Supply Side To Drive Commodity Prices Higher

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This story features RIO TINTO LIMITED, and other companies.
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By Chris Shaw

With the global economy slowly emerging from its worst post-war recession, Goldman Sachs expects the commodity supply-side constraints which became apparent over the past decade will re-emerge, which will in turn reinforce the sustainability of higher long-term commodity prices.

Volatility should also increase, as Goldman Sachs suggests the inability of supply to grow significantly over the past decade means as economic growth strengthens both globally and in emerging markets in particular there will be an ever increasing pull on the world’s resources, meaning a bidding away of the more scarce commodities from developed economies.

The big point of interest for investors, as Goldman Sachs points out, is not all commodity markets have finished the decade with the same supply constraints, proving such constraints can be alleviated with well aimed policy that encourages investment while also offering greater price support to those commodities where the supply constraints have not been addressed as successfully.

Looking at the 2010 outlook, Goldman Sachs suggests three themes are likely to continue to dominate the commodity markets, the first being differentiation between commodities based on the extent of any supply constraints that will drive price dispersion across the complex.

As examples it notes natural gas, refined petroleum products, nickel, wheat and aluminium have all seen significant growth in production capacity over the past several years and, apart from aluminium, all have limited exposure to emerging market demand growth. This has meant their respective price recoveries have been more modest, while the forward price outlook is similarly much weaker than for those commodities where the supply constraints are more apparent such as copper, crude oil, zinc, platinum, corn and soybeans.

Secondly, it sees scope for a resource realignment as emerging markets bid away scarce commodities, especially among those commodities where the supply constraints are greater. This implies a shift in focus from the sustainability of higher commodity prices towards the sustainability of higher economic growth rates, as scarcity will mean emerging market economies will be willing to pay more for natural resources given the greater value they add to their economies.

There are other costs as well, as China is now looking to achieve some efficiency gains in energy as part of its economic plan over the next five years, while Brazil has plans to reduce the pace of de-forestation of the Amazon. These measures have required higher commodity prices and prices will need to stay high for them to be implemented successfully.

Finally, Goldman Sachs expects to see greater macroeconomic correlations as resource realignment will increase the relevance of commodity prices and supply with respect to the broader macroeconomic environment and other variables such as foreign exchange rates, real and nominal interest rates and equity market valuations.

Such trends are likely to be more persistent in the future according to Goldman Sachs, at least until supply constraint issues are resolved enough to reduce the impact both commodity availability and commodity prices have on economic growth patterns.

Looking at the various commodity markets in more detail, Goldman Sachs notes in the oil market a slower than expected recovery in developed market demand has left global stocks at higher levels than expected, though long-dated prices have received support from OECD spare capacity drawdown on the back of solid expectations for emerging market economic growth.

To reflect this the broker leaves its 2010 average price forecast at US$90 per barrel, with prices likely to be lower early in the year but higher by the September quarter as demand returns to pre-recession levels. In 2011 the broker expects prices will average US$110 per barrel, driven by strong demand from emerging markets forcing prices higher to ration demand from developed markets once OPEC spare capacity is exhausted and non-OPEC output continues to decline.

In the natural gas market it has been stronger than expected unconventional production that has maintained supply despite a collapse in investment. This trend suggests higher production in 2010 and to reflect this Goldman Sachs has cut its NYMEX price forecast to US$6/mmBtu, down from US$7.30 previously.

If there was a similar decline in production in 2011 it would tighten the market however, meaning prices will need to move up the curve to encourage higher-cost unconventional and low-cost conventional investment. To reflect this the broker expects NYMEX prices will average US$6.50/mmBtu in 2011.

Supply availability issues are most apparent in the base metals complex, as the demand outlook is nearly the same for most metals given the urbanisation and industrialisation of emerging markets. This makes a ranking system appropriate, with Goldman Sachs putting copper in the most preferred position given its tight supply picture, following by zinc, with nickel and aluminium as the least preferred albeit with limited downside in both cases.

With the global economy expected to pick up strongly in the first half of next year base metal prices are tipped to hit new highs by the middle of 2010, with copper forecast to trade above US$8,100 per tonne and zinc at better than US$2,600 per tonne. By the end of next year prices should retreat somewhat however as growth momentum slows in the second half, while 2011 should again see prices move higher. Copper should again trade above US$8,100 per tonne that year, while zinc prices should exceed US$2,900 per tonne.

For precious metals the fact the US Federal Reserve remains on hold with respect to interest rates gives prices some additional upside room, though this trend should reverse once the US economic recovery strengthens and interest rates begin to move higher.

To reflect such a scenario, Goldman Sachs has lifted its 3, 6 and 12-month gold price forecasts to US$1,200, US$1,260 and US$1,350 per ounce respectively, which implies a 2010 average price forecast of US$1,265 per troy ounce and a 2011 average of US$1,425 per troy ounce. Near-term risk is to the upside in its view, with an earlier than expected tightening of US monetary policy the major downside risk through 2010 and 2011.

In the agricultural commodities Goldman Sachs notes weather remains the primary driver of prices given its impact on the supply side, this despite significant investment in seed technology. If it is assumed there is a return to more normal growing conditions in the coming year that leaves corn best placed for upside in its view given low inventories and high energy prices.

For soybeans, production in South America is expected to improve, so alleviating the threat of supply side issues. In wheat Goldman Sachs sees little upside given a combination of ample supply and a relatively lacklustre demand outlook. Having been the star performer over the past year or so, the broker now sees downside risk to sugar prices over the next year and beyond.

UBS suggests that to play the expectation of broadly higher prices in 2010 investors should focus on the diversified miners, as this group should outperform given the combination of supply shortages and renewed merger and acquisition activity by Chinese and other Asian interests, which is expected to push prices higher.

In UBS’s view it will be China that again will be the dominant driver of mining investor sentiment as its stimulus programs could see demand surprise to the upside, while re-stocking by the rest of the world should provide a boost to demand and speculative interest should remain supportive.

It remains possible governments will act to curb commodity prices generally, while higher interest rates offer a risk to mining equities generally. The other potential worries according to UBS are overcapacity or overstocking concerns emerging, which it sees as more likely in the second half of 2010 if they do occur.

Offsetting this is the weak US dollar, while as UBS notes the consequent rise in domestic costs in commodity currencies and rising asset diversification into commodities should in turn act to drive prices higher. It agrees with Goldman Sachs in taking the view supply tightness will differentiate commodity market price outcomes, with coking coal, platinum and copper markets expected to remain tight subject to supply disappointments.

In contrast, nickel, zinc, gold, thermal coal, iron ore and minor metals may be impacted by supply shortfalls or diminishing Chinese competitiveness, so UBS remains more bearish on those commodities where there is little constraint on new supply or where there are capacity overhangs. This implies a less bullish view on aluminium and steel.

For investors UBS suggests Rio Tinto ((RIO)) is a suitable exposure to play the theme of higher prices given its diversified asset base and its significant leverage to iron ore, which is twice as much as for BHP Billiton ((BHP)). As well the stock offers some value as on its numbers the shares are trading on a 2010 P/E of 10.7 times, which is below the sector average of 11.7 times.

Other stocks the broker likes on global markets include Xstrata, Freeport-McMoran and Shenhua Coal, while its least preferred include Harmony Gold, Kumba Iron Ore, Impala Platinum and National Aluminium. 

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