bank notes momentum-based selling appears to be slowing, while US commodity futures now look less stretched.
ANZ also argues the recent pullback in prices across the commodity sector will benefit the Chinese growth story, as inflationary concerns should have abated. This will allow authorities to ease currently tight monetary conditions, which will help accelerate structural reforms in the economy.
As well, ANZ expects the Chinese will look to exploit any arbitrage for cheaper imported commodities so as to re-stock low inventory levels and boost strategic reserves. The bank expects copper, oil and corn will attract the most interest.
Looking specifically at the various commodities and starting with the base metals, ANZ prefers copper given still strong market fundamentals thanks to ongoing strikes and market deficits. This suggests a recovery in prices in the fourth quarter and into 2012, this despite the headwinds of a weak US recovery, moderating growth in China and renewed shocks in Europe. ANZ is forecasting copper prices will rise to US$4.00 per pound by the end of 2011, which is down from a previous forecast of US$4.65 per pound.
For aluminium, ANZ's view is price upside is capped by oversupply but improving auto activity, relatively high energy costs and strong Chinese demand will support prices. Given this floor under the market the change in forecast is minor, ANZ now forecasting a year-end price of US$1.07 per pound, down form US$1.16 per pound previously.
Upside for nickel appears limited in the view of ANZ, as while demand side fundamentals are broadly positive the supply side remains quite nimble. While the market is moving into a typical re-stocking period production is also increasing, while nickel pig iron output continues to be a growing issue for prices. To reflect this ANZ has lowered its forecast for the end of 2011 to US$9.50 per pound, down from a previous estimate of US$12.20 per pound.
ANZ expects zinc prices will trend higher as LME supplies are falling and Shanghai inventories appear to have peaked. As well, physical premiums are likely to rise thanks to delays relating to warehouse deliveries. The bank is forecasting a year-end price of US$0.92 per pound.
Lead is expected to outperform zinc as power problems have restricted output of primary material in China and secondary production is down around 6% in year-on-year terms. As well, expected cold weather in the north in coming months should hasten the end of life of lead-acid batteries, while a recovery in the US auto market could also offer support. ANZ is forecasting a price of US$1.04 per pound as at the end of this year, slightly down from its previous estimate.
In the precious metals, ANZ expects gold will recover from recent falls as worries over the European debt situation and a bearish outlook for the US economy should continue to support the price. While the market is likely to remain volatile ANZ expects the gold price will end the year at around US$1,800 per ounce.
Chinese import demand for silver is slowing and ANZ suggests the metal's exposure to macro sentiment and use in industrial applications could restrict upside if the economic recovery turns out to be sluggish. In coming months ANZ expects the gold/silver ratio will stay in a range of 50-55 in coming months.
With respect to oil, while uncertainty should continue ANZ expects prices will rise mildly in coming months. This expectation allows for a vulnerable demand side stemming from a weak global economic outlook as it factors in possible lower OPEC output to alleviate oversupply concerns.
Iron ore is fully priced in ANZ's view and prices should ease in coming months as steel mills deal with low operating margins. Any downside should be limited as the bank expects some re-stocking and a pick up in Chinese manufacturing activity in the December quarter.
Coking coal prices are also tipped to ease in coming months as flood-impacted Queensland supply returns to the market. ANZ expects suppliers will continue to push for shorter-term price contracts, but this won't change the market in terms of being sensitive to any downturn in steel prices.
In contrast ANZ sees thermal coal prices as firming in coming months as seasonal demand starts to improve from India in particular. A capped Chinese coal price may limit upside but still strong demand should support prices in the bank's view.
Elsewhere, Barclays has also updated its order of preference in commodity markets to take into account recent market volatility. Given uncertainty with respect to the European debt crisis is likely to worsen before it improves, Barclays remains overweight previous metals as this sector is the most likely beneficiary of such conditions.
For the base metals Barclays has also raised its weighting as market conditions in China appear to be improving, for copper in particular. This trend should remain in place shorter-term. In contrast, weather remains a threat to agricultural commodities and Barclays has reduced its weighting to this sector.
Specifically, Barclays is overweight gold, gas oil, heating oil, copper, aluminium and platinum, while being underweight gasoline, soybeans, nickel, zinc and all soft commodities.
In energy, the announcement last week the benchmark DJUBSCI is to swap some of its West Texas Intermediate ((WTI)) crude weighting in favour of an allocation to Brent crude exposes investors to some potential losses in the view of Barclays. These stem from the US crude oil contract's dislocation from other global benchmarks.
The other issue for Barclays is the move heightens existing concerns with respect to the viability of the WTI contract as a pricing benchmark and tool for risk management. At current price differentials Barclays estimates the amount of crude held in DJUBSCI portfolios could fall by more than 20% from such a switch, something which would push oil price spreads even higher.
While the WTI may not yet be a completely broken benchmark the move indicates the relevance of WTI for financial markets is waning. Logistical issues have contributed to this and resolving such problems will take some time according to Barclays, the risk being by this time WTI will have lost too much liquidity to regain its position as a global benchmark.
Australian steel plays have found the going tough as the global economic outlook has worsened but steel markets elsewhere have also struggled, as JP Morgan notes the Latin American steel sector is now down 46% on average in year-to-date terms.
According to JP Morgan it is overcapacity that remains the largest issue for the sector, but a number of smaller issues have also contributed to the poor performance in the region. These issues include increased state shareholding and fragmented supply, higher raw material costs and low capex intensity in China that gives projects in that country a relative advantage.
In the view of JP Morgan, an imminent solution to these issues doesn't appear imminent, which suggests the sector will continue to trade in mini-cycles. This justifies a cautious stance, JP Morgan retaining a preference for mining with respect to exposure to the metals and mining space.
In coal, Citi sees scope for Indonesia's ban of low-rank coal from 2014 could help reshape the thermal coal market in particular. This is because by 2014 Indonesia is expected to be the main supplier of thermal coal to the Chinese and Indian markets.
If the ban is put in place Citi estimates it could impact on about 70% of Indonesia's exports. This could potentially wipe out more than 220 million tonnes of thermal coal in 2014.
One obvious solution would be to upgrade the lower grade coal to be impacted, which is coal with a calorific content of less than 5,700kcal. While Citi points out such an approach carries risk as the technologies involved have not been proven, any success could add more than US$10 per tonne to the cash costs of low-rank Indonesian producers.
This is significant as India is becoming ever more reliant on the Indonesian market for supply given ongoing production issues in the domestic Indian market. Citi estimates the Indian market could be short as much as 270 million tonnes of thermal coal by 2016, with India at present sourcing around 66% of thermal coal imports from Indonesia.
With limited alternative sources of supply in Citi's view, any move by Indonesia to limit exports will not only create higher costs for Indonesian producers but act as a supporting factor for coal prices in the future.
Turning to palladium, Barclays notes while the metal was the best performed of the precious metals in 2010 this has turned around this year and year-to-date the metal is the weakest performer in the complex. So far in 2011, palladium prices have fallen by 25%.
Unlike with platinum, the marginal cost and the average cost of production of palladium doesn't provide an indication of a cost floor or prices as the metal is primarily produced as a by-product.
On the plus side of the market, Barclays notes underlying demand from the auto sector has shown continual improvement over the past three months and this trend is expected to continue. This suggests improving palladium prices in the view of Barclays given implied stocks appear to be low at present.
The supply side is also supportive as while mine output is recovering production growth remains modest, though Barclays notes this has been offset to some extent by disinvestment by traders. This leads Barclays to suggest investment flows must stabilise before palladium's fundamentals again offer price support.
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