The Investor Extra. Commodities not feeling the love so far in 2013

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1 Markets Products Opinion Update May 2013 The Investor Extra In this issue... Commodities 2013: What sectors will the winners come from? Oil: likely to remain within the $80-$120 range in the short term Will gold prices hit the floor? Introduction Commodities not feeling the love so far in 2013 Buying opportunities open up in agricultural commodities It has been slightly surprising that commodities have noticeably trailed the risk rally over the past couple of years although clearly China s slowing economic momentum has had an impact upon the sector s performance. We continue to believe that the sector should be a long term beneficiary of global economic growth, driven by the emerging market economies. However, in the near term commodities will be something of a mixed bag. We believe there will be winners in the space but they will be limited to those commodities where the underlying bottom up fundamentals are improving. In this report we take a look through the main commodity sectors to identify where those winners might come from. We continue to believe that the sector should be a long term beneficiary of global economic growth, driven by the emerging market economies.

2 The Investor Extra / May 2013 Energy Oil Prices likely to trade in a wide range in the near term Since the world economy emerged from the Great Recession oil prices have generally traded in a wide range (see Chart 1). In fact oil prices represent a perfect example of the risk on, risk off feature of investment markets over the past couple of years i.e. oil prices have invariably moved higher in the early part of the last few years (as global economic data surprised to the upside) only to ease back as the summer gave way to a slower pace of economic growth. Longer term we believe that oil prices will gradually move higher as the economy and oil demand grows. However over the next couple of years we think prices are likely to remain within this range (around $80-$120) for a couple of reasons. Although global economic growth is forecast to improve into 2014 (see Chart 2 of global economic forecasts), we don t believe the growth rates will be strong enough in order to drive oil prices sustainably through a barrier of around $120 per barrel. The growth in world oil demand has been driven exclusively by emerging market demand over the past few years while oil demand in the OECD bloc has been lacklustre. Despite the slowdown in emerging market economies over the past 18 months, growth there will be strong enough to ensure global oil demand will continually move higher over the next two years. However oil demand growth across the developed economies remains more uncertain over this period given the mixed recovery patterns across the various economies and we believe this will be the main factor limiting oil price gains over the period. Supply considerations, on the other hand, will be the main factor keeping prices above a floor of around $80 over the next two years. Specifically, we Chart 1 Brent Oil Prices (US$ per barrel) Source: Bloomberg, April

3 Chart 2 World Economic Growth Forecast Source: Consensus Economics, April 2013 believe OPEC s need to run balanced budgets within its economies means that it will look to curtail production in response to falling prices. In reality OPEC is targeting a price of around $100 per barrel (the Saudi petroleum minister has been quoted recently stating his belief that $100 is a fair price ) as this price enables it to pay for growing government spending. Some investors point to the potential for shale oil to reduce prices. While we agree that technological developments have increased potential world oil supply, the impact on total global supply heretofore has been limited and has really only been noticeable in North America where production has increased by around 2 million barrels per day (around 2% of global supply) over the past two years. Furthermore, many of these shale projects require relatively high oil prices in order to make them economical. To highlight this, Goldman Sachs estimates that the marginal cost of production for North American shale projects is around $70-90 meaning that prices must be at or above these levels for the long term in order to ensure this potential production becomes a reality. Clearly there are other factors which could drive oil prices over the short term such as the behaviour of investors (we see this factor as amplifying price momentum rather than driving prices) and political risk. In our view political risk is probably the biggest short term upside risk to prices, particularly given uncertainties in the Middle East and in Asia. However, from a fundamental perspective we believe oil will continue to trade in a broad price range in the near future. 3

4 The Investor Extra / May 2013 Natural Gas Natural gas prices the US recovery begins Generally natural gas prices around the world have been mixed over the past few years; in Europe they have stayed relatively stable but we have seen significant differences in the US and Asia. In Asia, liquefied natural gas (LNG) prices have moved significantly higher (see Chart 3 highlighting Japanese prices), helped in particular by a big increase in Japanese imports as Japan has looked for an alternative to nuclear energy following the Fukushima earthquake. In contrast, Chart 3 Japanese LNG Import Prices (US$-MMBtu) Source: Bloomberg, April

5 Chart 4 US Oil and Natural Gas Rig Counts US natural gas prices have collapsed in the last few years on the back of rising supply and inventories. However, we have seen a trend over the past six months or so where US natural Source: Baker Hugh, April 2013 gas prices had moved so low as to act as a disincentive to further supply. Evidence of this came though clearly in the collapse in onshore natural gas rigs in the US (see Chart 4). It is also clear to see in the results of major integrated Chart 5 Annual Changes in US Natural Gas Marketed Production (Bcf) energy companies; Shell for example has been running its US natural gas business at a loss for the past two quarters as a result of the low price environment and has responded accordingly by curtailing supply. At the end of 2012 we argued that US gas prices would have to move higher over the medium term as a result of these developments and also because prices would have to move higher if North American LNG exports/and or greater shale gas production were to become realities. So far this prediction has played out with US natural gas prices up 20% so far in 2013 at the time of writing. This has been helped somewhat by a longer than expected winter season in the US but investors are definitely beginning to see gas production levels ease as a result of lower prices (see Chart 5 of the annual change in US gas production). Over the next couple of years we see the fundamentals for US natural gas continuing to improve and prices moving higher as a result. Elsewhere around the world we see the market for LNG in Asia staying fairly tight in the near term and European prices remaining stable. Source: US Energy Information Administration, April

6 The Investor Extra / May 2013 Metals Few positives to drive metals higher in the short term Apart from sporadic bursts of positive performance, industrial metals such as copper, aluminium and zinc have struggled to perform over the past couple of years. The main factor behind this has been slowing momentum in the Chinese economy and the rest of the emerging market economies. Given that growth rates in the Chinese economy will be lower in the next two years than they were in the last decade industrial metals will find it tougher to grind out gains. This isn t helped by the fact that inventories of many industrial metals have climbed rapidly over the past few months. For example, Chart 6 shows the rise in copper inventories over the past few months. In our view, investors will have to rely on improving bottom up fundamentals for industrial metals to move higher over the next year or so. In short this means demand will have to gradually improve (China will be crucial in this regard) and supply will have to stagnate which should ultimately lead to lower inventories. The recent fall in prices should help as it makes marginal production more uneconomic; for example, global resource consultants Wood Mackenzie recently estimated that around 15% of global zinc suppliers are losing money at current prices. Therefore it may take a few quarters of subdued prices before we see a recovery in the industrial metals. Not surprisingly gold has generated the most headlines of late on the back of its sharp fall in April. Gold has lost momentum over the past twelve months (see Chart 7) and even before its latest bout of weakness it had struggled to make gains in the face of weak economic data and/or political instability which signalled that it would struggle to Chart 6 Annual Change in Copper Inventories (Metric Tonnes) Source: Bloomberg, April 2013 Inventories are those from Shanghai Futures Exchange, COMEX and London Metals Exchange 6

7 Chart 7 Gold Prices (US$ per oz.) Source: Bloomberg, April 2013 continue its winning performance stretch (it had risen in each of the past twelve years, a feat not accomplished in any other financial market dating back to 1865). We still believe that there are fundamental positives for gold that should drive it higher; western central banks in particular continue to debase their currencies while still being very open to increasing reserve allocations to the metal. However, we had flagged in the January 2013 edition of The Investor that further gains in gold were growing more dependent on sustained growth in investor demand and we still hold that view. A few factors have shaken investor sentiment towards gold in the last month; as well as the sharp price falls, a number of prominent gold bugs such as George Soros have recently expressed concerns about a correction in gold prices. This has led to a sharp fall in gold investment (Chart 8 shows the decline in physical gold held in exchange traded funds) and the deterioration in sentiment also wasn t helped by Cyprus decision to sell excess reserves of gold on the back of its bailout. As with the industrial metals, we believe the marginal cost of production should represent a fundamental floor for gold prices. At present this stands at around $1,000-$1,200 per ounce compared with the current gold price of around $1,500 per ounce. Could it fall to these levels? Of course it could but we believe it would take another bout of investor nerves on gold to drive this and it s impossible to forecast such a development. Our best guess on gold is that it will move modestly higher from these levels (perhaps up to $1,600) over the next few months however, investor behaviour will play a critical role in dictating this next move this behaviour is difficult to predict. Chart 8 ETF Gold Holdings (Million Ounces) Source: Bloomberg, April

8 The Investor Extra / May 2013 Agriculture Agriculture Interesting entry points opening up in the sector Agricultural commodities have also endured a tough start to 2013 (see Chart 8) after a year where tight supply/ demand conditions coupled with difficult growing conditions in the US drove prices rapidly higher. It is fair to say that supply/demand conditions globally are still very tight for many agricultural commodities but there is greater US planting this season (core planting in the US is set to be at its highest levels in 70 years in 2013) and increased supply from South American countries that has prompted the price falls in We believe there are short term reasons why there could be some further weakness in the sector; for example, the outbreak of bird flu in China could hit imports (which would be used as bird meal) and there is the potential for agricultural inventories in other international countries to also recover Chart 9 Performance of Dow Jones UBS Agricultural Index (Rebased to 100) which would put pressure on prices. However, growing emerging market demand will continue to be the dominant theme which drives commodities such as corn, soybeans and wheat higher. Furthermore, price rises such as those we saw in 2012 have typically led to a higher supply response internationally. However if prices remain at their current levels, crops such as corn may not see as aggressive a supply response next year as in Therefore, this may in fact sow the seeds (excuse the pun!) for a recovery in agricultural commodities later in the year. In short we think prices have the potential to move slightly lower from current levels, however the prices action since the turn of the year is opening up an interesting tactical buying opportunity for investors in agricultural commodities. Source: Bloomberg, April

9 In conclusion Recent price action could present some interesting investment opportunities Although Chinese growth will slow over the medium term we do not believe this automatically means the long term prospects for commodities have dimmed considerably. The world economy will still be driven along by the emerging economies over the next ten years and the loose monetary policies implemented by western central banks could also produce higher inflation over the medium term. Both of these should help commodities move higher eventually. In the near term, we believe the sector will be something of a mixed bag with its share of winners and losers. On the energy side of things we believe there are a number of factors at play which will drive US natural gas prices higher in the next two years. Oil prices could also represent a good tactical opportunity for investors given their recent price fall although overall we think prices will largely stay in a wide $ band for the foreseeable future. There is little momentum in metals markets at present and while we think industrial metals could begin to improve in the latter part of the year, the next move for gold is very uncertain in light of the rapid cooling of investor sentiment towards it. Finally, in agricultural commodities any further weakness in corn prices represents an interesting tactical opportunity for investors as emerging economy and biofuel demand continues to grow, stocks remain relatively tight and weather issues always have the potential to jeopardise yields. The world economy will still be driven along by the emerging economies over the next ten years and the loose monetary policies implemented by western central banks could also produce higher inflation over the medium term. 9

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