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James Williams, Hedgeweek

Influence on prices shifts to the West


Over the past 12 months the S&P 500 index has gained nearly 24 per cent. With the US economic recovery building momentum, the UK enjoying its fastest period of growth since 2007 and the Eurozone returning to some sort of normalcy, many commentators are expecting the influence on commodity prices to shift from East to West.

“I agree with this to some extent but it will be commodity-specific,” says Jeremy Baker, Head of Commodities at Harcourt Investment Consulting. “A lot of industrial metals are still geared towards Asia and China. China for example is 50 per cent of the copper market.”
Certainly there are risks to some Emerging Markets who are not commodity producers and whose currency declines against the greenback have led to significant outflows. As Bloomberg reported this month, investors have withdrawn USD29.7bn in the first two months of 2014: equaling total net outflows (USD29.2bn) for the whole of 2013.
But one should not throw a blanket over all emerging markets. The argument is more nuanced than that.
“Chile, Turkey, Peru, South Africa; these countries are all commodity producers. A weakening currency is a benefit to their mining industry. Domestic costs can be anything from 15 to 40 per cent of the total cost basis. It won’t necessarily improve production, but a weaker currency will help reduce the marginal costs of production and that’s important,” says Baker. In his view, China will not tighten its monetary policy because of currency weakness but more in response to restrain domestic credit.
“I think China is insulated from the wider emerging markets crisis. The issues there are more credit related.”
For anyone who has invested in commodities over the last three years returns have been disappointing. Over the last two years the Dow Jones-UBS Commodity Index has fallen -10.49 per cent. In 2013, returns were close to -9 per cent. The belief is that as the West starts to build through the economic gears, the supercycle that was rudely interrupted in 2008 will recover; that is, a lot of the negative market sentiment has been priced in to commodities. Already in 2014, DJ-UBS Commodity Index is up 6.6 per cent.
It is very early days, of course. The risk of WTI and Brent falling below USD90 and USD100 (12 months forward) is about 50 per cent according to the commodity price outlook and risks report published by the IMF on 12 November 2013. Tail risks causing crude prices to climb above USD120 or USD130 are estimated to be 8 per cent only.
“We are underweight precious metals right now, not because we are bearish but more because the price of precious metals is going to be challenged by the relative strength of the US dollar as a store of value. I agree we are seeing a strong OECD economic recovery. We’ve been on that theme for the last three years, which is being driven by the US and the massive increase in hydrocarbon production,” says David Donora, who co-manages the Enhanced Commodities Strategy at Threadneedle, adding: “In terms of oil-based energy we have high conviction and are significantly overweight. It’s a sector where both fundamentals and structure are very clear.”
The point Donora makes on commodities having been challenging for investors in recent years is that the very reason the global economy has been able to recover is thanks to lower priced adequate supplies of commodities.
“One of the reasons investors have enjoyed solid returns on their equity portfolios is precisely because commodities have not been the headlines for the last three years,” says Donora.
‘One prerequisite to sustain higher commodity prices is an increase in incomes of end consumers. I think that will be a theme for 2014: the share of corporate profits will be to some extent rebalanced and distributed towards employees and consumers. That will be the first step in the underpinning of higher commodity prices over the next few years.
“We are becoming more bullish on commodity prices because we have meaningful global economic growth.”
Harcourt’s Baker says that within energy he would recommend being long Brent Crude and short WTI. “In the US, economic growth could go someway towards reducing the inventories of Cushing. That could flatten the curve for WTI, which we have seen recently. But the overarching story for us is one of being slightly more bearish WTI than Brent.”
One contract that Harcourt has made meaningful returns in its Belavista fund this year is Henry Hub natural gas. This again plays into the energy revolution taking place in the US where natural gas prices for front-month futures have surged 79 per cent over the last 12 months to USD5.87/mn Btu. Towards the end of 2013 this was very much a demand story as the US was gripped by a polar vortex.
“We have changed our trading style a little bit and become more tactical in trading natural gas. That’s played out very well for us in the first quarter of 2014,” says Baker who thinks that over the next few months natural gas will become more of a storage-related story.
“If you look at natural gas storage levels there’s been significant depletion of inventories especially against the five-year average. Come April, those inventories will need to be re-injected through to October. The key question will be: how much can production increase? Will higher prices lead to some form of demand destruction? Potentially,” says Baker. A hot dry summer in the US would also lead to greater demand and deplete resources.
“We expect summer contract prices to trade higher and the curve to be flatter. There’s still some reasonable upside in the summer contract price relative to longer dated contracts. In March you could see prices pull back as weather anomalies subside. Prices could fall more for March and April contracts relative to July/August contracts,” explains Baker.
Donora, who confirms that the fund’s highest conviction is in oil-based products, thinks that soft commodities is a market that is bottoming and has some upside potential.
“We’ve brought our underweight position on soft commodities back up to neutral. We will look more constructively towards soft commodities during the year and position the portfolio accordingly,” says Donora.
One contract that has worked particularly well for Donora is coffee, largely as a result of dry weather in Brazil and concerns over the size of the Arabica crop. Prices have risen 55 per cent year-to-date.
“To put things into perspective, the price was over USD3/lb a few years ago and nearly fell to USD1/lb towards the end of 2013. Having a bounce from that level is not earth shattering but does give some indication to us that coffee prices at this level do not support increasing production.”
Baker confirms that the main conviction in the fund at the moment is short grains. “This is a position we also held last year in the old and new crop contracts of corn. That was quite a strong contributor last year. This year we remain short corn and soybeans and long wheat.”
A recent research note by Capital Economics suggested that both corn and wheat prices could fall below their current level by year-end. But Donora says that whilst that might be possible there are a number of concerns he has:
“Firstly southern hemisphere producers (Brazil, Argentina, Uruguay) would have to flawlessly execute the harvesting and delivery of crops to market. Given the political instability in Argentina right now, I think there are serious question marks on this being achievable. Secondly, you would need to see perfect weather conditions in the northern hemisphere. If such conditions were to be satisfied then fine, but we don’t have any great expectations that will happen so we are not bearish on grains.”
In soybeans and soymeal there is tightness in the market with the soybean forward price for year-end already around 15 per cent below the current spot price. “The curve is in backwardation right now and is a market in which we as commodity investors will enjoy the roll return in both soybeans and soymeal,” adds Donora.
As the influence from developed markets on commodity prices begins to take hold the industrial metal complex could be slower to react than energy and soft commodities. Many of the industrial metals used in infrastructure development such as copper, aluminium, steel are being consumed, as one would expect, by emerging market countries, of which China is the dominant player. It is predicted that China’s urban population could reach one billion people within the next 15 years and as Baker points out, the shift towards a domestic-based economy in China will support higher commodity prices: “Currently, we remain short on copper but it is an area where we might have higher conviction in the second half of 2014. Per capita consumption for commodities, globally, will continue to grow. However, it is going to be more directed at certain commodities where there are real market inefficiencies like copper, platinum and palladium and to a lesser extent lead and zinc.
“The excess capacity in metals such as aluminium and steel means it’ll be a long time before we see a structural bull market.”
Donora notes that copper production will increase through the first half of 2014 and keep the market supplied and thinks that slower emerging market growth means “we wouldn’t be surprised to see further downside in copper”.
“In the short-term, we think this is more about western economic growth and that it will take a while for base metal prices to recover, even though the US has some infrastructure rebuilding. For most of 2014 it wouldn’t surprise me if we hold a large underweight position in base metals. The slowing of China’s economy and the infrastructure story over there means that the demand driver, whilst still robust, is not increasing as fast as people had been expecting.”
By people Donora means the main base metal producing companies. They cut capital expenditure last year and this is continuing in 2014. However, projects that are delivering more metal into the markets still have momentum and are going to carry through for the first half of 2014.
“We need time for growth in demand to overtake supply and for markets to tighten up. We think that’s very much an end-2014 story. Currently, we have a positive view on zinc and lead and a negative view on copper, aluminium and nickel,” concludes Donora. 

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