Rudi's View | May 08 2008
(This story was sent to paying subscribers on Tuesday morning)
By Rudi Filapek-Vandyck, editor FNArena
Supply and demand dynamics are far from the only factor determining whether prices for oil, copper, coal, coffee and rice go up or down. Other factors can at times play at least an equally important role, such as the value of the US dollar and the impact from speculators and financial investors on a particular market.
While every market has its own characteristics, and these can change significantly at certain times and under different circumstances, therefore making any attempt to generalise incorrect by default, it is nevertheless probably a fair assumption that the price for most commodities, soft and hard, precious metals and energy included, is predominantly determined by the aforementioned three key factors: supply-demand, US dollar and financial investors (not necessarily in that order).
This immediately explains why it is so difficult to accurately predict where prices for a certain commodity will be in a year, or even in six months. Make two correct assumptions, but the third one wrong and one can possibly still end up on the losing side of the market. This also explains why securities analysts have been constantly (and still are) behind the price curve over the past years. The difficulty in accurately predicting supply and demand numbers aside, how many would have taken into account that the US dollar would weaken as much as it did against most other currencies? And how do you know how many investors will jump into the market and what their impact will be on further price developments?
Other experts have tried to determine the precise importance of the various key factors on commodities prices over the past years as not everyone is equally convinced that China, and China above anything else, is solely responsible for what we shall conveniently call the Commodities Super Cycle. They’ll argue that the weakness of the world’s reserve currency, and the awakening of the financial community to a new class of investment assets, have played a significant role in the relentless bull trend for commodity prices since 2003. These experts are, of course, correct. But to what extent has each factor contributed? The answer to this question remains the subject of public debate.
This debate is likely to flare up again now that market expectations have started to change towards the US dollar. A steadfastily growing number of experts believe the story of an ever weakening US dollar is coming to an end. US interest rates may well have further to fall, but after the US Federal Reserve will be finished, Europe will finally be in cutting mode, and so might be Australia. This should put an end to the most straightforward currency trade of the past decade.
On top of this, global share markets are on the rise again and as a result the star performers from the first months of the year -commodities and energy- will have to share some attention (and investor money flows) with listed equity. How much money will flow out of commodities and into share markets? Such questions are simply impossible to answer. But the fact that many a global fundmanager again considers US share markets as a good place to be in itself will strengthen the improving prospects for the US dollar (especially since Europe is considered not attractive at all).
And so it is that two out of three key factors are gradually turning less supportive for prices of commodities in the weeks and likely months ahead. What will be the end result? Headwinds or a secular downward shift? We don’t know exactly how this process will play out, but maybe we can draw some conclusions from one market that already has seen it all over the past eighteen months: uranium.
Spot uranium had its moment under the sun when market fundamentals shifted dramatically in the second half of 2006. An already tight market, underpinned by projected booming demand and dwindling secundary supply, all of a sudden became even tighter when one of the most important new mines flooded, pushing out a significant amount of new supply into the future. We all thought it was pure panic from utilities that saw spot uranium rise from circa US$65/lb to US$138/136/lb in less than nine months, while in fact this quick run up in prices was almost solely the result of speculators jumping on the bandwagon in what simply seemed a story too good to be true.
As such, the uranium price spike was fuelled by market expectations of looming deficits but significantly stretched by the presence of financial investors. Uranium is a relatively small market but those investors never represented more than about 15% of the market, whereas estimates for oil, copper and others are relatively much higher (financial investors are believed to represent at least half of all trades in the oil market). The subsequent correction in spot uranium was supposed to have run its course by the final quarter of 2007 and experts thought we would soon see uranium back at US$125/lb. Instead, an earthquake in Japan again temporarily changed underlying market fundamentals, and spot uranium soon started a second price correction that has caused the spot price to fall to US$65/lb.
Should uranium be back at its price level of 2006? The answer to that question is probably negative. But then again, spot uranium should never have surged to US$138/lb in the first place. In both cases the responsibility lies with financial investors. Where would spot uranium have been without them? Always a tricky question, and impossible to prove, but I think most market experts would probably agree with me if I say that without the significant stimulus to the upside spot uranium would probably have never reached higher than circa US$95/lb. And today it would probably be priced at around US$80 instead.
In other words: financial investors in charge of price direction easily add around 45% on top of what the price otherwise would have been. On the other hand, when market fundamentals shift these same investors will cause a price fall much deeper than normal as well. In this case uranium fell more than 50% to a price level nearly 20% below where its price otherwise would have been.
The good news is, it can easily spike back if either market fundamentals shift again or if investors decide to re-enter the market in a dominant fashion. One would presume that the first factor will trigger the second (though I certainly don’t expect spot uranium to return to US$138/lb anytime soon).
What lessons can we draw from this regarding commodities in the year ahead?
For starters, watch out for changing market fundamentals, especially when this change implies a switch from a supply deficit to a surplus. The consequences can be simply dramatic. On the other hand, the risk for prices is firmly skewed to the upside in case investors jump on board of a market in deficit, squeezing the maximum out of the situation. As such, improving market fundamentals for copper should be a no brainer, and as long as non-OPEC production seems poised to continue to disappoint, crude oil should remain well above US$100 a barrel as well.
What the experience with uranium doesn’t tell us, however, is how big an impact a strengthening US dollar will be on all of the above. I guess we have to find that one out as the year progresses.