Joined: 17 Jul 2006
|Posted: Wed Sep 06, 2006 10:06 am Post subject: Commodity Prices
|On Commodity Prices
Simon Hayley's report argues
o The historical returns on commodity futures appear attractive. However, in this Focus we look at the factors behind these returns, and find strong reasons why they cannot be expected to continue.
o One statistic often cited by commodity bulls is that even before the start of the current boom, investing in commodity futures gave a real return very similar to that on US equities. But almost the whole of this return was because futures prices were generally below spot prices (backwardation). Prices of the commodities themselves declined in real terms.
o This backwardation has now disappeared, so the prospective return on commodity futures will now be more similar to the return on the commodities themselves. This means that the appropriate historical comparison is with the negative real returns made on the underlying commodities. Indeed, many futures are now priced above spot levels (contango). This introduces an important headwind for investors, since underlying spot commodity prices now need to rise significantly if investment in futures is even to break even.
o There would be good reasons to expect a backwardation whilst speculation in commodity markets was only a niche interest. Correspondingly, it should come as no surprise that the backwardation has disappeared as mainstream investors started moving into commodities. The flood of investors into commodities appears already to have destroyed the main source of the earlier returns.
o Bulls argue that commodity prices will carry on rising, with supply struggling to catch up with increasing demand (in particular from China). But commodity prices are already unsustainably high, boosted by the Chinese investment boom and increased speculative demand. Investors thus face a double whammy, with the costs of the contango compounded by a sharp fall in spot prices.
o Diversification benefits are also likely to be weaker than in the past. Previously, inflation tended to boost commodities whilst undermining other assets. But inflation is not the risk that it used to be. Instead, the key risks over coming years are (a) slower global growth, and (b) reduced investor risk appetite. These factors are likely to undermine commodities at least as much as other assets.
David Fuller: Simon Hayley is quite right to point out the risks to commodity investment or trading where contangos rather than backwardations persist. In such an environment, a buy-and-hold strategy would most likely lose money unless the price trend was clearly upwards. As veteran subscribers may recall, it is precisely because of contangos that I often manage a long position in commodities, even when the price is in an uptrend, attempting to lighten somewhat on rallies and increase longs on reactions that remain within the rising trend.
I read Simon Hayley's explanation of why backwardations or contangos occur with interest but prefer a simpler summary based on supply and demand, particularly regarding the immediately available material. Basically, if the demand for 'spot' material for imminent delivery (normally from consumers of the resource but occasionally investors or others willing to stockpile it) exceeds the supply readily available, the commodity will trade at a backwardation (premium of the 'spot' price over futures prices).
Conversely, if the supply for immediate use exceeds demand, the commodity will trade at a contango (premium of futures prices over the spot month. And while demand from investors or traders who acquire futures rather than take delivery of the commodity can increase the contango, it normally reflects the 'carry' cost, determined by interest rates. Therefore if US short-term interest rates rise, as we have seen over the last two years, the contango will also increase, assuming no immediate shortage.
Recent strikes by miners contributed to a temporary shortage of nickel for immediate delivery, resulting in a significant backwardation. This was exacerbated by some ill-timed hedging, presumably by producers, who had shorted nickel and were subsequently being squeezed because they were having trouble making deliveries. Copper had been in a backwardation since late 2003 but this has disappeared recently as supply has increased relative to demand which may have contracted. Robusta coffee, which Eoin has been commenting on, has moved into backwardation recently. Most other commodities are in contango as there is currently no shortage of 'spot' material.
My main disagreement with Simon Hayley concerns the outlook for commodities, which tend to move in very long-term (20 to 40 year) bull and bear markets. The current bull trend, which has been mainly but not exclusively in the industrial sector to date, only commenced four to five years ago. I believe this will be the biggest and possibly longest bull market ever for commodities, mainly because of the unprecedented and rapid economic growth within previously underdeveloped countries with very large populations (see also my more detailed assessment in response to an earlier report by Simon Hayley, posted on Thursday 22nd June 2006).
Attached here for Simon Hayley's argument on commodity prices
o We argued in early May that global commodity prices had become unsustainably high. Prices have now fallen somewhat, but we anticipate much larger falls to come. China is of key importance: for some commodities it has accounted for almost all the recent growth in global demand. Commodity bulls like to argue that China has now reached the most commodity-intensive stage of its development, so its demand for commodities must continue to grow very rapidly. This assumption has helped support commodity prices, but our analysis suggests that it is dangerously na´ve.
o Chinese demand for metals has more than doubled over the past five years, leaving stocks low and markets tight. This sudden jump in demand is largely due to the massive Chinese investment boom, since investment is much more commodity-intensive than consumer spending. Investment has leapt from 33% of GDP in 2000 to around one half in 2005. This is not sustainable.
o Premier Wen has stated bluntly that "investment is still expanding too fast", and the authorities have introduced measures to rebalance the economy from investment spending towards consumer spending. Thus, even with the Chinese economy as a whole continuing to grow rapidly, investment spending is set to decelerate, suggesting that growth in demand for metals will also slow.
o Chinese demand for oil has also grown rapidly, although this is just one of several factors that have left global markets with little spare capacity at the moment. But the Chinese government aims to increase fuel efficiency by 20% over the current five year period, implying that oil consumption too is set to grow more slowly over coming years.
o Demand for agricultural commodities has been growing more gradually. Overall food consumption has been rising, but is now reaching a plateau. Demand for meat has been growing by over 7% per annum, although this too is set to slow. But global production has been able to expand to meet this increased demand without increasing prices in real terms. With demand growth now set to moderate, this gives little justification for assuming that Chinese demand will significantly boost agricultural prices in future.
David Fuller: It has long been a Fullermoney policy to read reports that differ from our own views, in the interests of perspective. And in the same vein, we have posted a number of intelligently argued views with which we may disagree, either wholly or in part. Fullermoney subscribers usually appreciate this and are more than capable of making up their own minds.
And as veteran subscribers know, a key Fullermoney theme covering industrial resources since 2003 has been: Supply Inelasticity Meets Rising Demand. We are believers in the commodity supercycle, and if we are wrong in what I have frequently described as the cyclical versus secular debate concerning industrial resources, Simon Hayley articulates the reasons.
The common ground is that both he and we at Fullermoney had expected a correction in response to accelerating prices up into May. Medium-term corrections for individual commodities can last from a few months to two and even three years on rare occasions, before the secular trend resumes.
Having written so extensively on the subject of commodities and particularly the industrial resources sector of this group, I won't restate the entire argument. However I'll post a few bullet points of my own, for review and to appraise new subscribers of our thinking, in case they have not had time to search the Fullermoney Archives on this subject.
o Historically, commodities often have the longest cycles, lasting 20 years or more. The current bull market is only 5 years old.
o The approximately 21-year bear market since 1980 considerably reduced production capacity for industrial resources and expansion has lagged analysts' expectations due to shortages of equipment and qualified manpower, costs and environmental considerations. Politics remain another impediment.
o It can take from 5 to 10 years to develop a new mine and some metals are even becoming scarce. Conventional oil production may have peaked.
o However the biggest and relatively new development in recent years concerns demand for industrial resources. Simon Hayley's report and others with a similar view are mainly China-centric. They largely overlook the embracing of capitalism by previously economically moribund countries in Asia, Eastern Europe, the Middle East, Central and South America and even parts of Africa. Many of these countries are growing very rapidly with the additional help of globalisation, technology and resources wealth, which is now being ploughed back into vast infrastructure development programmes. Consumer spending is also growing rapidly in many of these countries, adding to demand for resources, from energy to metals.
o The numbers are staggering: 5.5bn people in the developing world now have a real chance of emulating the economic success of 1.5bn people in the developed world. This can only lead to unprecedented demand for industrial resources. Inevitably, demand is also increasing for agricultural commodities. And while crops do not experience the same supply inelasticity delays as industrial resources which have to be wrenched from deep within the earth, they are subject to the vagaries of weather.
o I too expect some economic slowdown during the second-half of 2006 and perhaps extending into 2007, due to higher interest rates. However if this leads to a soft landing, as I suspect, rather than recession, the global economy will still be synchronised in a period of economic expansion, which has always been bullish for commodities. Periodic corrections such as we are currently experiencing aside, this remains a secular bull market for industrial resources.
o Lastly, this inflation-adjusted chart of the CRB Index since 1961 probably says more than all the words that I have written on the prospects for a secular bull market in resources. Barely out of the starting blocks, for this chart not to move substantially higher over the next 15 to 20 years, we would have to assume little emerging market growth, little inflation and a big increase in the production of resources. And for good measure, here is an inflation-adjusted chart of the Goldman Sachs Commodity Excess Return Index, dated back to 1970, which is heavily weighted in favour of crude oil.