After a sustained rise, global commodity prices have started to soften. How will this impact demand and future prices? Kevin Norrish, Managing Director in Commodities Research at Barclays Capital, discusses the outlook with Rajesh Bhayani.
In the last one quarter commodity prices have declined, probably after many quarters. Now, there are arguments supporting a further fall in prices and demand. Can we say commodities as an asset class is at a crossroad?
We don’t think commodity assets are at a crossroad. Although there has been some short-term volatility in Q2, the overall picture for investors is still very positive with total returns of benchmark indices for the asset class such as the DJ-UBS index up in excess of 40 per cent since the recovery from the financial crisis began in early 2009. Investors take a long-term view of the asset class based on strong long-term structural factors like emerging market demand growth and the need to encourage investment in vast amounts of new supply that will be needed over the next 20 to 30 years. Commodity assets are also still regarded as an excellent portfolio diversifier and hedge against inflation, based on their track record over many business cycles.
With QE2 ending, fresh flows of liquidity towards commodities are unlikely. Could this result in investors fleeing from this asset class?
It is an oversimplification to attribute the post-QE2 rally in commodities to higher liquidity alone. Fundamentals have been much more important, especially demand. After unprecedented growth in 2010, which saw most commodities hit fresh all-time highs for physical demand, the consumption picture has remained very strong in 2011. For example, oil demand rose a further 2.4 million barrels per day (bpd) in Q1 after expanding 3 million bpd last year. In base metals, aluminium demand rose eight per cent in Q1, lower than the 2010 growth rate but still above historical averages. Supply for many commodities is still lagging. Global copper production has fallen so far this year, for example, and downgrades have been made to output of key agricultural commodities as well because of poor weather. Geopolitics is also becoming more important. Unrest in the MENA (Middle East-North Africa) region alongside a big reduction in oil market shock absorbers like spare capacity and inventory levels make the risk of an oil price spike this year much greater than for some time.
Along with talks of a global slowdown, big consumers like India and China are also slowing as monetary policy tightens. How will this shape the commodity market outlook in the next few quarters?
There are certainly some legitimate concerns about the near-term outlook of emerging markets growth, and the effect of that on commodities demand. However, recent concerns about the cyclical slowdown are obscuring the fact that the medium-term growth outlook is still exceptionally strong across the emerging economies, in which positive income effects are proving to be much more important than price sensitivity in shaping commodity demand trends. Despite high prices China’s crude oil demand is up nine per cent so far this year. Further, countries such as China, India and emerging Asia are at the most commodity-intensive stages of their development. The average Chinese consumes just 2 barrels of oil per year compared with 20 in the US. The average Indian consumes just one barrel a year.
Chinese government targets for the expansion of the rail network, rural electrification plan and public housing construction are all expected to contribute to robust demand growth this year, especially as it seems the country may be nearing the end of its rate-hiking cycle. In India tighter monetary conditions are starting to be felt, but so far there is little evidence in the data of any softening, of commodity demand, suggesting that structural dynamics might be outweighing cyclic ones. Aluminium consumption is growing at double-digit rates, while copper demand bounced back in March following a subdued start of the year. In oil, domestic sales hit a new all-time high in May and growth for the year-to-date is running in line with last year’s robust pace. Likewise, Indian coal imports should stay on a strong growth path, underpinned by robust demand growth in the power sector.
After the International Energy Agency’s (IEA) decision to release extra crude oil, prices have come down. What is the outlook and how will that affect the economies?
We think that the IEA release does little to address the long-term structural imbalances in oil markets, which are, at root, about too much demand growth and not enough new supply. The IEA oil release is primarily a way of borrowing oil from the future into the present because the strategic reserves will ultimately have to be replaced, so any impact in reducing prices is likely to prove temporary. Also, it is important to note that the IEA release closes neither the quality nor the quantity gap caused by Libyan oil being taken out of the market.
Have commodity markets overcome the impact of Japan’s earthquake?
The Japanese events may have contributed to a softer patch of global macro-economic data in Q2, but it looks like the economy – and commodities demand – is recovering healthily. Across the base metals, for example, the average size of demand decline just after the earthquake at around seven per cent year-on-year was much less than expected with weakness in sectors such as autos being offset by strong reconstruction demand.
There was talk of coal and gas demand going up due to the nuclear disaster in Japan.
The Japanese earthquake has certainly resulted in a big change in energy consumption patterns in Asia, the main feature of which is a huge increase in Japan’s LNG imports in order to meet its nuclear energy shortfall. In contrast, Japan’s coal demand has softened due to the shut-in of coal plants following the earthquake, though we do believe that in the longer term the uncertainty around nuclear energy will be positive for most fuel sources including coal. The big boost to Pacific basin coal prices recently has come instead from China and we expect demand there to remain robust.
We have seen divergent trends in gold and silver in the last couple of months. Do these metals have some steam left?
We think the outlook for gold is more secure than for silver. Gold’s traditional role as a financial safety hedge in times of macro-economic uncertainty is keeping prices well supported and we see the ongoing issues for European sovereign debt, emerging market inflation and general macro-economic uncertainty as positive for gold. Meanwhile, we have long viewed silver as one of the few commodity bubbles in the making, with little fundamental support for prices. Silver mine supply hit a record high in 2010 for the seventh consecutive year. Meanwhile its main industrial end-use in photography is falling due to the growth in digital cameras. There may be times when silver prices appreciate faster than gold, but price corrections tend also to be much greater.
How are agricultural commodity prices expected to move, given FAO’s forecast that they will be high for years to come?
A combination of stronger demand driven by rising living standards and changing diets in emerging markets, alongside more challenging weather patterns for farmers have been the big drivers of global food prices recently. Recent bad weather has left the stocks of some key agricultural commodities such as corn at extremely low levels and it will take more than one year of good harvests to replenish them. This suggests that the price outlook is still a volatile one for agricultural commodities. Solving the global food challenge over the coming years will partly depend on higher prices encouraging greater investment in the farming sector. However, it will also need governments to reform many of the subsidy regimes and trade restrictions that have hampered the efficiency of global agricultural markets and which have been a key factor preventing supply side-growth in recent years.
