Commodities | Sep 05 2013
-Geopolitical risk widens
-Libya more serious risk to oil
-Fed meet key to gold outlook?
-Macquarie gets bearish on copper
By Eva Brocklehurst
An escalation in geopolitical risk has the propensity to widely affect commodity markets. Historically, crude oil and gold have been the most sensitive to such developments. This reflects gold's historical status as a safe haven and the fact that the Middle East, a major source of geopolitical risk, holds more than two-thirds of the world's oil reserves. Deutsche Bank analysts observe that other sectors can also be vulnerable to these shocks. Maybe even more so in this day and age.
If the conflict triggers broad-based selling in the equity market and downgrades to global growth it can quickly infect industrial metal prices. Deutsche Bank finds geopolitical events have tended to be shorter in duration and more muted in magnitude for both oil and gold as commodities over time, with gold particularly de-sensitised by the major crises that hit the world's financial system. A more violent reaction would eventuate if oil markets suffered from a further loss in crude oil supply. Up until now the loss in crude oil production from the civil war in Syria has amounted to an estimated 110,000 barrels per day. This is therefore significantly less that the decline in Iranian and Libyan production over the past year, which is equivalent to an estimated 1.23 million and 1.18 million barrels per day respectively.
National Australia Bank analysts have noted that oil prices strengthened in July, reflecting heightened concerns over the security of supply as well as an uptick in Asian crude demand and ramped up refinery runs. More recently, the threat posed by potential military action by the US on Syria has provided further impetus to prices. The Brent-West Texas Intermediate differential narrowed in July to an average of US$3/barrel, the lowest level since January 2011. It was expanded takeaway capacity from Cushing and high refinery crude runs that drove down inventory levels at a record rate. The analysts are relatively optimistic about the outlook for oil prices. The impact of stronger global demand on prices is expected to outweigh the effect of improving supply factors over 2013, even when taking into consideration the likelihood of tightened supply from the Middle East.
In Deutsche Bank's view the loss of Libyan production poses the more serious risk to global crude oil markets, given the implications for OPEC spare capacity. The analysts believe the increasing economic and financial pressure on Brazil, India, Indonesia, Turkey and South Africa, if sustained, could spill over into a number of commodity markets such as crude oil, thermal coal and the platinum group metals.
Precious metals have been the best performing sector in terms of excess returns so far during the third quarter, notes Deutsche Bank. This rebound will be tested with the US Federal Reserve's meeting this month and a likely further increase in US yields and a strengthening US dollar. For the NAB analysts, the outlook for the global economy is looking brighter and inflation seems to be under control. As a result, gold is no longer starring, with sentiment reaching fresh lows. NAB analysts also ask whether the end to the US Federal Reserve's asset purchasing program will stifle any potential upside to the gold price. Maybe the upcoming FOMC meeting will hold the key. While the risks to gold appear skewed to the downside, it is quite possible that other asset classes that have benefited from loose monetary policy will fall in value as QE is unwound, underpinning investor demand for gold.
The price of gold fell by a notable 4.3% in July, but has stabilised more recently, recovering by a modest 2.8% to date. Spot gold is currently around $1,380oz. The price of gold will certainly record its first annual decline since 2000, the NAB analysts contend. Compounding the recent weakness is the relative strength of other asset classes that have benefited significantly from extremely loose monetary policy settings. Potential triggers for a rising gold price include a surge in inflation or re-emergence of global recession fears. Neither of these are expected to happen.
Latest data from the World Gold Council shows that identifiable gold demand fell further in the June quarter, down 13.7%, consolidating a 17.0% decline in the March quarter. The decline largely reflected a sell-off in investment but total quarterly supply of gold rose by 4.2%, to around 970 tonnes, driven by a seasonal pick up in mined production. The Indian rupee has plummeted over recent months, making the purchase of gold more expensive for Indian buyers. Despite this, gold imports appear to have held up well. In response, the Indian government introduced a suite of restrictions aimed at reducing gold demand and strengthening the rupee.
Base metals have received some support recently from more upbeat economic data, particularly from the large advanced economies, although China is showing early signs of stabilising as well. In aggregate, base metal prices are around 2% lower over the year to August. The NAB analysts think metals markets will be in surplus in 2013, as a result of increasing metal supplies and slower demand growth. This shift in market fundamentals, combined with elevated inventory levels, will keep metals prices susceptible to any negative demand side shocks.
Investor positioning in copper is now back to neutral, according to Deutsche Bank, and this signals the end of the short-covering rally. The analysts think better than expected data out of China may be the next catalyst, but retain a preference for metals where over-capacity is less of an issue, such as copper and zinc over nickel and aluminium.
Macquarie thinks copper bulls are just plain wrong. A 10% rally in the price since June 24 has been attributed to tightness in the Chinese copper market, but, on Macquarie's examination of Chinese copper fundamentals, the market is not booming. Instead, the recent rally has been driven primarily by investor short-covering which offers a good opportunity to sell ahead of strong supply growth, as well as a widening surplus over the next twelve months.
Aside from a return to expansion in Europe and stabilisation in Chinese interbank lending rates, copper bulls have been encouraged by three main factors. These include the record highs in Chinese copper cathode premiums, extremely strong Chinese copper consumption and a shortage of Chinese scrap/copper producing raw materials. Macquarie has another explanation for copper's strength. It's investor positioning in a heavily short market. The copper specific factors are too focused on a tight copper market in China, while Macquarie points out the LME copper price has outperformed Chinese prices by 2% since June 24.
On the Comex copper contract, non commercial traders, which includes fund and speculator positions, have moved from a record short position to net flat in only three weeks. To Macquarie this suggests it's investors that have driven the strength in prices. The analysts do acknowledge that Chinese buying tends to be extremely price sensitive, and increased buying after a strong rally is not a usual occurrence.
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