FYI | Apr 09 2008
Question: would oil be at US$108.50 per barrel if it wasn’t for the weaker US dollar?
Answer: one can never be too certain about these things, but I’d be inclined to think the answer is negative.
Similarly, the market entrance of investors and speculators (“financial market participants”) into resources and energy sectors has had a sizeable impact as well. This is even more so with more and more financial products being developed that allow investors to diversify into base materials (“stuff”) without having to choose between listed companies on the share market.
It is usually argued that playing the commodities theme via the share market is a less risky option as futures markets, and especially those for commodities, can be notoriously volatile. Witness, for instance, the movements in the gold market over the past month. However, not only is there now a whole plethora of new investment products available that are easier accessible than futures, now that producers are struggling with higher costs, a tight labour market and unfavourable currency movements, one has to question whether playing the commodities theme through the share market is not simply equal to taking on board a few extra layers of risk?
Investors will have noticed shares of listed companies do not always trade in synch with price developments of the underlying product. This was especially the case during the first three months of this year when global equity markets were going through a severe de-valuing phase, while prices for the likes of gold, copper and oil were recording new all time highs.
No matter how hard one believes in the concept of the Commodities Super Cycle, I am sure that at times investors find it easier to lose money than to actually benefit from it.
The share market aside, we can safely say that the direction of commodity prices is being determined by three key factors: supply and demand dynamics, investor activity and the US dollar. Get the first one correct, but one of the other two wrong and you can still end up miserably wrong. In addition to these three key elements most commodities will have at least a fourth important element in play. For oil that’s the so-called geopolitical factor.
Geopolitics can also be important for the direction of gold, but at times selling by central bankers can play an even more important role (or as is presently the case: selling by the IMF). Sometimes, and this is especially the case for agricultural products, government policies need to be kept an eye on as well. The most obvious examples of this would be restrictions on genetically modified crops, or on imports and exports and the push to promote ethanol as an alternative to oil products.
The problem with having so many factors in play is how do you know what is more important and when? For example: many a resources skeptic will argue the sector’s outperformance in the first quarter had more to do with speculators seeking alpha than anything else. Others have been arguing for months that commodity prices have been predominantly enjoying the automatic push from a sliding US dollar. But what’s going to happen once the greenback finds its bottom? (The problem with this thesis thus far has been that the US dollar has simply continued falling even though it has been forecast to find a bottom at various stages throughout the past years. And as long as the Federal Reserve continues cutting interest rates, and others such as the ECB, the RBA and the Bank of China do not, this is likely to remain the trend).
Many silver market watchers believe increased supply will push the market into surplus this year. Yet, many others, including highly regarded industry consultant GFMS Ltd, argue that it is increased investor demand that will continue pushing silver to new highs (get the first one correct, but the second one wrong and you likely end up still miserably wrong). Similarly, spot uranium would have never reached as high as US$136/138/lb last year if it wasn’t for excessively bullish investors who kept on buying product on the spot market, only to find out later there were no other buyers once they started looking to crystallise their paper profits.
Lee Jee-Hoon, research fellow at the Samsung Economic Research Institute in Korea, has tried to assess the importance of all of the above factors for commodities. He concentrated his analysis on the top four contributors of the IMF Commodity Price Index -crude oil, wheat, copper cathodes and iron ore- in an attempt to forecast future price movements. Here are the conclusions of his analysis:
Price movements of West Texan Intermediate (WTI) crude oil futures between January 2007 through February 2008 can be attributed in the order of 40.3% to what we all would describe as “speculative money”; geopolitical risk “only” represented 39.7% of the price movements, while the US dollar’s weakness is believed to have contributed 4.5% with supply/demand taking up the remaining 1.8%. (Those with a quick mind, and a penchant for instant mathematics, will have observed that the teller has stopped at 86.3%. Unfortunately, it is not clear where the remaining 13.7% has gone. We have to assume that only the most important price contributors have been listed).
Even if those figures are not necessarily 100% correct (after all, what is?), if our Korean researcher has done a relatively good job, this should give investors a much clearer insight into what determines the direction of the oil price – it certainly is not the direction of the US dollar.
As far as his price prediction for calendar 2008 goes, Lee Jee-Hoon refers to the Asian standard, the Dubai crude, which he predicts will average 24% higher in price this year compared with 2007, with the price in the first half of the year expected to be higher than in the second half “as speculative buying, geopolitical risks and the [US] dollar’s value are expected to calm down or even reverse”.
As you would have expected, one cannot take the example of crude oil and extrapolate it to other commodities. For wheat, for example, Jee-Hoon’s analysis has revealed that speculative money plays a role of 48.1% (which is much higher than in the case of crude oil), while government policy actions take up 16.8% in direct influence. The US dollar comes third with a direct price contribution of 15.6%. Supply/demand dynamics only account for 1.4%.
The forecast is for an average price increase of 33% this year for wheat.
Let’s move on to copper cathodes. Surprisingly, perhaps, the main price factor for copper is… the US dollar, with Jee-Hoon ascribing as much as 54.8% of copper’s price rise to the US dollar’s weakness. This is, explains Jee-Hoon, because Chile is the largest producer of the metal and therefore everytime the US dollar weakens against the Chilean peso the price of copper has to go up to make up for the loss.
Supply/demand characteristics rank second (as opposed to crude oil and wheat) with a calculated contribution of 26.1%. Speculative money only comes third with a direct contribution of 7.2%. There is a little twist to the copper figures: labour strikes’ importance receives a 0.0% – but that’s because there were none, explains Jee-Hoon.
His forecast is for the price of copper to average US$8,340 per tonne this year, 12.5% more than in 2007. Similar to crude oil, he expects to see a higher price in the first half than in the second part. The main caveat he has built into this forecast is: in case of any labour strikes in the second half, the outlook could change materially.
Which brings us to iron ore. Amidst all the stories we hear, and read, about an extremely tight market for iron ore, not in the least because global demand for steel has continued to surprise to the upside, Jee-Hoon has come to the conclusion that 55.4% of the price of iron ore is being determined by US dollar weakness. Chinese demand only comes second with a direct contribution of 32.2%. Market dominance of producers is placed third with a relative price importance of 12.4%.
In his end conclusions, our Korean researcher acknowledges the above mentioned factors cannot be seen as being totally independent of each other; there is an interaction such as, for instance, that a change in the supply-demand balance will attract more speculators.
As far as the overall conclusion goes, this is what Jee-Hoon has to say:
“Overall, it appears speculative investing, [US] dollar depreciation and geopolitical risks have driven the strong surge in commodity prices since January 2007, not supply/demand dynamics. In particular, speculation money and the dollar’s depreciation appeared to account for 56.5% of the recent price spikes on average.
“Since speculators account for more than 40% of the four commodities analyzed, the recent price spike can be seen as only a temporary phase. If demand eases from China and other emerging markets, speculative activity could also roll back. Consequently, market watchers could not dismiss the possibility of sudden and big drops in commodity markets.”
Till next week!
Your editor,
Rudi Filapek-Vandyck
(as always firmly supported by Greg, Grahame, Pat, George, Paula, Sarah, Chris and Joyce)
