Commodities | Oct 09 2006
By Greg Peel
It was beginning to look like the whistle had been blown. Game over, thanks for playing. That was the commodity boom that was. Did you miss it? Oh I am sorry.
Analysts were not calling Armageddon, but consensus was forming that the long awaited supply side catch-up was beginning to have an affect at just the time when the US and global economies were slowing. This is exactly the sort of bad timing that dominates the cycle of commodities markets, or at least it used to. Calls were made to marketweight or even underweight resources stocks in favour of banks and even out-of-favour consumer stocks.
At the same time, resources analysts were increasing their metal price forecasts. Some readers found this concept a bit confusing, but the truth is analysts tend to be conservative in their pricing so as not to risk overvaluing miners and other resources companies. So while spot prices were coming down, forecasts were shifting up, but the two have not yet met. Analysts returned to a now long-held credo that metals prices would fall, but ultimately settle at above historical average levels.
“Although the resources bulls are no doubt a little bruised and battered given recent equity performance, we note commodity markets have remained incredibly resilient in the face of increasing concern regarding global growth and, more specifically, the US economy”, said the Macquarie analysts this morning.
This pretty much sums up the situation. Commodities investors have taken a battering. But why?
There is a lot to be said for the theory that commodity markets are different now for the simple reason of unprecedented investor interest – specifically interest in investing in commodities more directly as opposed to the previous practice of simply buying mining stocks. The reality is that falling metal prices had more to do with this new weight of money than of simple demand/supply economics.
It all started with the oil price. A month ago it looked like oil would sail through US$80/bbl. Iran was being particularly recalcitrant, Israel was bombing Lebanon again and tropical storm Ernesto signalled the potential beginning of another lethal hurricane season in the Gulf. Analysts were ascribing a fear “premium” into the oil price of some US$12-15.
When fears subsided on all fronts, simultaneously, the door was open for the premium to be diminished. And so it was. Oil fell from around US$77/bbl to US$60/bbl almost without looking back. Fuelling the slide was news that the US housing market was tanking, giving more weight to the argument that the US economy was slowing fast. When you think about it, removing the premium suggests the oil price is fundamentally only down about US$2-5.
As soon as the oil price started collapsing, so followed the metals prices – both base and precious. That’s when analysts started calling for a more significant correction, and the likely end of the runaway commodity boom.
But note that the energy component of any global commodity index is extremely dominant – around 70-80% in fact – so falling oil prices triggered break-downs in commodity indices which thus saw investors flee. Fund managers and traders alike needed to dump metals. In other words, while a weaker US economy is naturally not good for commodity prices, commodity prices were nevertheless being sucked down in the oil price vortex.
Now we seem to have hit a ledge. The oil price, which some pundits were suddenly calling at US$50/bbl soon, is now dependent on whether or not OPEC countries go ahead with production cuts. With this support in place, metals prices have also stopped sliding. The “resilience” of which Macquarie speaks is a reflection once more of demand/supply fundamentals.
The reality is that inventories are still very low and the supply side is still very much constrained. Macquarie can’t see this changing in 2007, and has therefore decided to raise commodity price forecasts yet again.
The other factor is a tempering in recent panic about the potentially hard landing the US economy was about to face. Says Barclays Capital:
“Metals markets have proved immune to the growth concerns that have impacted negatively on prices in other commodity markets recently. Extremely tight fundamentals have supported prices and as pessimism on growth eases, the prospect is for metals prices to move higher once again.”
Underlying demand, says Barclays, remains strong. Sectors such as the steel industry, commercial construction and infrastructure are seeing to that. Mine supply continues to underperform, markets remain tight, and inventory levels are low and still falling. Metals are very vulnerable still to supply disruptions, and notably there are a number of labour negotiations coming up this quarter in the copper industry.
Nickel supply constraints also appear extremely tight, and a slowing in the rate of Chinese aluminium production suggests the aluminium market is also facing tightness soon. Barclays sees upside over the next 3-9 months for the prices of copper, nickel and zinc.
“A move up in long-term metals demand growth rates, plus rising costs of production means that consumers will have to get used to long-term average prices for most industrial metals that will be a lot higher than in the past.”
Macquarie is also raising its prices specifically in copper, nickel and aluminium. Convinced that demand growth will improve through to 2008, and that new supply will be lacking, Macquarie has lifted its 2008 forecast prices significantly. Copper is up 35%, for example.
(This takes 2008 copper to US$2.70/lb. The spot price is US$3.42/lb. Remember – analysts’ forecast prices, particularly into the distance, are a lot lower than spot prices.)
And if you thought investors had bailed out of commodity products altogether by now then think again. Barclays notes that while investments in commodity index funds have slowed, investment in commodity-linked notes has absolutely soared in 2006, from around US$300m to over US$1.2bn, with no sign of a change in trend. While there has been some plateauing of gold ETF investment, that market still hit an all time funds high last month.
Yet for all the talk of the commodity investment revolution, funds globally are still way underinvested in commodities. Total assets held by institutional investors are around $50tn globally, notes Barclays. Direct commodity investments at just $120bn represent less than one quarter of one per cent of this global portfolio. Commodity investments are one tenth the amount invested in hedge funds and around one quarter the market cap of one single oil company – Exxon-Mobil.
Barclays further points out that any talk of “bubbles” in commodity prices is misconceived. While metals such as copper are traded on futures exchanges, and form parts of commodity indices, other less appreciated metals trade away from the glare of the speculative and investment markets. Their prices represent more fundamental demand/supply balances.
Iridium prices are up 360% since the beginning of 2004, tungsten up 280% and rhodium up over 900%. By contrast, copper is up only 210%.
Since 1970, only one metal – nickel – has actually hit an all-time high on an inflation-adjusted basis. Copper has come close, but other metals are still way behind. When you throw in the soaring costs of metal production in the twenty-first century, the implication is that we may yet have a fair bit of upside to negotiate.
Macquarie suggests that stock market investors have gotten ahead of themselves as far as pricing in further commodity price weakness is concerned. To that end, many miners are trading at historically low multiples.
On a global basis, Macquarie likes BHP Billiton (BHP) first, followed by Rio Tinto (RIO), CVRD, Xstrata and Anglo American amongst the large diversifieds.
For leveraged plays, Macquarie likes Norilsk and Jubilee Mines (JBM) for nickel, Kagara Zinc (KZL), Alcan and Alumina (AWC) for aluminium, and Lihir (LHG) and Oceana (OGD) for gold.