Quick Thoughts On Commodities for 2009:

Given the sharp losses in commodity markets, I wouldnt be surprised to see some commodity markets bouncing around a lot. However, the economic backdrop remains challenging, and this will weigh on markets. A few thoughts:

• Grains and and softs to outperform on the back of lower inventories and supply issues due to weather and credit availability. Furthermore, demand less likely to be dampened as EM consumption basket is food heavy.
• Higher levels of market volatility. Trader's market. US dollar will be key.
  
• Overall "U" shape for commodities in 2009. Further downside, but potential for higher prices at the end of the year.
  

Happy New Year

What If Oil Spikes?

I think Oil prices are heading South. A technical break below US$35/bbl in Brent Crude would be a negative signal and could see oil head lower to US$20/bbl. But what if a combination of overzealous cuts by OPEC as oil reaches its bottom (wherever that may be), a rise in political tensions in the middle east Israel-Palestine and potential for dollar weakeness lead to a spike in oil?

Take Iran for example. It has a deteriorating fiscal and balance of payments position, which can realistically only be remedied in the short run by a dramatic improvement in oil prices. Would Iranian President M. Ahmedinejad take advantage of the israel/palestinean situation to up the foreign policy rhetoric? Would they demonize themselves politically by playing hardball with regard to the Non Proliferation Treaty and Nuclear weapons? Maybe! If i were in Ahmendinejad's shoes, perhaps i would just enough to raise the level of political and economic risk within the region to see oil prices higher. After all the alternative is lower oil prices, social instability. I dont think its too far of a stretch of the imagination. N. Korea has played this game so often in order to get US aid handouts, particularly under the Clinton Administration.

But what are the implications of higher oil prices under the current economic back drop? Well, i think very negative and imply a further deterioration in the growth outlook and a longer period of general economic malaise:

• A supply-side oil shock could lead to stagflation
• Companies' profit margins would likely get squeezed, weighing on profitability.
• Global equity markets would get hit as profits decline on the back of smaller margins, combined with consumers tightening their belts.
• Business investment would decline on the back of price volatility, combined with slowing growth, tighter credit conditions and shrinking profits.
• We would see the continued redistribution of dollar reserves away from oil importing countries to oil exporting countries, while also improving their terms of trade.

Any thoughts?

Oil's Not Well

I had seen this article on Bloomberg, but Naked Capitalism also posted it up.

• A decade after OPEC failed to prevent oil from collapsing to $10 a barrel, the world’s biggest producers are delaying actions needed to arrest the steepest slide in energy prices.

  Ministers from the Organization of Petroleum Exporting Countries postponed debate on a second cut in output in as many months during meetings in Cairo Nov. 29. They will wait until later this month, after a slump in global economies and the popping of the commodities bubble sent oil down almost $100 from its record price in July to as low as $48.25 a barrel in New York on Nov. 21.

  “They are riding the economic wave just like the rest of us,” Adam Sieminski, Deutsche Bank AG’s chief energy economist, said in a telephone interview in Washington. “In the past when there has been a big economic downturn, OPEC has had to go through a series of cuts to stabilize the oil market.”

  They haven’t done enough this time around to halt the 67 percent drop. Merrill Lynch & Co., forecasting the first contraction in global demand in a quarter century, sees crude bottoming at an average $43 a barrel in the first quarter, 21 percent below where it ended last week. In December 1998, crude tumbled 61 percent from its peak to as low as $10.35 when OPEC failed to eliminate a supply glut.

  Demand Suffers

  OPEC members, the producers of 40 percent of the world’s oil, said at the Cairo meeting that they would wait to gauge the effect of a 1.5 million-barrel cut agreed to Oct. 24. That reduction was meant to restrict OPEC’s daily output by 5.2 percent, about the same amount that Spain, the world’s ninth- largest economy, uses in a day.

  Ali al-Naimi, the oil minister of Saudi Arabia, OPEC’s largest exporter and its de facto leader, said in Cairo that $75 a barrel oil represents a “fair price” needed to support investment in new fields. The group’s next meeting is in Oran, Algeria, on Dec. 17.

  Oil fell as much as $99.02 a barrel from its July record, making the four-month slump steeper than crude’s drop from its 1996 peak to the low set in December 1998.

  At that time the hesitation of countries including Iraq, Venezuela and Russia to rein in output amid the Asian financial crisis and a warm U.S. winter contributed to the decline. Now, sinking demand is the main issue as the world’s largest economies slip into recession.

  Crude oil for January delivery dropped as much as $1.47, or 2.7 percent, to $52.96 a barrel in after-hours electronic trading on the New York Mercantile Exchange. It was at $53.07 at 10:19 a.m. in Singapore.

  Supplies Rise

  OPEC, the International Energy Agency and the U.S. Energy Department reduced consumption projections in November because of the economic outlook. OPEC trimmed its forecast for average oil use next year by 530,000 barrels, or 0.6 percent, and the IEA cut its estimate by 670,000 barrels, or 0.8 percent.

  “Prices are coming down because demand is,” said Robert Ebel, a senior adviser on energy and national security at the Center for Strategic and International Studies in Washington. “There’s no way of knowing how long this will continue.”

  U.S. crude-oil supplies rose for a ninth week, the longest stretch since April 2005, the Energy Department said Nov. 26. U.S. fuel demand declined the most in 27 years in the first 10 months of this year, the American Petroleum Institute reported Nov. 18.

  The world’s three biggest economies, the U.S., Japan and Germany, are in or close to recession. The countries represented about one-third of global demand in 2007.

  ‘The Main Determinant’

  Oil prices may fall more as world growth slows, Fatih Birol, the IEA’s chief economist in Paris, said in an interview Nov. 27.

  “The main determinant will be how the global economy performs,” Birol said. “If the economy continues to slow, this will put downward pressure on demand and also have an impact on prices.”

  OPEC reduced its quota 11 percent in the year through March 1999 to battle falling prices, according to data on the group’s Web site. Its decision in October to cut removed less than half that amount from the market.

  By June 2000, the cartel’s quota was almost 25 percent lower than the 27.5 million-barrel limit agreed to in the three months from January 1998 through March 1998.

  While New York-based Merrill Lynch predicts a recovery in the second half, with 2009 prices averaging $50 a barrel, Barclays Plc says crude will trade at $72.10 next quarter and average $100.50 for 2009, according to a report Nov. 21.

  Spending Programs

  Oil producers are depending on crude prices to support spending programs. Venezuela, the largest oil exporter in the Western Hemisphere, estimated an average price of $60 a barrel for its 2009 budget. The Latin American country depends on oil for half its public spending and more than 90 percent of exports.

  Russia‘s 2009 spending plans are based on a forecast of $95 a barrel of Urals crude, and Finance Minister Alexei Kudrin said Sept. 16 the budget will break even next year if the price of oil averages $70 a barrel. Urals crude, Russia’s benchmark blend, was last priced at $49.60.

  Oil producers “do have leverage but it depends on how much unity they can muster up,” said Simon Wardell, an analyst at Global Insight Inc. in London. “They’re facing budget shortfalls, so a decline in output will hurt them even if it does push prices up.”

  At the same time, international oil companies, concerned falling crude may make new exploration projects unprofitable, are curtailing investment plans and slowing projects. That may affect supply when demand does recover.

  Investment Plans

  Producers such as Royal Dutch Shell Plc are cutting back plans to develop deposits like Canadian oil sands. Shell indefinitely postponed the second-phase expansion of its Athabasca project because of rising construction costs. Shell, based in The Hague, also delayed seeking regulatory approval for Carmon Creek. Higher cost plans require $80-a-barrel oil to be profitable, according to Merrill Lynch.

Im not much of an oil analyst, but supplies continue to increase in the US (EIA) and demand is going to continue falling. Its not only about driving cars, but industrial processes in many countries are energy intensive, particularly in less energy effiicient producers like... yes you got it... China! - I also don't buy the 10% growth figure for China! anyway, there is huge doubt abou their statistics!

Industrial production, and manufacturing indices are falling, energy intensive smelters (aluminium etc) are cutting back production, and this will reduce energy consumption. Russian IP is also down. The world is slowing and Supply cuts will lag. Not only will they lag, but there is a disincentive for countries like Iran and Venezuela - 2 members of OPEC - to cuts supply, as they neet the petrodollars to secure political support. As such, these countries are likely to continue exceeding their quotas and at the expense of those more honest members. Indeed, one of the reason that the cut was delayed to December was to ensure that each country was abiding by the cuts imposed last month /October. Meanwhile, many oil projects are still profitable at $30-50. The margins decline, but given that the sunk costs are so large for these projects, closing fields is the last option taken. Plus, companies and producers will often produce at below marginal costs for a while if they anticipate prices to increase over the medium term. This has been the case for some base metals, and with the oil curve in contango (recently dubbed super contango), there would be little reason for oil fields to shut down.

The problem however, is that given the tight credit conditions, new explorations of oil could be deterred, and this could justify the super contango..... Time will tell.

Her Name Is Rio...

Interesting "analysis" by reuters on Rio Tinto, The london-based mining company. BHP Billiton decided not to go ahead with the purchase. Rio built up a huge debt load, and will now have to sell assets in order to roll its debt over. BHP Billiton, perhaps thought that it could buy the pieces it wanted at a cheaper price. Read for yourself:

• As BHP walks, Rio may have to sell more assets

  By Nick Trevethan

  SINGAPORE, Nov 27 (Reuters) - Rio Tinto, the world's No.2

  miner, may have to sell more assets than it bargained for as

  it tackles nearly $40 billion of debt that scared off a takeover

  bid by bigger rival BHP Billiton.

  Rio took on huge debts to fund last year's $38 billion acquisition

  of Alcan, and pledged to raise $15 billion, most of

  it this year, from selling non-core assets.

  But sliding metals prices and slowing demand have made

  those assets worth less, and the global financial crisis has

  made it tougher for potential buyers to get credit.

  To date, Rio has raised just $3 billion from disposals.

  Analysts say Rio might have to go beyond those non-core

  businesses and offer up more prized assets if it wants to

  avoid having to go cap in hand to investors for more equity

  or having to cut planned spending or dividends.

  And BHP could be a bargain buyer.

  "The non-core -- the salt, borates, talc and packaging assets

  -- are up for grabs, but in this market I doubt very

  much that they are worth $15 billion," said a resource equities

  analyst in Melbourne, asking not to be identified.

  "I'm not factoring in any asset disposals. It's impossible to

  say whether they will even get book value."

  Rio spokesman Nick Cobban said: "We have raised $3 billion,

  but we recognise the change in global economic circumstances

  and we won't reach the $10 billion target this

  year. We have not put a date on (hitting) that target.

  "The sale processes continue, but we won't make any announcements

  until they are completed."

  BHP's shock decision to walk away from its $66 billion offer

  for Rio knocked more than a fifth off Rio's market value in

  Australian trading on Wednesday, and prompted rating

  agency Moody's to signal a possible Rio credit downgrade.

  On Thursday Rio pared its losses slightly, rising 2 percent in

  Sydney. BHP shares, which rose nearly 4 percent on

  Wednesday, added another 5.7 percent.

  RISING INTEREST

  Rio Tinto is currently paying a little more than 2 percent

  interest on its debt pile, but analysts said that could rise

  sharply in the next round of refinancing in the 2009 fourth

  quarter as lenders re-price risk amid a global credit crisis.

  "They will have to divest far more quickly than they may

  have liked and BHP might be there to snap up some of

  those assets," said Andrew Harrington, coal analyst at Patterson

  Securities in Sydney.

  He said BHP has around A$8.5 billion ($5.47 billion) in cash

  and current assets, and end-June debts of around A$12

  billion.

  Harrington noted Rio owns 75 percent of Australia-listed

  Coal and Allied, and a sale of that stake could net around

  A$8-10 billion, including a takeover premium.

  "The question remains: who would want to spring for their

  thermal coal assets? Credit markets are tight so you'd need

  pretty deep pockets, which makes me think BHP may now

  be thinking about buying choice pieces of Rio without having

  to acquire all the stuff they don't want."

  Other bidders for Rio assets may include private equity

  firms Apollo Global Management and Bain Capital, as well

  as Australian packaging group Amcor Ltd and U.S. packager

  Bemis Co attracted by the flexible food packaging

  business, one of the largest in the world, though its size

  could make it hard to raise funding in the current climate.

  BHP Billiton chief Marius Kloppers did not rule out making

  a pitch for Rio assets at its Australian annual general meeting.

  In response a question whether BHP would be interested in

  any Rio Tinto assets if they came up for sale, Kloppers said:

  "If opportunities come up...we would be very interested in

  looking at any assets that are tier 1, low cost, long life, environmentally

  sound and so on," Kloppers told reporters after

  the meeting.

  The Rio spokesman said the company was focused on selling

  the assets it had already flagged and had no immediate

  comment on whether it was considering other sales.

  "Rio may need to look at new asset sales initiatives. They'll

  need to balance those sales against equity or debt funding

  next year," said FW Holst analyst Rob Craigie, noting, however,

  that the next 6-12 months would not be an easy time

  to sell.

  Rio may avoid having to sell off more of the family silver -- if

  commodity markets pick up after prices slumped by half in

  the last five months. Rio is looking for a recovery in the second

  quarter in China, and increased demand for its raw materials.

  The Rio spokesman said the company was in a strong position

  financially.

  "We don't see any reason to raise more equity. We have

  strong cashflow and we are disposing of some good businesses.

  We have no payments due until next October."

  He said Rio generated cashflow of $1.5 billion a month in

  the first half of this year and noted many of its sales contracts

  were locked in until April. Rio has around $9 billion

  of debt due to be repaid next October.

  "From the Rio point of view, you're still dealing with a company

  with A-grade assets," said Tim Schroeders, portfolio

  manager at Pengana Capital.

  "Yes, there's a focus on their debt position, but their interest

  cover is very adequate."

Some Thoughts On Base Metals

The implications of China facing a hard landing should not be underestimated, particularly for commodities. China is the largest importer of base metals and the largest producer of Aluminium. Here I briefly discuss Copper and Aluminium.


Looking at the technical picture, Aluminium could hit US$1,600/tonne by xmas. If it fails to breach trendline resistance, then we could see it reach that level as shown by the chart.

Copper on the other hand, has broken through its short term resistance and is more or less trading sideways. Nevertheless, we believe that given the Global housing and construction bubble which is now bursting (from the US, UK, Europe, Dubai and China - to name a few). Demand for aluminium and copper will subside. Granted producers have already started cutting back output, but i do not believe that this will be sufficient to restore a balace in the short to medium term. Evidence of this exists at the LME warehouses which have seen a rapid build up of copper and aluminium inventories. As such we still see further downside ahead with a price target of US$1,500/tonne for aluminium and US$3,000/tonne for copper.

Having said that Reuters (not online) recently published a bullish view on steel for 2009. Im not sure what to make of it as I do not follow steel. Given that steel has only recently been listed (exchange traded) There is not as much info, but i will be looking into this going forward:

• China's steel demand seen rebounding from Q2 '09-CRU
  SINGAPORE, Nov 26 (Reuters) - China's steel demand is
  likely to bounce back from the second quarter of 2009 on a
  surge in domestic infrastructure spending, UK-based consultants
  CRU International said on Wednesday.
  By the end of next year, China, the world's biggest consumer
  of steel, could see demand rise 5-6 percent, said
  John Johnson, CRU's chief executive for China.
  "It's like a mirror image. If you can imagine 2008 started
  strong and end poorly, 2009 will start poorly but end better,"
  he told Reuters on the sidelines of a shipping seminar
  in Singapore.

Its not out of the question. As previously mentioned, commodities with low levels of inventories could bounce back quite rapidly should general economic activity or demand for a particular commodity pick up quickly. This, combined with a potentially weaker dollar next year would be supportive of higher prices.

Food For Thought

Higher food prices are here to stay according to NYT:

• For more than a year, food manufacturers have been shaving package sizes and raising prices, declaring that they had little choice because of unprecedented increases in the cost of raw ingredients like corn, soybeans and wheat.
• Now, with the price of grains and other commodities plunging, it may seem logical that grocery prices will follow. But while prices for some items like milk and fresh produce are dropping, those of most packaged items and meat are holding firm or even increasing. Experts warn that consumers should not expect lower prices anytime soon on most items at the grocery store or in restaurants.Government and industry economists project that the overall cost of food will continue to climb in 2009, led by increases for meat and poultry. A big reason, they say, is that food companies stillhave not caught up with the prolonged run-up in commodity prices, which remain above historical averages despite coming down from their highs early this yearhe Agriculture Department is forecasting that food prices will increase 3.5 to 4.5 percent in 2009, compared with an estimated 5 to 6 percent increase by the end of this year.

As the article claims, producers were behind the curve in absorbing the changes in cost structures of raw materials. Also they have passed on costs to consumers in less that honest ways by reducing the amount of product without changing the price. (although this is probably a healthy option) see Panzner on financial armageddon. As such, costs have yet to be passed on to the consumer.

This begs the question: Under a scenario or rising food prices, will inflation subside as quickly as anticipated? This is particularly interesting in emerging markets where food accounts for approximately 40% of their consumption basket. Worst case scenario, very slow growth and stubborn inflation? Not sure, a hard landing could well be deflationary particulaly in countries like China with excess capacity. This would likely drive the general price basket down.

Nowhere To Hide

This refers the point I made. Commodities are not as insulated as some of commodity gurus claim they are. From Reuters (not online)

• Commods lose diversification edge with crisis
  By Barani Krishnan and Jennifer Ablan
  NEW YORK, Nov 25 (Reuters) - Using commodities to
  hedge potential losses in stock markets has not worked
  lately, and the tighter link among assets these days means
  diversification benefits may not be as great as before.
  Hedge funds, pension funds, mutual funds and wealthy individuals
  who invested in commodities on the theory that
  they move independently of other asset classes watched
  helplessly as the global economic nosedive turned commodities,
  once the top asset class, into the year's worst
  performer after equities.
  Those who have studied commodities and longtime investors
  in energy, metals and grains say that in ordinary times,
  these markets make good alternatives to stocks.
  But these are not ordinary times.
  "This is the worst I've seen in my 10 years in the business,"
  said Rian Akey, chief operating officer at Cole Partners, a
  Chicago fund manager that invests in commodity hedge
  funds.
  "The theory of diversifying into commodities has relied on
  all things being different to stocks, i.e. different fundamentals,
  different pricing issues, different asset classes, etc.,"
  Akey said. "All that goes away when people are selling everything,
  no matter what, to raise cash. Then, you have high
  correlation, instead of non-correlation."
  Until June, commodities were the best performing asset
  class for four straight quarters as easy credit, booming
  growth in giant developing economies like India, China,
  Russia and Brazil and surging inflation sent prices of oil,
  gold, copper, corn and other resources to record highs.
  The Reuters-Jefferies CRB Index, a global commodities
  benchmark, saw its best gains in 35 years in the second
  quarter, returning 33 percent. Now, it is down that much
  for the whole year. The only worse performer is the MSCI
  All-World Index -- a stocks benchmark for institutional investors
  -- which is down 48 percent.
  Akey, who wrote a paper in 2005 that showcased commodities
  as an effective risk-adjusted return source and
  portfolio hedge, said the credit crisis has shown the asset
  class is not the antithesis of stocks as many believed.
  "In a negative equity environment, you have the potential to
  make money in commodities. But it can be damaging if
  people put too much reliance upon commodities as an equity
  hedge because you can also lose money during down
  periods in equities as well," he said.
  "The current environment is characterized by deleveraging
  and clearly, fundamentals are not the driver. I don't think in
  the short-term you're going to see diversification being
  highly beneficial for anybody," Akey said.
  Brian Hicks, co-manager of a resources fund at U.S. Global
  Investors, summed up a similar feeling when commenting
  recently on how commodities and equities had tacked on
  to each other on their way down. "There is nowhere to
  hide," he said.

This ties in well with the marco view approach. Growth, deleveraging of assets, dollar movements...etc

Commodity Markets Using A Macro Framework

Lately, I have been to many commodity related conferences and there are a few things to point out:

• Many people who attend dont know much about commodities (and are thus keen to learn more about them)
  
• Conference organisers often tell money managers that commodities are an essential part of a diversified portfolio
• We are in a commodity super cycle
• Speaker often confuse attendees with useless information

Hopefully these next few arguments will shed light on the bullet points above.

Firstly, commodity markets are subject to supply and demand dynamics. Like other goods they are relatively scarce or abundant, and this helps determine the price. Commodities are widely traded and are thus pretty liquid instruments, especially front month contracts (1st month futures contract). Having said that, from what I have understood, supply and demand dynamics work in different ways during different types of markets. For example, in a bull market, commodity groups (base metals, agricultural softs or grains, and precious metals) will move together, and some of the individual commodities are substitutes to one another. Here, supply and demand dynamics play a key role, as supply or demand shocks, such as a poor harvest in a producer country or a government policy aimed at increasing its inventories can have strong positive shock on the price. While the same dynamics work in a bear market, they have less of an impact. bear markets are often unexpected, the decline in prices accross all assets has the effect of forced deleveraging. This impacts all commodity groups, although there are some difference depending on how abundant supplies are. Secondly, global real GDP will give you a key indication of where commodities will head next. If you see the global economy slowing, then it is likely that commodities prices will also likely decline. Thirdly, one must take exchange rate effects into account. A stronger US dollar, usually implies commodity price weakness, at least in the short term. Fourthly, investor positions also matter as institutional investors can help increase prices as they can cause them to decline by selling assets at a discount, or in a firesale.

The point I am trying to make here is that we have to look at commodity markets in a wholistic sense. Much like good equity analysts, they dont only look at the stock price/cashflow etc in isolation from everything else and must take global economic trends into account. The current economic environment is testament to this. So for people who dont understand commodities, this, i find is the most consistent and balanced approach.


Balanced Portfolio
Commodity markets have become increasingly important in portfolios. They are often cited as not being very correlated to the movement in stock prices and will never go to zero. Furthermore, they are generally liquid contracts, although if you re trading futures you must roll them over and the cost of carry can be expensive (derivative products get round this). I personally find that commodities are correlated to the business cycle, and in a very strong fashion. While they may one of the latter shoes to drop, if this economic and financial fall out teaches us anything, it is that commoditis are correlated with the business cycle.

Commodity Super-cycle
I Buy this argument. I mean, unless supplies and inventories increase quickly, then inventory levels for a majority of these commodities remain low by historical standards. While growth is slowly rapidly, and this will weigh on prices and demand, incentives to increase production also decline. Should a pick up in global economic activity coincide with low inventories, then prices will rise and they will rise fast!


Speaker Confuse Attendees
I find that often, speakers dwell too much on small details, and dont get the whole big picture. One must understand this before looking at the details.

PBOC Rate Cut & Commodities

So, financial markets continue to be weighed on by poor economic data and moves by policy makers to prevent a rapid deceleration in economic activity. China is one example, where it cut its lending rate by 108bps. This demonstrates how concerned Chinese officials have become regarding a faster than anticipated slowdown in their economy. What does this mean for global growth and commodities? Well, global growth is expected to slow rapidly according to the OECD, with a recession in the US and Europe. A hard landing in China, possibly to 6-7% in 2009 would exacerbate the growth problem.

My first thought when reading that the People's Bank of China cut interest rates, was that commodity markets would dump, particularly base metals. In fact, they rallied slightly according to bloomberg ( apologies, can't find the link), and the logic is that China has now addressed its growth problem. Wrong! While a sharp bounce was the knee-jerk reaction, commodity prices will continue to decline as concerns of a hard global landing come to the fore, and policy makers prove too slow to prevent a deceleration in economic acitivity in China. Emerging market countries, and in particular, China were supposedly 'immune' to a US downturn, and had 'decoupled' from the developed world economic cycle. This proved to be a myth.

End game: Slower growth = lower commodity prices ( no two ways about it)