Commodity prices have rebounded despite high inventories caused by weak demand during the recession. This price impetus came from a perception that the worst of the global recession was over. Rising demand from an expected global recovery will require extra capacity in many commodity sectors. Commodity prices were surprisingly buoyant in 2009, and are expected to increase further in 2010 as world activity expands after the global crisis.
The commodity rally has gone hand-in-hand with a weak dollar and an increasing risk appetite in financial markets fuelled by, among other things, better-than-expected Q3 earnings reports. Cheap and abundant liquidity has flowed into all risky assets from equities to credits and clearly into commodity markets as well.
However, it would be wrong to dismiss the rally as a pure consequence of cheap liquidity and a weakened dollar; strong fundamentals have contributed as well. The recovery in the business cycle has continued and we see more and more signs that commodities demand both within and outside the OECD area has improved.
Global recovery
Chinese growth continues to power ahead, fuelling an almost insatiable need for commodities. This is reflected in the continuously strong imports of copper into China. Indeed, positive demand revisions have continued with the IEA, EIA and OPEC alike continuing to revise their forecasts for 2010 oil demand upwards. We have thus moved from a situation with negative demand revisions last year to positive ones.
It is hard not to notice, however, that returns in the current recovery phase have been much stronger than witnessed previously in this phase of the business cycle. This commodity price rally at the early stage of the recovery in global industrial production (and ahead of global economic growth) differs dramatically from past experience. After previous global industrial downturns, prices typically continued to fall or rose at very modest rates, far below the increases recorded this year.
What explains the early rally in commodity prices? As for prices of the most risky assets, the initial impetus came from the perception that the worst of the global recession was over and that wide-ranging public interventions had succeeded in lowering uncertainty and systemic risks in the financial sector. Against this backdrop of expected improvement in near-term outlook, commodity markets benefited from increased incentives to hold inventories. At the same time, improving financial conditions provided for increased credit availability for inventory financing at more normal costs while rising inflows into commodity funds likely facilitated the hedging of inventory positions.
The additional forward-looking demand for inventories, and some stabilisation in stock build-ups as end-user demand bottomed out, allowed for easier absorption of the continued excess supply (current supply minus current end-user consumption). Downward pressure on spot prices eased as a result.
I believe the global recovery still has substantial steam left (considering there is more stimulus spending of governments to come in 2010 and beyond) and expect the all-important ISM indicator to hit the strong expansion level of 60 soon enough. However, considering the business cycle sensitivity of commodities, we should expect to see a lot of nervousness and price volatility in markets during 2010. The market is simply different now, with much more spare capacity and a significant positive output gap in the global economy, which would have to close in order to create the same degree of upside pressure on prices. Although, at times, the extra liquidity around the world would clearly overwhelm fundamentals as the chief driver of commodity prices in 2010.
Looking ahead into 2010, the prices of many commodities are likely to increase further. The demand side should generally be the main source of upward pressure, as global activity is widely expected to expand at a faster pace. Information about expected future spot prices derived from key commodity futures options confirms that investors anticipate higher prices in 2010.
Looking at commodity price prospects from a longer-term perspective highlights how prices are expected to remain high by historical standards. The effects of the crisis have been to reduce prices somewhat below their 2008 peaks, but demand is expected to continue rising at a solid pace as industrialisation continues in emerging and developing economies. Accommodating this demand will eventually require further capacity expansion in many commodity sectors, with some need to tap higher-cost sources.
China has been on the lookout for resource companies around the world to feed its voracious appetite and I expect this trend to continue in 2010. As the stimulus spending of China continues unabated, upward pressure on commodity prices is expected to continue in 2010. Small attempts to tighten monetary policy in China will have only a temporary negative effect on commodity prices.
International hedge funds are also expected to continue to invest in commodities to take advantage of the all-time low interest rates currently prevailing in the US, thus creating a nice feedback rally for commodities in 2010.
Base metals
Leading indicators suggest that base metals could rise further as global growth and demand improves. I favour copper over aluminium as the fundamental picture has deteriorated further in the latter with idle production capacity being re-started in a period of elevated stocks. Demand for base metals is likely to get a further boost as factories based in G-7 nations rebuild their inventories.
Base metals have rocketed sharply higher despite a large build-up of inventories stocked in warehouses in London and Shanghai. Aluminium inventories held at the London Metals Exchange are bulging at near record levels of 4.6 million tonnes.
Global output of aluminium is running at 38.4 million tonnes per year, exceeding demand at 35 million tonnes. Yet, aluminium futures in Shanghai rose to 17,000 yuan per tonne, up 60% from a year ago, with Chinese factory output running 19% higher.
Japanese buyers paid premiums of $30 per tonne over the spot price for longer-term contracts, after a European trading house bought over a million tonne from Russia’s Rusal, the world’s biggest aluminium producer. Investment bankers are utilising new and creative ways of lending money to base metal producers, with nearly 70% of the supply of aluminium sitting in LME warehouses tied up in such financing deals, and therefore, not available for delivery in the spot market.
Bankers are buying aluminium on the spot market and selling forward at a profit. The metal is stored in a warehouse until delivery. Bankers are financing the deals by borrowing dollars in the Libor market at 0.25%, thus creating artificial demand for aluminium. However, there’s always the risk that such quasi ‘carry trades’ could be unwound in a violent way when the Fed begins to lift Libor rates.
Still, base metals are buoyed by Chinese demand, absorbing 43% of the world’s supply last year. China imported 1.45 million tonnes of aluminium in the first 11 months of 2009, up 1,225% from the previous year, and 3 million tonnes of copper, up 136%. The cash price for iron ore doubled from its March lows, to $118 per tonne, as Chinese steel mills imported 566 million tonnes, up 38% compared with the same period last year.
The story of aluminium remains one about large LME stocks. Aluminium inventories at LME have surged during the past year and are currently running at record highs. Aluminium prices have, along with prices of other commodities, plunged since the global recession took off last year. Still, prices are up almost 25% this year. A range of countries have introduced stimulus packages to support car sales, which have helped boost demand for aluminium.
Although LME stocks have continued to build over the summer of 2009, cancelled warrants on aluminum, i.e. stocks booked for delivery have simultaneously surged. This could partly reflect the effects of Chinese imports but may also be a sign that demand is finally picking up.
On the face of it, it should not be a problem for the market to satisfy an increase in demand given record-high stocks.
However, with the market in contango and thus having an incentive to sell aluminium forward, a fair amount of stocked metal may be tied up in financing deals and thus not be accessible for instant delivery.
Lately, prices have capped some of the gains seen in 2009 and cancelled warrants have witnessed a setback. This could be a worrying sign given the bulky inventories. However, producer stocks of aluminium have simultaneously declined, albeit by less than their LME counterparts.
After plummeting in late 2008, aluminium seemed to receive some support as US durable goods orders picked up over the summer. This may partly be attributed to base effects and partly to, for example, the cash-for-clunkers programme, which likely released some pent-up demand. But sales fell back a little in September 2009, suggesting that the expansion may not prove sustainable. In addition, with China seemingly on track to become a net exporter of aluminium again, OECD demand would need to pick up swiftly in order to avoid the stock situation weighing on prices.
Source: Financial Express
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