Commodities | May 03 2006
By Greg Peel
An excellent cartoon appeared shortly after the stock market crash of 1987. Commentary post the collapse included views that this was not the beginning of a bear market, merely a correction. The cartoon featured two big, ugly, smirking grizzly bears standing behind the door of a darkened room. One says "There’s no one in here, except us corrections".
While the stock market did not trend down materially after the crash, it took the first Gulf War in 1990 to provide some new impetus. It would thus be fair to say the crash was more than just a correction. It is notable, however, that very few commentators called the crash, and that the war came out of the blue as well.
All the talk in the commodities market at the moment is about a looming correction. There are many reasons given to justify why there should be one, other than the simple fact prices have run ridiculously hard. But you’ll be hard pressed to find a commentator calling a bear market. Any correction, they say, should be viewed as a buying opportunity.
The obvious question thus arises: if everyone’s talking about a correction, and suggesting one buys the dips, will we actually have a correction? Moreover, corrections of any significant magnitude (as opposed to the recent bouncing around of prices) usually occur when they’re least expected, not most expected.
Correction triggers suggested to date include interest rate increases (China, Europe, Japan, Australia, even the US might go up again), increased margins on metal futures, poor rollover returns on commodity futures funds, simple technical analysis, and much more besides. Although volatility levels have noticeably increased, and falls have been suffered, no real correction has yet been felt.
It is hard to go past the three pervasive elements of ongoing demand, ongoing supply shortage, and investor interest. That is why everyone says buy the dip. There really is no end in sight for the greater commodities bull market as far as most are concerned.
Two Citigroup experts (one mining analyst, one an economist) sat down to chew the fat about their respective views last week, and published the conversation in Citigroup’s Portfolio Strategist. This is part of what was discussed.
Outside of the speculative impetus, the feature of this commodities cycle is the inability of the industry to "mount a meaningful production response". It has taken 15 years of underinvestment in capacity to get us to where we are today. However, the weight of speculative interest cannot be ignored.
Citigroup calculates that roughly US$200 billion of investment money has flowed into the commodity complex. US$30 billion of this has gone into base metals, which represents 12% of global annual demand. In other words, a full 12% of base metal long positions will never actually be consumed.
Investors have now spread their sights even further. Said the mining analyst:
"We also saw investors last year looking for even more obscure metals. It went from zinc and lead, then tin, cobalt, molybdenum — that’s getting into specialty metals territory. When questions came about bismuth and antimony, I knew we were at the far reaches. When someone called me about indium and ruthenium, I had to get out my periodical table."
A bit of a frenzy, perhaps?
Citigroup believes this is a multi-year bull market that is not going to end any time soon. The short term charts on all the metals all look vary similar in their outrageous recent price hikes, but it should be remembered, notes Citigroup, that aluminium, nickel and steel all had 30-40% price corrections last year.
Now those were real corrections, not just single digit percentage blips. Hot-rolled steel was knocked from US$800 to US$420. It has since returned to US$600, but that’s taken eight months. Nickel hit US$8 last year, was slammed down to US$5, and has gradually clawed back to US$8 once more. Aluminium was strong last year until Chinese exports hit the market. It has also now clawed back on demand/supply fundamentals.
These returns from price correction were all based on very real demand catalysts and supply constraints. Thus Citigroup believes these metals are sending "very real price signals".
Copper and zinc, however, have seen spectacular price rises without correction. They are probably "most divorced from their fundamentals", the experts suggest, and thus are vulnerable.
The demand story is pretty much the same over all the metals. The difference in this bull market as opposed to bull markets of the past, even given the China-India (Chindia) factor, is the inability of the supply side to respond. This comes down to that 15 year period of underinvestment, but there have been more problems besides.
Looking at copper again – the most dramatic performer of all the metals – the demand environment last year was actually relatively weak. But the price was driven by a wave of 22 separate mine and smelter outages and shortfalls. So far this year there have been eight shortfalls, which means even the bears have had to turn bullish on the price. Citigroup notes copper production was expected to exceed consumption in 2006 by 200,000 tons, but already we’ve lost that amount in the first four months.
Nickel has also suffered from mechanical failures, strikes and riots. Aluminium supply is a bit healthier. Steel supply, on the other hand, appears to be running well.
Again these numbers put copper in the "vulnerable" class, if one presumes such supply disruptions can be sorted out. There are, however, a spate of mine worker wage negotiations to get through yet this year, and more strikes for better pay are on the cards.
Citigroup notes that the major impetus to metal price corrections in earlier years was fears of a "hard landing" for the Chinese economy, due to everything from excessive investment to SARS. In each case opinions swung to a soft landing, and up we went again. "Any kind of macro scenario that rekindles these China hard-landing fears is scary for metals", said the mining analyst.
But the view on China is a largely positive one at the moment, as it is for most of the rest of the world’s major economies. This will keep demand ticking over, until such time as prices exceed income. If prices rise and wages don’t, soon demand will suffer for products. Eventually companies will no longer be able to absorb costs and will cut production.
Citigroup doesn’t believe we’re at that point yet, but "too much of a good thing, and you can definitely erode demand at some price".