Patience Required

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This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, editor FNArena

Nothing moves up in a continuous straight line, not even during a commodities Super Cycle. Rising prices for most base materials have been replaced with a more subdued pattern since the middle of the year. In fact, base metals in particular have had to endure another price correction this month and many an expert is predicting this may not improve until into the new year.

On Monday the LMEx index, which groups the main six exchange traded metals, temporarily dipped below its two year average support line -for the first time since 2003- suggesting this correction is far from over and more weakness is to be expected. The importance of the event has many a technical chartist closely watching his charts for metals and minerals these days.

This week also saw one of the more bullish experts on commodities, Barclays Capital, cut some of its near term price forecasts for base metals.

So this is it then – the end of the Super Cycle?

While it is easy to lose the bigger picture out of sight in times of falling spot and share prices, it’s probably a good thing to look back and remember ourselves the past four years have seen many dips and retreats. Resources analysts at Citi reported a few weeks ago the metals and minerals sector has had to endure two to three major pull backs in each calendar year since 2004.

Looking at a historical price chart of BHP Billiton ((BHP)) shares, the global bellwether for the current Super Cycle, Citi’s calculations seem about right. The current pull back marks the third one for calendar 2007. I counted four major retreats in 2006. Only two in 2005. And three relatively minor ones in 2004.

On each occasion the reason for these pull backs has been the same: investors became worried about the prospects for global growth. Base materials are highly sensitive to the supply and demand balance, and thus to global growth. It is the nature of these markets that even a slight change can cause rather large differences in product prices.

No wonder then that investors have grown increasingly cautious towards the sector as pessimism about economic prospects for the US became widespread over the past few weeks. There’s a growing fear that soon other parts of the globe will be infected by the latest US “disease”, starting with the UK and most of continental Europe, and Japan.

To put it very simple: the difference between optimists and pessimists in the market at the moment appears not so much determined by a positive or a negative view on economic growth next year, but seemingly more so by the fact that the first group believes central bankers will cut interest rates in time to save global growth. The second group fears it is already too late, or that cutting interest rates won’t be more than a temporarily bandaid.

There are comparisons being drawn with the year 2001. Does anyone still remember the years before this Super Cycle driven revival of global equity markets started in 2004? Those were very bearish years and they were preceded by the Federal Reserve under Alan Greenspan cutting interest rates to 1% – alas it turned out it was still not enough to keep the bear out of the markets.

Of course, such comparisons are almost by definition too simplistic. There are some key differences this time around, one among them is that we currently have this Super Cycle for commodities -back then the world was melting down from the TMT bubble (TMT had become the new buzzword- it stood for technology, media and telecommunications; key sectors that were poised to benefit from this new thing called internet).

But then again, we didn’t have a global financial system in serious distress. Who would have imagined only a few months ago that Citigroup -the world’s largest financial institution at the beginning of the year- would have to call in support from the Abu Dhabi Investment Authority for a US$7.5bn cash “lifeline”?

Many an economist is expecting some very weak data from key economies such as the US, the UK, Europe and Japan in the weeks and months ahead. Even if Chinese data will continue to look robust -as they are expected to- this is likely to keep many an investor on the cautious side of the market.

It is against this background that the Commodities Super Cycle is about to enter its fifth calendar year. China will become even more important than in the past four years for keeping the positive momentum going for base materials. However, investors may have to wait until the world has become more comfortable again with the economic outlook elsewhere before spot and share prices can genuinely resume their uptrend.

But don’t let all these issues fool you – the cycle itself is changing. If current expert expectations prove accurate 2008 will be the year that will see supply finally catching up with demand for some metals. This will create a wider divergence between price developments in the sector. As per usual, there’s no such thing as a general consensus, but zinc and aluminium would seem to have the most subdued price outlook, while copper remains most experts’ top favourite.

But this is as far as the base metals are concerned. Precious metals should perform better as downward pressure on the US dollar is seen as unlikely to abate in the near term, while ongoing problems in the global financial system and the potential for higher inflation further add to the sector’s positive momentum.

It is most likely though that this is where the balance will shift in undeniably favour of the bulk commodities; coal and iron ore. Recent spot price developments suggest both commodities may well see contract price increases of 50% -or more- next year, and this is unlikely to be matched by any other major commodity (uranium included).

Resources specialists at GSJB Were returned from a trip to Tokyo this week with the view that global supply chains for coal are even more stretched than they thought. The analysts now believe the price prospects for coal do not only look better for the coming year, but also for the year thereafter – a scenario cautiously suggested by some experts for iron ore as well.

One potentially interesting observation made is that India has started to play a major role for both thermal and coking coal, leading the analysts to conclude that “the emergence of India is now having a very significant impact on selected commodities”. If true, this would be a major change from the past four years as well.

GSJBW has raised its price forecasts for the coming year to +53% to US$150/t for premium hard coking coal, to +59% to US$102/t for semi-soft coking coal, to +62% to US$90/t for thermal coal and to +78% to US$120/t for low volume PCI.

This should bode very well for the upcoming iron ore contract negotiations.

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