July 21, 2014

Commodity sectors rotation on the move: the Energy and the Agriculture sectors are likely to catch up with Base Metals, while Precious Metals should underperform

Commentary by Robert Balan, Senior Market Strategist

"Some investors and analysts contend that while the world’s second largest economy may be slowing, Beijing is likely to avert an economic meltdown and the economy is now so large it will continue to suck in rising quantities of raw materials for years to come.”

Chuin-Wei Yap, “China Extends Commodity Buying Tear”, WSJ, May 8, 2014

As the global economy moves through the phases of the global business cycle, commodity investors should expect certain sectors to outperform other segments of the market. What counts the most in understanding commodity sectors rotation are economic developments in the two largest commodity consuming blocks in recent years — the EM economies (with China as the lead proxy), and the OECD countries (with the US as proxy). The tendency had been in recent years for the OECD business cycle to lead the EM business cycle by several quarters.  Moreover, one of the primary drivers of global growth's ebb and flow is arguably the US Federal Reserve monetary policy. Why so? The Fed policy determines the level of short term rates, which in turn, impacts the evolution of long term rates, which are very important in the determination of the future levels of commodity prices. All of the above factors play a large role in setting the market value level of the US Dollar. The US Dollar and US interest rate outlook (in nominal and relative terms, e.g., yield curves), impact the economies of the EM block in general on the basis of external competitiveness and production costs. The EM dimension also provides to the sector rotation decision matrix a so-called "China factor", which may well be a proxy of the Asian EM block — arguably the world's single, most prolific commodity consuming region in recent years.

Chinese economic activity probably follows the evolution of US long-term yield curves, but there is little doubt that cyclical commodities, especially the base metals, are currently beholden to China's growth trends. Base metals are usually coincidental to China's GDP, or at worst, lag behind by a quarter. Since China’s economic growth has likely bottomed in Q1 2014, and is expected to fare much better over the next three quarters (following the lead of the long-rate yield curve), base metals prices are likely to have more room to the upside, in our opinion. The DCI® Industrial Metals Price Index is up by more than 10% from its mid-March 2014’s lows as the economic activity in China is accelerating. The index remains however in the lower range of these past 4 years and has hence significant upside potential in the coming months.

The agriculture and the energy sectors have a strong opposite relationship with the US Dollar. The latter leads the agriculture sector by 4 weeks and the energy sector by 16 weeks. The global business cycle is negatively correlated with the US Dollar growth rate. The agriculture and energy sectors are therefore probably situated in the middle of the global growth cycle, and still have room to grow for another quarter or so — the period which we expect to see the USD fall further.  Since the end of April, the DCI® Agriculture Price Index dwindled by about 16% driven by improved crop conditions in the US and in Latin America and a higher US Dollar. The index should benefit from the likely decline of the US Dollar. This should also have a positive impact on the DCI® Energy Price Index, which fell by about 6% since mid-June. The stronger economic activity in EM economies and OECD countries should provide further upside potential to the energy sector. On top of that, supply risks remain important in the energy and the agriculture sectors. Rising geopolitical tensions (Russia-Ukraine, Middle-East, South China Sea) and weather risks (El Niño) could indeed fuel more volatility in these markets.

The precious metal sector has very strong negative correlation with real long term rates. We expect real long rates to fall further in the next few months. However, this should be mitigated by the expected acceleration of global growth as it reduces the need to hold safe-haven assets such as gold and silver. The precious metals sector could therefore lag the other sectors and by Q4 we could see a flat price trajectory from where it is located now. The most cyclical sectors are therefore likely to lead the pack. The “China factor” and stronger growth in the rest of the world would hence support the upside move of the base metals sector and the energy sector. The latter should benefit like the agriculture sector from the decline in the US Dollar and from elevated supply risks.

Commodities and Economic Highlights
Commentary by Robert Balan and Alessandro Gelli

Can US Corn prices drop further?

The agriculture sector has been the worst performer within the commodity complex these past three months. Within this sector, the worst performer was US corn, which prices fell by more than 25% since the beginning of May, below $4 per bushel, the lowest level since mid-2010. This was driven by improved conditions for the corn crop. According to the Planalytics, the US crop yield for the 2014-15 season could reach 163.3 bushels per acre, significantly above the 5-year average of 145.5 bushels per acre. Moreover, the percentage of corn currently planted in “good” or “excellent” conditions reached 76% last week, the highest level for this time of the year since 1994. The US corn production could therefore reach 352.1 million metric tonnes (mt), which would be the largest crop after the record crop harvested last season (at 353.7 million mt, up 29.2% y/y). This is well above the 5-year average of 321.9 million mt. On the demand side, the situation is only slightly deteriorating according to the USDA. On one hand, US demand for corn is expected to be similar last year at 295.5 million mt, an elevated level, up 4.1% above the 5-year average. On the other hand, US exports are expected to decline to 43.2 million mt, down 10.5% y/y.

The USDA therefore expects US corn inventories to rise to 45.7 million mt, the highest level since the 2005-06 season and a 44.5% increase over the 2013-14 season which already experienced a 51.8%y/y build in inventories. US ending inventories of the 2014-15 season are indeed expected to be more than twice larger than ending inventories during the 2012-13 season, which was the lowest level since the 1995-96 season and contributed to the sharp rise in corn prices these past two years. Due to the importance of the US market — the US is the world’s largest corn producer and exporter— the USDA forecasted that global corn inventories would rise to 188.0 million tonnes, up 8.4% y/y and the highest level since 1999.

While the market is pricing the best case scenario — a second bumper corn crop in a row — supply risks remain present. Especially, the US corn crop has benefited recently from the rains, which reduced earlier drought worries. Nonetheless, the pollination phase has just started, a period when the corn crop is significantly more vulnerable to a return of dry weather. There is also a risk of too much rain especially during the harvest in October-November. The likely occurrence of El Nino during this period — an 80% chance according to the US government — could bring heavy rain, which could slow down the harvest and negatively affect the crop yield. Moreover, at these low prices, demand for corn could increase at a more rapid pace. US net exports sales of corn rose last week to 1.1 million mt, the highest level since March 2014. Support from the demand side and the persisting supply risks should prevent corn prices from falling significantly from this level. In fact, the rapid correction on corn prices could soon be followed by a rebound as excessive optimism on the US grains crop could gradually fade to more pragmatic levels, which would include supply risks.

Zinc’s outperformance could take a break

Zinc prices have outperformed the base metal sector sharply these past few weeks driven by ongoing concerns about supply due to the closure of several large mines amid improved Chinese demand outlook. These medium to long term factors are occurring while the zinc market is being supported by short term factors. Indeed, demand for zinc is accelerating as suggested by the latest data. Japan and Korea zinc exports are down, while at the same time Chinese zinc imports are up significantly. During the first half of 2014, Chinese refined zinc imports were up by +54% y/y, the strongest growth since 2009. This contributed to a sharp drawdown in European and US zinc inventories, which have been moved to China. Visible zinc inventories — at the LME and the SFHE — dropped by 43.5% from January 2013 level to 869’044 mt last week, the lowest level since October 2010, implying a deficit in the market.

Moreover, Chinese economic data have gradually improved, reducing concerns of a hard landing and increasing expectations of stronger growth in the second half of the year. China accounts for 45% of global zinc demand and plays therefore a key role in zinc demand outlook. Furthermore, some major mines have closed or are expected to shutdown. Xstrata’s Brunswick and Perseverance mines in Eastern Canada were closed last year, while MMG’s Century mine in Australia (500’000 mt per year), Vedanta’s Lisheen mine in Ireland (167’000 mt per year) and Skorpion mine in Namidia (162’000 mt per year) are expected to halt operations in the coming 2 years. Moreover, according to Teck Resources, over the 2013-2016 period, mine depletion is likely to remove 1.5 million mt of zinc out of the market, which represents 10.9% of global mined zinc supply in 2013. On top of this, new zinc mines are small. Only two projects —  MMG’s Dugald River in Australia (200’000 mt per year) and the Rampura Agucha’s underground extension in India (401’000 mt per year) — have a size comparable with the above mentioned mines.

Thus, despite these new projects the zinc market is expected to remain in deficit in 2014 and in 2015. The zinc market’s deficit next year should keep upside pressure on prices. However, the market has already priced some of this deficit, leading to a too fast large build in long speculative positions as suggested by the simultaneous rise in open interest and prices. Moreover, zinc prices should be negatively affected by likely lower Chinese imports in July due to the reduced arbitrage opportunities between the LME and the SHFE. The SHFE-LME price spread (including premiums) recently dwindled to the lowest level since February 2013. This could temporary halt the zinc outperformance within the base metals sector for the coming weeks. Nonetheless, strong medium term fundamentals should provide zinc prices enough support to outperform the base metals sector after the summer break.

The likely restart of Japan’s nuclear power plants could reduce oil and gas demand next winter

Last week, two nuclear power plants successfully passed the safety inspection made by the Japanese nuclear authority. This could lead to the restart of Japanese nuclear reactors, which have been idle since October 2013. Despite being widely unpopular, the restart of nuclear reactors remains on Prime Minister Abe’s agenda as it could help narrow the large trade deficit. Indeed, since the halt of nuclear reactors, the power sector had to rely on imported fossil fuel.

At first, natural gas and oil demand increased sharply following the gradual shutdown of the nuclear fleet. But last year, coal use by the power sector increased as some major coal plants damaged by the 2011 Fukushima catastrophe were repaired and gradually took over market share from natural gas and oil as coal is a cheaper fuel. Demand for oil by the power sector between January and June 2014 remained nonetheless almost 200% (+275’000 b/d) above the same period in 2010. Natural gas use by the power sector is also up by 41% during this period, reflecting the more important role of oil and gas as fuel for the power sector.

The restart of the two nuclear reactors could occur in the second half of this year if both the government and local authorities allow it. This should lead to a lower use of natural gas and oil by the power sector. Oil demand is likely to be particularly affected as this fuel is the most expensive. Nonetheless, oil use by the power sector was already expected to decline in September and October due to lower seasonal demand for power. The restart of these nuclear power plants in the second half of the year could hence have a more important impact on oil and gas demand during the winter when power demand rises seasonally as nuclear energy will grab market’s share at the expense of oil and gas.

Chart of the week: The Energy and the Agriculture sectors are likely to bounce

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