Commodities | May 08 2006
By Chris Shaw (Tokyo)
Investors may be surprised to learn that the debate between "supercyclists" and commodities bull market skeptics is still ongoing, especially since global investors seem to have thrown all reservations overboard over the past few months.
There have been a few pauses and corrections along the way, but the trend for commodity prices over the past few months has been up, and strongly so. The strength of the gains has even surprised the more bullish experts in the market such as GSJB Were, Macquarie and Citigroup.
At Natexis Commodity Markets the concept of a super cycle has thus far failed to find fertile ground. Judging by Natexis’ latest quarterly review of the sector this would seem unlikely to change in the near future as the experts express the view that prices are near their peak denominating the recent rally as without regard for market fundamentals. A similar view has been upheld by JP Morgan’s team of resources analysts as well.
Natexis points out the strength in prices comes despite most of the metals (zinc being the exception) having higher inventories than was the case last year, which in its view makes the risk/reward trade-off less attractive now given the difference between price levels and the marginal cost of production has grown.
Natexis suggests investment money has been driving the sector in recent months, the money continuing to flow in as despite the worsening fundamentals commodities are now being viewed as an actual asset class. At the same time, the group notes the level of selling has not kept pace with the stronger buying interest, primarily because producers have not moved to hedge their output to the same extent as has traditionally happened when prices have strengthen considerably.
As a result, Natexis suggests investors should now be more cautious towards the sector, as while economic indicators such as the European Purchasing Manufacturers Index show conditions remain positive, there are risks for prices going forward. Inflation is one, the group position being as inflation strengthens it will put upward pressure on interest rates, which is a negative for growth.
Both Australia and China have lifted official interest rates in recent weeks, many others across the globe are expected to follow suit.
Similarly, the analysts suggest higher commodity prices themselves could act as a break on growth as they have the impact of increasing input and production costs, which impacts on margins and therefore earnings. An example of the risk can be seen in the fact US finished goods prices have risen 3.5% year-on-year, but at the same time commodity prices have risen more than 13%, so a margin impact appears likely at some point. If this was to flow through into lower economic growth, commodity prices would likely correct according to the group.
Natexis is forecasting average prices for both 2006 and 2007 will be below current levels, so it suggests prices are at or near cyclical peaks despite inventories remaining at historically low levels and with little significant supply response yet to emerge. The group’s forecasts show prices falling in 2007, examples being average prices for aluminium of US$2,600/t this year and US$2,200/t in 2007 and for copper of US$5,000/t this year and US$3,750/t next year. Nickel is tipped to fall to US$12,000/t next year from an average of US$15,000/t this year, while zinc is expected to weaken to US$1,850/t from US$2,450/t this year.
The silver market is a case in point for prices believed being out of line with fundamentals, Natexis taking the view much of the recent buying interest has been in relation to the establishment of the silver ETF, or exchange traded fund.
Concerns the establishment of the fund could remove physical silver from the market has pushed up leasing rates as borrowing has increased, but the underlying market hasn’t moved as was expected. Natexis notes net commercial long positions on the COMEX exchange, which should have moved higher on concerns of supply being taken out of the market, actually decreased in February and only partially recovered in March, indicating some uncertainty over the sustainability of prices.
The supply/demand picture has also deteriorated in recent months, the group noting stocks, particularly of the European dealers, have risen in recent months as demand has decreased. India has seen the greatest slump in demand, with figures suggesting the combination of higher prices and increased government sales have led to periods where net demand was effectively zero. Natexis notes it is a similar story in several other East Asian markets, while demand in Italy has also fallen.
Supply is not helping, as the group expects mine production this year should be flat or slightly up before showing substantial growth in 2007. Government sales of silver in a number of markets are also likely to increase, while the stronger price is seeing increased interest in scrap, so it expects total supply will be higher both this year and next year.
Natexis notes several industry players have estimates prices should be closer to US$7.00/oz to match the supply/demand fundamentals in the market, the group taken a slightly more positive stance and forecasting average annual prices of around US$9.00/oz for both 2006 and 2007.