Rudi's View | Feb 20 2013
By Rudi Filapek-Vandyck, Editor FNArena
There's so much more to commodities than initially meets the eye.
Bullish market commentators (and there's never a shortage of those) are glaringly pointing at the sharp run-up in share prices since mid-last year with BHP Billiton ((BHP)) shares, for example, running from close to $30 to above $38 by mid-February; a gain of some 26% in less than three quarters of a year. But on an annual comparison most share prices in the sector have still only posted modest gains.
In other words: the sector has underperformed the global recovery rally in equities and this has remained the case as the rally continued in the first seven weeks of calendar 2013.
This relative underperformance, it has to be noted, is in contrast to the changes that are taking place inside the global commodities experts' community with analysts suggesting the bias is now likely to the upside for the months ahead. This suggests the sector has some catching up to do from here onwards.
What has held back investor enthusiasm, outside of the surprise delivered by Chinese spot prices for iron ore, is the widespread anticipation that supply has started to catch up with demand for many members of the raw materials family. Price projections for rare earths, silver, uranium, thermal coal and nickel, for example, are still falling and it's not like any of them started 2013 with lots of exuberant optimism in the first place.
What 2011 and 2012 have taught investors is that raw materials are not simply a punt on China's economic management. "No hard landing" says many an economist today with an air of "told you so", but has anyone looked at share prices of coal and nickel producers lately? Another major disappointment has come from large global funds managers who thought commodities seemed ideal to diversify portfolio risk. Instead, most commodities have acted like an extension of global risk appetite; both to the downside as to the upside. Many of those funds have now exited the sector.
One only has to look at the sharp price falls that have occurred for all prices for coal products over the past two years, and then the extended time prices have remained at levels believed to be unsustainable for suppliers, to really put a scare on investors used to dealing with markets in supply deficit. And so it was in late 2012 that investors, globally, started to contemplate that the year ahead could well become the year when global supply of copper, iron ore and crude oil would follow the lead of uranium, lead, nickel and others. In all these examples, price falls from peaks have been nothing other than significant, if not spectacular.
But as said in the opening sentence: more often than not there's more than meets the eye in commodity markets. Take copper as an example. More bearish market commentators have observed the price of copper has not kept pace with what appears to be exuberance in equity markets. This is seen as evidence that, sooner or later, equities need to correct to fall back in line with copper, widely regarded as the best benchmark available for global economic health.
However, as pointed out in the past on multiple occasions, Chinese manufacturers had been using copper inventories as collateral to achieve credit and funding outside the restrictions on the Chinese banking sector. It would appear that as credit restrictions loosen and funding costs became more friendly, many of those deals have been unwound and copper inventories sold. This is a very opaque side of the market in China, so estimates by experts vary significantly. But if we stick with UBS's estimates on this matter, then inventories linked to such collateral funding deals had risen to some 700m tonnes by mid last year, after which half is estimated to have been sold on market.
This is significant and could easily explain why the price of copper has lagged so far in this global risk appetite recovery rally. It also suggests that demand should be higher than inferred by price movements thus far.
The biggest surprise so far has transpired in the iron ore market. Last year, analysts were starting to price in annual price forecasts of no higher than US$120/tonne, with retracements to sub-US$100 prices in the not too distant future, but prices are back above US$155/tonne and there are no signs of weakness just yet. Moreover, bullish analysts, like the ones at Goldman Sachs, are now contemplating stronger-for-longer scenarios with an annual price average forecast of US$144/tonne for calendar 2013, with upside bias.
The big change in overall market sentiment is based upon two key factors: one widely reported, the second generally ignored (at least in Australia). Chinese steel manufacturing has proven more resilient than analysts thought it would, while on the supply side India has completely removed itself as an international exporter. [Last year I reported that India's removal as an exporter would give the sector a boost – see "Iron Ore: Not What You Think" from 24 September 2012]
Analysts at Macquarie recently returned from a conference in India and they concluded the outlook for iron ore exports from India remains uncertain at best. There's a strong lobby inside the country to keep all the iron ore for domestic consumption, while the central government remains determined to prevent future breaches of production licenses and environmental laws. The result is that Indian exports may not return for a while just yet, and possibly not at all. As a former number three supplier of iron ore to the world (predominantly to China and domestic steel manufacturers) it goes without saying that either scenario involving India will have a noticeable impact on the supply-demand balance for iron ore globally.
As things line up so far, it would appear India's exports are unlikely to come back with a vengeance this calendar year. This supports a stronger-for-longer scenario as proposed by the likes of Goldman Sachs. On Macquarie's assessment, the removal of India's exports has added between US$10 and US$20 to the price of iron ore in recent months.
The biggest question mark remains as to what exactly is going to happen to the price of crude oil this year and next. Last year, the world received a big wake up call when the Wall Street Journal highlighted new forecasts that put the US back in pole position as the world's number one producer in only a few years' time. Economists now believe it is realistic to expect the combination USA-Canada to become self-sufficient by or even before 2020. This has instantaneously tempered previous expectations for higher oil prices in the years ahead.
I observe, for example, the latest market update by analysts at CommBank suggests prices for West Texas Intermediate (WTI) and Brent will converge over the next three years. By then both will be trading around US$100/bbl, if CBA's current projections prove correct. The positive news, suggests CBA, is in the short to medium term as the market is pricing in a premium for potential geopolitical fall-out (Iran) and with spare capacity at OPEC shrinking. CBA has raised annual average price forecasts to US$113/bbl for this year and US$108/bbl for next year (Brent).
In my view, the biggest surprise as far as US energy goes, was recently highlighted in US President Obama's State of the Union address, when the President declared that half of all added electricity generation in 2012 had come from renewable energy sources such as wind and solar (see chart below). While this may not have a noticeable impact on the country's thirst for petroleum products, it is bound to have an impact on demand for gas and coal sooner or later. Note that China is harbouring similar ambitions.
All those mid- to longer-term considerations may well be relegated to the sidelines for most industrial raw materials in the weeks and months ahead if forecasts by US strategist Julian Garran prove correct. On Garran's analysis, most of the world has been de-stocking raw materials over the past two years as economic growth slowed, credit markets tightened and confidence in general slumped. One important factor in this process, argues Garran, has been the withdrawal of French banks and of RBS as suppliers of credit in Emerging Markets. This gap has now been filled by US banks.
Recent data suggest credit conditions in emerging markets are improving at a time when real interest rates are falling. Garran believes both factors will play a major role in the global re-stocking that is about to take place throughout Asia (incl China), in the US and even in Europe (he can call on historical evidence to support his forecast). Even if Europe were not to participate in what Garran labels "a synchronised global restocking event", one would have to assume re-stocking in the two most vital components of the global economy -Asia/China and the US- should be enough to prove the skeptics wrong in the months ahead.
In the words of Garran: "Consensus consistently underestimates the power of restocking cycles after a heavy destock in the previous year".
(As I will be traveling to Melbourne on Monday, where I will give a presentation to investors (see below), this story was originally written on Sunday, 17 February 2013. It was published in the form of an email to paying subscribers on Monday, 18 February 2013).
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(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)
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Rudi On Tour in 2013
– I will visit Melbourne this week for a presentation on invitation by the local AIA branche. Title: "The Big Confusion that is the share market". When: Tuesday 19th February 2013. Where: Telstra Conference Centre, Level 1, 242 Exhibition Street, Melbourne
– I will visit Perth in March for two presentations both on Tuesday March 5: ASA first at noon and AIA later in the evening (7pm)
