June 16, 2014

Gold not ready to shine yet: too soon to own the metal

Commentary by Robert Balan, Senior Market Strategist, Marion Megel, Metals Analyst

"Growth in world economies and ending of the Fed’s programme are expected to push gold to hit new low.”

Adnan Younus Agar, Arif Habib Commodities, June 13th, 2014

Gold has been one of the worst performing commodities over the past two years, driven by higher real rates, low global CPI growth and improving economic and financial conditions, which reduced the perception of risk. While the gold price has rebounded since the beginning of the year, it is still facing important downside pressure by the same factors that negatively impacted it these past years. Consequently, we consider it is too early to re-enter long structural positions on gold.

Over the past 24 months, gold was the third worst performing commodity (-21.9%), after sugar and silver. This downtrend seemed to have paused since mid-December last year, when gold rallied from $1’200 to almost $1’400 an ounce in mid-March. This has contributed to the relatively good performance of gold since the beginning of the year. The gold price is indeed up by 5.9% year-to-date, driven by lower real rates, the weaker US Dollar and a rise in the US headline CPI.

However, despite this rebound, the gold price isn’t likely to move significantly higher in the coming weeks, as several factors are likely to continue to weight on gold’s performance. First, macro conditions are improving, as suggested by the latest data and the upward move of the OECD Leading Economic Indicators. These are likely to have a more positive impact on cyclical commodities, while on the other hand, stronger global economic growth is reducing the need to hold safe-haven assets such as gold. The US economy is indeed likely to grow at a faster pace. US GDP growth is expected to reach 3.4-3.6% during Q3 2014, while the industrial activity in China has stabilised and is expected to accelerate in the coming months. The expected improved US economic activity should also convince the Federal Reserve to continue tapering off its asset purchasing program. This is also likely to have a negative impact on the gold price.

Moreover, the global CPI is still heading lower. The latter correlates with the gold price to a more significant degree than the US PMI. Thus, it will tend to cancel out the positive impact from the US CPI, which rose by 2.0% y/y in April 2014, the strongest increase since July 2013. On the other hand, the World Consumer Price Index growth fell to 2.0% y/y in Q1 2014, the lowest level since Q4 2009.

These two factors are likely to more than offset the impact of the expected decline of real rates and the US Dollar on the gold price, which we estimated could fall to as low as $1’000 an ounce. Gold is hence likely to underperform until the end of Q3 2014 other commodities and especially cyclical commodities, which tend to perform well in this environment. Given the negative situation for the yellow metal, gold investment demand has declined. World gold ETFs’ holdings headed downwards, losing more 35% from its January 2013 peak. Physical investment demand is also under pressure, as gold coins and bar demand fell by 40% y/y in Q1 2014. Gold may prove however more appealing at the end of the year when the macro-economic situation may turn back in favour of the metal.

Commodities and Economic Highlights
Commentary by Robert Balan, Alessandro Gelli and Marion Megel

The Atlantic hurricane season could have a larger impact on international crack spreads

On June 1st, the hurricane season has officially started in the Atlantic Basin. The US National Oceanic and Atmospheric Administration forecasted a below-normal season, implying 8-13 named tropical storms, 3-6 hurricanes and 1-2 major hurricanes. The development of El Niño would also reduce the number of tropical storms. There is nonetheless a higher risk than last year, when only two hurricanes (and no major hurricanes) developed in the northern Atlantic. The June-November 2013 season was the season with the fewest number of hurricanes since 1982. Over the past 10 years, the Atlantic hurricane season experienced on average 16 named storms, 8 hurricanes and 3 major hurricanes.

The hurricane season adds another risk to the oil industry, as infrastructure, either offshore or on the coast, are vulnerable to extreme weather. Usually, a hurricane on the US Gulf of Mexico tends to push lower crack spreads as a tropical storm or a hurricane first reduces crude oil supply produced offshore and crude oil imports for US refiners on the US Gulf Coast. However, when a hurricane hits the shore, damaged refineries are unable to produce as much petroleum products as usual, while reducing crude demand, leading to higher crack spreads. When refineries and offshore oilfields are hit together the impact on the crack spreads is limited, but outright oil prices increase due to the net reduction in oil supply (as damaged offshore fields could remain idle for a while before being repaired).

Nonetheless, due to the tight oil boom, the situation has changed on the US Gulf Coast. Growing domestic supply has reduced the need to import large amount of crude oil. Between 2010 and 2013, crude oil imports on the US Gulf Coast dwindled from 5.4 million b/d to 3.8 million b/d. The decline in light sweet crude oil imports, which has a similar quality than the newly produced tight oil, has been particularly severe. Nigerian crude oil imports dropped from about 600’000 b/d to 88’000 b/d during the same period. Furthermore, the share of US offshore crude oil production of total US production has fallen from 28.4% to 16.4% also during the same period. Moreover, increasing domestic crude oil supply, which can’t be exported, contributed to boost US refining activity. In turn, this translated into higher petroleum products exports. The latter from the US Gulf Coast increased from 1.8 million b/d to 2.6 million b/d between 2003 and 2013. Thus, a hurricane is likely to have now a greater impact on petroleum products. A hurricane would hence reduce US petroleum products supply available for exports, adding upside pressure on international crack spreads.

Saudi Arabia should be forced to boost output above last year level

OPEC members are having a difficult year. Some of them are facing important supply issues, which should force Saudi Arabia to boost output in July and August above the 10.2 million b/d reached in August 2013 and which was the highest level since August 1981. Saudi Arabia needs indeed to respond to seasonally stronger foreign and domestic demand and to replace supply disruptions in other OPEC countries.

The deterioration of the political situation in Libya is suggesting that crude oil exports are not likely to rebound rapidly in the coming months. Moreover, there are reports that some oil reservoirs have suffered from consecutive halts and restarts, implying that the Libyan production potential may have fallen. Libyan crude oil production stood at 1.5 million b/d in April 2013 (a level close to its maximum capacity) and dwindled to 220’000 b/d in April 2014.

Recent events in the northern part of Iraq are increasing concerns about a contagion of violence towards southern oil regions. Already some companies in these areas are complaining about growing security issues, leading to delays. The start of the Kurdish crude oil exports through their new 100’000 b/d pipeline to Ceyhan in Turkey is mitigating the ongoing halt of the Kirkuk-Ceyhan pipeline as violences are preventing work to repair the pipeline which was damaged in March 2014. Growing violence could contribute to supply disruptions in the southern part of the country, offsetting gains made earlier this year.

The nuclear negotiations with Iran are approaching a wall, according to French officials. This could result in the extension of the temporary relief measures implemented in November 2013. This would imply that Iranian crude oil exports would remain flat at around 1.0 million b/d, while Iranian crude oil exports stood at 2.1 million b/d in 2011.

Amid supply disruptions or high supply risks, Saudi Arabia is facing stronger seasonal demand from its power sector (direct crude burning) and higher demand from foreign refiners. This should force the Kingdom to boost output above the elevated level reached in August last year. In turn, this would reduce the country’s spare producing capacity, making the oil market more vulnerable to a supply shock.

Central banks continue to pile up gold

Last month, the World Gold Council released its Gold Demand Trends report covering the first quarter of the year. The research house confirmed that the world’s central banks have remained net buyers of gold in the first three months of 2014. Official net purchases reached 122.4 tonnes, in the range of buying that has been observed in the past three years and the highest quarterly figure since Q1 2013. This level remains remarkable compared to the circa +400 tonnes that central banks used to sell each year prior to 2008.

Central banks have remained net buyers as they try to diversify their foreign exchange reserves away from the US dollar. One strong illustration was Iraq last quarter: following comments from the country’s general manager of investments Muneer Omran that “Iraq has no plans to sell gold from its reserves”, the central bank actually increased its reserves by 36 tonnes. Furthermore, Russia and Kazakhstan purchased respectively 5 and 6 tonnes in the first quarter.

In Europe, central holdings also rose by 7.7 tonnes, boosted partly by Latvia joining the Eurozone and adding 1.1 tonnes to total reserves.  In May this year, signatory countries of the Central Bank Gold Agreement added that they “do not have any plans to sell significant amounts of gold”, suggesting that holdings could remain elevated for the rest of the year. This contrasts with previous sales under the agreement that peaked at 497 tonnes in the year ending September 2005. Over the past five years, European central banks sold just 23.5 tonnes of gold out of a possible 2,000 tonnes, according to the World Gold Council.

Furthermore, there is currently a lot of speculation regarding China’s gold reserves, which remain undisclosed. Given the massive gap between domestic purchases on one hand and production + net imports on the other hand, and given the fact that Beijing has repeatedly expressed its intention to dethrone the USD as the world’s reserve currency, world’s central banks purchases are probably much higher than estimated.

Ethanol margins could suffer from the Chinese ban on corn products

Last week, the Chinese government suspended issuing permits to import corn-based products for animal feed. This is likely to have a negative impact on ethanol producers, which are a producing dried distillers’ grain (DDGS), which is a by-product of ethanol production. The Chinese government is preventing such imports due to the high risk of containing a genetically modified strain that isn’t approved in China. This is the official reason. However, some market participants think that it was decided due to growing domestic animal feed output, reducing the need to import DDGS. This action could have a major impact on the DDGS market as China is the world’s larger buyer of DDGS.

US corn exports to China had already declined due to restrictions. Imports of DDGS had remained strong as some port officials had been lenient. According to F.O. Licht, US DDGS exports reached 1.16 million metric tons in March 2014. The amount of DDGS cargoes that are likely to be asked to re-route could reach 250’000 metric tons. The Chinese government’s decision is likely to add downside pressure on DDGS prices, reducing US ethanol producers’ margins.

The latter had been enjoying elevated margins due to lower corn prices and strong demand for ethanol, keeping ethanol inventories at low level until recently, despite elevated output. Nonetheless, during the past 3 weeks, US ethanol inventories have increased, while inventories tend to decline during this time of the year, reflecting a weaker supply/demand balance. The Chinese ban on US DDGS imports could affect further ethanol producers, leading to lower activity. In turn, this could lead to lower demand for corn by ethanol plants, adding downside pressure on corn prices.

Charts of the week: Lower demand for safe-haven assets is affecting gold prices

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