There are three very distinct commodities stories currently in progress. The first is the continued capacity constraints within industries that exhibit long supply lags, and where investment has been distinctly tardy. This story covers most of the base metals and also energy, together indirectly with a few agricultural commodities that have links with the energy market. It results in price dynamics that combine long-lasting grinding upward trends with the possibility of occasional episodes of violent upward spikes. The key factor across these commodities is that of friction, with demand pushing up against capacity that has proved to be too low relative to the demands of non-OECD (Organisation for Economic Co-operation and Development) growth, in particular.
The second commodities story is evidenced in some industries where there are no binding supply-side constraints, and where inventories are often a significant multiple of output flows. In some of these sectors, price dynamics are being primarily determined by the flow of funds into the market, and in particular, by speculative money moving into a commodity on the basis of what can sometimes be fairly flimsy fundamental stories. This scenario is at the moment being reflected in the behaviour of precious metals prices.
The third, and final, story is that of commodities with relatively fast supply-side responses, where the fundamental balances can often be weak, and where upward price moves tend to be corrected within months, rather than grinding on for years. This is the case for most agricultural commodities.
Our general bias is that we like exposure to the first story, where we expect some further upside in some commodities, and rough stability with upward price risks in others. We are, by contrast, keen to avoid heavy exposure to the other stories, which can, in our view, produce price dynamics of extreme fragility. With some exceptions within categories, that leads us to prefer to have exposure to base metals and energy, and to prefer to reduce exposure to precious metals and most agricultural commodities. That bias towards the market going forward has also been the one that has been the most successful over the past year. In terms of absolute price changes, energy and base metals have been the strongest sectors, in that order.
In total return terms, it has been the same sectors that have been strongest, but in the reverse order, with energy held back by a time structure of prices that has been less supportive for cumulative long-side returns.
For the commodities sector as a whole, there are four key themes that produce our overall positive stance. First, there is the resilience of the global economy. Second, is the limited ability to substitute materials in sectors where availability is scarce. Third, further constraints are being put on supply growth in many commodities as the result of the escalation in operating and construction costs for commodity producers. Finally, there remains the potential for further significant investment inflows in 2006, as investors continue to arbitrage between commodities and other assets.
While the above four factors in combination leave us enthusiastic about the prospects for commodities in general, there are some differences in our approach to the individual sub-sectors and in our relative degree of enthusiasm across those sub-sectors, as is explained in further detail below.
Precious metals
Precious metals prices have continued to push upwards, in what is perhaps best described as a sustained bout of market exuberance. Gold has pushed through US$550 per oz., platinum through US$1,000 per oz. and silver through US$9 per oz. These increases have come despite a lack of concerted dollar weakness.
Given the breaching of key psychological levels and the associated triggering of a series of positive technical conditions, it is perhaps hard to stand in the way of the strong move up. Such has been the scale of the flow of money into the sector, that there does of course remain some scope for further short-term gains.
However, looked at over a quarterly horizon and beyond, we have doubts as to the sustainability of the upwards move. We believe that the rally in prices is now looking stretched and has a distinct fragility; as a result, we are underweight precious metals within the commodities sector as a whole.
There are two main negative dynamics for precious metals: the first is the concentration of speculative interest in futures markets, which appears to be now becoming overextended. The strength of the flow of speculative funds into precious metals has been the primary trigger of the recent decoupling of prices from the path of the dollar. While upward price momentum remains, those funds are likely to stay heavily invested. However, once the rally stalls, the sheer size of speculative length suggests that the downward correction might be swift and brutal.
The second main negative is the generally rather weak fundamental picture. In gold, for example, higher prices have caused Asian demand to slow markedly and increased the level of recycling.
We remain unconvinced about stories suggesting imminent buying of gold from major central banks. In practice, the ability of central banks to purchase significant quantities of gold is severely constrained by limited availability in relation to those reserves, and we do not see any significant role for gold as an instrument of central bank reserve diversification.
We suspect that the path of the Japanese economy may also become a critical variable in the medium term. Much of the heaviest buying of precious metals has been seen on the Tokyo exchange, and seems to be reflective of some aversion from Japanese investors to domestic yen-based assets. If the path of the Japanese recovery follows our base case, we would expect that aversion to fall, and reduce a source of buying pressure in the market.
Given that the overall balance of risks is, in our view, becoming skewed to the downside, we would wish to reduce exposure to precious metals, except as part of a very short-term trading position. However, given the positive technical price trends in place and the evident enthusiasm of many investors to purchase gold even at current elevated price levels, we certainly would not advocate an overt short position in this market.
Base metals
The rise in base metals prices, and most particularly copper, has been attributed to a variety of factors in recent months. These have included speculative funds and the consequences of failed short positions taken by key market participants.
We see no reason to ascribe the main source of strength to forces from the shadows, when the fundamental basis of the 3-year-long move up remains so strong. It is our view that price behaviour is being driven primarily by binding supply-side constraints across the metals sector, which have resulted in falling inventory cover in the face of continued strength from the demand side. Costs are rising, and the supply-side response has been made more lacklustre by shortages of equipment and, in some cases, by a lack of sufficient incremental resource prospects.
Price rises in base metals over the past year have been led by copper and zinc, both of which have risen by more than 50% year-over-year in London. We expect the move up in both metals to continue into the first half of 2006, setting fresh multi-year highs, with some extreme supply tightness emerging in the face of robust demand.
Given our base macroeconomic forecasts, particularly for global manufacturing and for China, we expect the demand side to remain vibrant across the sector.
In the case of copper, while there are some price-related drawbacks in demand in process, the rapid expansion of the Chinese power supply network is helping to buttress demand. Further, despite the price impact, copper demand is ending the year in stronger shape than it did the first half of the year, partly due to the timing of consumer de-stocking.
In the ca
se of both copper and zinc, we continue to recommend buying into any short-term price weakness. While we expect the cycle to show signs of turning in the second half of this year, there is still a final leg up to be ridden over the coming quarter.
While copper and zinc have been the swans of the base metals world over the past year, we believe that there are now reasons for interest in some of the other base metals. In particular, we recommend exposure to nickel, where prices now appear to have bottomed out after weakening across the first three-quarters of the year.
In our view, nickel prices are showing a significant degree of upside potential. Producer sentiment has turned less bearish, and availability has started to show some tightness at European steelmakers. We believe that there is already a considerable degree of bad news contained in the nickel price, and the tightening of balances we expect in early 2006 should start to chip away at the current surplus.
Aluminum market fundamentals are also strong, the result of a lack of availability of raw materials, notably alumina, and escalating power costs that have slowed primary capacity growth and resulted in a number of recent smelter closures. While we see the potential for temporary pullbacks in prices, the extremely positive long-term fundamentals suggest further significant upside potential in 2006.
Given the current tightness across most of the base metals, and the increasing sensitivity of prices to supply-side disruptions, we are maintaining an overweight position on base metals relative to the commodities sector as a whole.
In addition, we also believe that further forward portions of the base metals time curve currently represent better value than the equivalent positions in other commodities. In terms of prompt prices, the overweight position is compelling for the first quarter and into the second. However, our current view of the timing for the top of cycle is such that we would be more neutral, and indeed tend towards an underweight view, when it comes to positioning in a commodities portfolio for the second half of 2006.
— The preceding is an edited portion of Barclays Capital’s Commodity Refiner Q1 2006. It represents the opinions of the authors and does not necessarily represent those of the Barclays group. For access to all of Barclays’ economic, foreign-exchange and fixed-income research, go to the website at www.barclayscapital.com.
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