Commodity markets have performed largely in line with our expectations: Crude oil prices have held up well above US$60 per barrel, while natural gas and oil products have seen the largest price gains over the quarter. Copper led the gains in industrial metals, with prices setting several all-time highs in the third quarter, and the other industrial metals also performed better compared to the second quarter, though still some way from their peaks. Precious metals joined in the commodity bull-run this time around, with gold rising within striking distance of its 18-year high, dragging the rest of the complex along with it.
This broad strength in commodity markets was reflected in a very strong performance for commodity investments with the energy-dominated Goldman Sachs Commodity Index (GSCI) registering an annualized return of 83% in the third quarter and the broader-based DJ-AIG index returning the equivalent of 63% annualized.
One of the key themes for commodity markets in the second quarter was a period of independence from the dollar, allowing the commodities to be guided by their individual fundamentals. The traditional negative correlation with the dollar resumed across a number of commodities in the earlier part of the third quarter. However, most commodities again found freedom from the currency markets towards the end of the third quarter, which allowed precious and industrial metals to surge higher on the basis of non-currency factors.
Perhaps of most significance in this aspect is gold, which traditionally had the strongest link to the dollar. Disregarding a weaker euro, gold soared to fresh 17-year highs in September on the combination of a lack of European central bank selling, economic uncertainty and increased inflationary risks after Hurricane Katrina, as well as a pick-up in market sentiment following evidence of fundamental improvements in the first half of 2005.
In light of these, it is therefore not surprising that commodity indices continued to outperform other asset classes, a further testament to the resilience of commodities to shocks that would negatively affect other markets.
Katrina and commodities
The key events that grabbed news headlines in the third quarter were the two hurricanes occurring over a space of less than a month in the U.S. In addition to the tragic loss of lives, the disasters have made already tight U.S. oil products markets far more serious and exacerbated the growing division between tight products and ample crude. In mid-October, over 60% of the U.S. Gulf of Mexico’s 1.5 million barrels per day of crude oil production and around 1.6 million barrels per day (around 10% of U.S. total) of refining capacity was still shut down. Lost refinery production due to both hurricanes could now total over 200 million barrels (half of which would be gasoline).
We believe the greatest upside risks lie with oil products, with the upside of crude oil capped by potential further release of strategic crude stocks — which, given the lack of spare capacity, does not directly ease product market tightness.
Industrial metals were understandably shaken as Katrina added uncertainty to U.S. economic outlook and metals demand. The complex came under severe selling pressure in mid-September. A 7% fall in nickel (perceived to possess leading abilities for the complex), mainly because a strike was averted at the world’s largest nickel producer,
Barclays Capital expects the interruption to growth to be short-lived and believes that natural disasters tend to have a net positive impact on economic activity. Furthermore, a glance at metal consumption patterns after previous natural disasters provides some indications of what can be expected over the next few quarters. Metal consumption as a proportion of U.S. industrial production (IP) after Hurricane Andrew in 1992 was boosted in the following quarters after initial weakness. A similar reaction was witnessed in Japan after the Kobe earthquake in 1995. This time around, reconstruction will occur against the backdrop of robust global growth, lagging metal supply and low inventories.
Gold’s exceptional performance in the third quarter is undoubtedly due to the uncertain macroeconomic environment after the hurricanes. The divergent path of gold and the euro in the wake of Katrina was in stark contrast to before the hurricanes, when gold simply followed the euro’s movements. Indeed, it appears that market participants have turned their attention to the strength in energy prices, which is justifiable as high oil prices inevitably lead to rising concerns over the economic outlook and increased inflationary risks — a positive environment for gold. Meanwhile, robust physical demand has been supporting (rather than driving) prices. With our expectations of continued strength in the energy complex, uncertainty over the impact of high oil prices should help retain a healthy level of fund interest and help support gold at historically high levels.
The China factor
As the markets head into the fourth quarter, fundamentals appear to be even stronger for several markets and we advocate an overweight position in energy and industrial metals. In industrial metals, consumer demand should pick up as we approach the seasonally busier period, while the supply side remains very constrained — all these occurring against the backdrop of extremely low inventories to act as a buffer in the face of supply disruptions.
China is, of course, increasingly a pivotal factor for the outlook of industrial metals demand and prices. China’s economic growth continues at a strong pace, with both IP and fixed asset investment activity still registering solid growth. This, coupled with the under-hedged positions of consumers after a period of de-stocking, will ensure that Chinese metals demand will remain extremely robust going forward. Chinese net imports of refined copper remained strong in September at 110,000 tonnes, while imports of concentrates rose to a record high of 413,000 tonnes in August, in line with the rapid expansion in domestic smelting capacity this year. This, together with lower-than-expected global mine production this year, is helping to quickly deplete the concentrate surplus accumulated over the past year. With growth in mine output likely to be subdued next year, we believe this means that the Chinese market will become more reliant on cathode imports, and that the Western world refined copper market will remain very tight in the first half of 2006.
Meanwhile, Chinese aluminum exports were down significantly in August/September, confirming that the changes to the tax scheme are starting to discourage Chinese smelters from selling abroad.
Last year, China accounted for almost half of what proved the biggest ever increase in global energy demand (oil, natural gas, nuclear and coal). Within this, it accounted for a third of the 3 million barrels per day rise in global oil demand. China’s demand growth has slowed significantly this year (growth looks like it’s coming in at less than 500,000 barrels per day in 2005), but this slowdown will prove temporary, mainly the result of de-stocking and the artificial depression of oil demand via unsustainable price management by the government.
Given China’s growing energy demand (due to urbanization, rising living standards and infrastructure development) and very low level of per capita oil consumption (around 2 barrels of oil per head per year compared to 25 in the U.S.), it is likely to be the fastest-growing country for global oil demand growth over the next 10-15 years, and even in the short term, the risk is for a sharp pick-up in oil demand.
Shorts at risk
Wi
th our positive outlook on the energy and industrial metals in mind, we believe the strategy of playing these markets from the short side, adopted by many tactical and systems investors, is extremely risky at this time. Large speculative short positions reflect expectations for price corrections from multi-year highs — an understandable view, but one with which we beg to differ.
In the case of copper, in particular, the large speculative short position looks vulnerable amid a steep backwardation, and we expect to see more forced short-covering ahead. In mid-October non-commercials extended their net short in crude oil, with the gross short positions moving to an all-time high. In product markets, fund net length in gasoline contracts was at relatively high levels, with the amount of profit-taking since the spike in prices in late August looking fairly modest, signifying expectations of further upside in gasoline prices. By contrast, short positions in heating oil looked extremely risky. We expect to see an increase in long positions in this sector as fundamentals will firm up with the onset of winter.
Alternative to mainstream
One of the best gauges of the evolution of commodity assets from being an alternative to becoming a mainstream investment over the past two years has been the massive inflow of money to U.S. commodity-linked mutual funds. Assets under management have risen from less than US$500 million at the start of 2003 to almost US$13 billion currently.
Measures of the flow of retail sector funds into commodity investments accelerated again in September, confirming that investor appetite for commodities via simple index exposure remains high. Data for August had shown a considerable slowdown in inflows with the US$170 million total ranking as the lowest for almost two years. However the September inflow of US$687 million represents a strong recovery and ranks as the sixth-largest monthly inflow since the start of our data series in 1997.
In addition to index-linked commodity investments, there are now many other options also available to investors. There are a number of exchange-traded commodity funds offering alternative ways for the retail sector, and the range of commodity structured products on offer has also risen dramatically in the past year. These comprise baskets of commodity options that take advantage of downward-sloping commodity price curves and are achieving significant penetration of the investor base in Europe. We expect demand for commodity investments to stay at high levels, especially with the relatively underdeveloped Asian markets showing signs of potential for rapid growth in the coming months.
Our commodity segment views in summary:
q Energy: Gasoline availability remains tight, with the combined cumulative loss of gasoline product due to hurricanes Katrina and Rita expected to reach more than 100 million barrels. In the short run, there is little problem with crude oil availability although the scale of lost crude oil production is mounting in significance and could become a problem further down the line. Given the even greater levels of vulnerability of the oil market to shocks in the wake of recent lost refinery and crude oil output, we view a move to net short in the balance of speculative positions in energy markets during October as adding significant upside potential.
q Base Metals: Vastly different assumptions on the effects of high energy prices on economic growth and metal production costs have helped drive a large divergence in views on the price outlook. Traditionally, near-term supply forecasts are reasonably certain. Today, however, the range of supply growth forecasts is even greater than that of demand, which normally tends to be the more volatile part of the equation. This is likely to keep price volatility high, but underlying support is very strong due to severe supply constraints, low inventories and positive demand indications. We see the upward price trends remaining intact, and continue to recommend consumers and investors to buy into price dips.
q Precious Metals: Net non-commercial long positions continue to build in the precious metals complex following the lead of gold, where net length reached another record high in mid-October. A strong technical trend and the general macroeconomic uncertainty over high oil prices are supporting gold. Gold looks well supported above US$470 in the short term, and fund enthusiasm remains intact. The other precious metals will continue to track gold closely, while platinum is getting a boost from expectations that the high gasoline prices will spur more interest in diesel engines (still mainly met by platinum autocatalysts). We see a turning point for gold at the end of this year when prices could fall sharply.
— The preceding 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 web site at barclayscapital.com.
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