The commodity super-cycle is very much alive, and the lows witnessed last year may not be seen now, says DIEGO PARRILLA, managing director and head of commodities-Asia Pacific, Merrill Lynch. In an interview with Rajesh Bhayani, he dwells at length on the outlook of various commodities and predicts that later in the cycle, as inflation becomes a key driver, commodities will outperform equities. Excerpts:
What is Merrill Lynch’s strategy in the commodities space?
Commodity is a fundamental building block of our global product platform and services. We have the ability to provide our clients with better financial and physical commodity solutions. A good combination of financial-physical commodity solutions and traditional banking solutions — such as advisory, financing, liability risk management, asset allocation and wealth management — is really powerful. Our key areas of focus are energy and metals, including crude oil and refined products, natural gas, LNG, coal, power, wet and dry freight, carbon emissions, precious metals and industrial metals.
We have seen the commodities space changing in the past few years. According to you, what are the key trends that have emerged?
In my view, the commodity super-cycle is very much alive. We are taking a breath and adjusting to one of the largest shocks in recent memory. The rise in prices was not driven by speculation, but by unsustainable levels of demand growth in a supply-constrained world. We just couldn’t cope with it.
Transportation fuels are still very much dependent on crude oil. Despite efforts to have alternative technologies and bio-fuels, no viable alternative is seen in the medium term. The bad news is that we are addicted to crude oil via its refined products such as gasoline, diesel and jet-fuel. This will, in our view, result in producers capturing a greater share of the economic rent from the refiners.
On the power generation side, we see a bright future for LNG as it is a cleaner alternative to coal. Metals and agriculture too paint a bright picture, but here the tightness in supply is much less acute than that in energy.
In addition to the tight supply-demand balance, we see additional pressures such as weakness in the dollar versus emerging market currencies that can eventually lead to higher prices. Overall, we see commodities, energy in particular, accounting for a higher share of the global GDP.
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If the recovery in demand is forcing commodities to move up, then do you think the low levels seen in many commodities early this year may not be seen in the near future?
In our view, it is very unlikely that commodity prices will correct towards the low levels seen at the beginning of the year. This is mainly due to a combination of stabilising demand, ongoing stimuli, tight fundamentals and a weak dollar versus emerging market currencies.
Gold is again trying to surpass previous highs. What is the outlook? Does that signal a return of the inflationary era?
We believe gold will reach $1,500/oz over the next few years as part of three waves. The first one will be driven by credit markets. The second by dollar weakness. And the third one will be triggered by commodity strength. In our view, we are currently seeing the first one and the beginning of the second is playing out. However, we expect the yellow metal to remain volatile. The market is already positioned for a long forward march, which can result in drastic corrections.
While the central banks in the West have decided to sell less gold, China is increasing its gold reserves. In such a scenario, what are the chances of the yellow metal emerging as an alternative to the US dollar?
In my view, gold will continue to play a meaningful part of central bank reserves. But that does not mean it is a viable alternative to the dollar. We have tried it before. While it will be a nice gift to gold producing countries such as Australia, South Africa and Canada, in my view, gold as a reserve currency is neither practical, nor realistic.
Do you think sugar will take rest now as the price of the sweetener has reached a 28-year high? That apart, what is the outlook for commodities such as soya and other oilseeds?
Agricultural commodities have a much shorter supply-and-demand cycle than energy or metals. Technological and efficiency advances have led to a much stronger mean reversion. Weather also plays a key role and makes medium-term projections so much more difficult. Having said that, we are constructive on agricultural commodity prices over the medium-term. Particularly those commodities that have a transportation fuel angle -- such as sugar, corn, or soybeans.
What role China is expected to play in shaping the outlook for agricultural commodities and metals?
China is a major driver across all commodity markets and, in our view, it will only continue to grow. China is not only a large producer, but also a larger consumer. The country understands better than anyone else that its growth depends on its ability to source physical commodities at the right price. That is why China is taking a range of policy measures and positioning itself for strategic investments and acquisitions. Like India, China has a very large pool of potential consumers in the $5,000-20,000 per capita range.
Most resource commodities such as metals, crude oil etcetera are at their 2009 highs. Please explain the outlook.
In the short run, we see a limited possibility of a big spike in crude oil and energy prices. Fundamentally, over the next few months, we will benefit from some spare production capacity, new refining and upgrading coming on stream and relatively high inventories. However, over the medium to long term, the picture is much more bullish. Crude oil is very much a transportation fuel. It’s becoming increasingly difficult to find the next barrel of oil. So ,we see a huge increase in prices without any meaningful increase in supply.
The outlook for refined products such as gasoline, diesel or jet-fuel is less bright. While they will obviously follow the trend in crude oil, we believe the next wave will be driven by the strength and tightness in crude oil, and less so due to limited refining capacity or tightness in refined products as was the case in the recent rally above $140/bbl.
We see a bright future for LNG. In the power generation and industrial sector, natural gas is a cleaner alternative to coal. From the supply perspective, natural gas is relatively more abundant than crude oil, and in case of the former there is no cartel at the moment that can jack up prices by engineering short-supply.
Metals too have a bright future, but the tightness in supply is most acute in energy. Within base metals, copper is probably the one with the tightest supply fundamentals. Copper resembles oil more than any other base metal.
Do you see a direct link between commodities and equities as both the markets are scaling new peaks?
Equities discount future expectations and commodity spot prices represent the situation of the day. In this sense, both have recovered together. But in our view, as we advance in the cycle and demand grows, commodities will shine. Later in the cycle, as inflation becomes a key driver, commodities should outperform equities.
