September 15, 2014

Commodities: too much pessimism on demand growth, and too much optimism on supply

Commentary by Alessandro Gelli, Commodity Analyst

"Blessed is he who expects nothing, for he shall never be disappointed”

Alexander Pope

Commodities had a difficult summer. All major commodity sectors with the exception of base metals fell over the past three months. The Diapason Commodities Index® fell by more than 9% during this period, driven by the decline in the agriculture and the energy sectors. The DCI® Energy Index and the DCI® Agriculture Index declined by 11.6% and 13.4%, respectively. The DCI® Precious Metals Index was also down by -3.6%. However, contrasting with these three sectors, the DCI® Base Metals Index performed significantly better as it was up by 5.2% during this period. The stronger US dollar, the large reduction in speculative positions, soft energy demand and higher supply in the grains market were the major factors behind the fall in prices of the energy, the agriculture and the precious metals sectors.

The decline in commodity prices was amplified by the significant reduction in net long speculative positions. We already detailed the situation for the oil market in last week’s Diapason Commodities Insight Weekly (Commodities and Economic Highlights, Speculative positions suggest oversold conditions in the oil market, September 8th, 2014). But since then, net long speculative positions on oil futures have declined even further. They are down 70% since the last week of June to 246’355, the lowest level since June 2012. This is the largest decline in net long speculative positions since the ICE started to release data on speculative positions on Brent futures in 2011.

This is not an isolated case; on CBOT soybeans and corn futures net long speculative positions dwindled respectively by 95% and 72% since early April 2014 to the lowest level since December 2011 for soybeans and the lowest level since February 2014 for corn. On wheat, net long speculative positions moved into negative territories, close to the record low levels reached at the beginning of this year. Net long speculative positions also have fallen significantly in the sugar and cotton markets to the lowest level since February 2014, and to the lowest level since December 2012, respectively. On the other hand, net long speculative positions are at elevated levels on the coffee and the cocoa markets, which have been among the best performers since the beginning of the year, due to a tight supply/demand balance. ICE coffee and ICE cocoa prices are up by 53.7% and 12.6% year-to-date, respectively.

The significant decline in net long speculative positions to relatively low levels suggests that key commodities have reached oversold conditions. This is further confirmed by the bullish sentiment which has also fallen these past weeks. On crude oil, the positive sentiment fell below 40% - an important level as it has only been breached 5 times since 2009. In the agriculture market, the bullish sentiment also dwindled to low levels, implying oversold conditions. On soybeans, the positive sentiment fell to 25%, the lowest level since 2008. It is only the third time since 2007 that the positive sentiment on soybeans falls below 30%. On wheat, the bullish sentiment decreased to 20%, the least since April 2009. On corn, it fell to 21% - the lowest level since 2005. In the sugar and cotton markets, the bullish sentiment also declined to low levels. These movements contributed to a significant reduction in the Diapason Weighted Commodities Bullish Sentiment Index 3-Month moving average, which declined to 49% last week from 60% in June 2014. It is only the third time since 2010 that the index falls below 50%.

There may be a silver lining to all this however. In June 2012 and in November 2013, after the index dropped below 50%, the Diapason Commodities Index® recovered by between 9% and 11% in the following 5 months.

Thus, while commodity prices may still face some downside pressure in the coming days, oversold conditions are predominant in key commodity markets, suggesting that market participants have overreacted to the downside. Stronger US and Chinese economic growth expected during the second half of the year should more than offset the still-weak-but-improving economic activity in Europe. Moreover, while market participants have become overly pessimistic about global economic activity, they may have become too over-optimistic regarding the supply growth in the agriculture and energy markets. Those extreme expectations may not be realised.

Commodities and Economic Highlights
Commentary by Robert Balan and Alessandro Gelli

The start of the refining maintenance season could boost distillate crack spreads

The summer driving season has ended. This period is key for the oil market, and especially petroleum products, due to typically strong seasonal demand, but does not necessarily translate into the outperformance of petroleum products within the oil sector, due to the also elevated refining activity. Refiners typically boost activity when demand for petroleum products peaks — in summer and in winter. According to the International Energy Agency, global refinery crude throughputs increased by more than 2.0 million b/d over July and August to 78.7 million b/d. Weaker than usual refining activity in Europe, due to low margins, was more than offset by new refining capacity and stronger crude runs in Russia and in the Middle East.

Both refining maintenance seasons — in spring and in fall — are usually adding upside pressure on crack spreads, due to an important reduction in refining activity. The fall in petroleum products production is usually larger than the seasonal decline in demand, leading to a drawdown in petroleum products inventories, which in turn is adding upside pressure on crack spreads. This is then encouraging refiners to increase activity as much as possible once they have completed maintenance work.

During the maintenance season, the petroleum products market is more vulnerable as inventories are declining and as the spare refining capacity could be low. Indeed, an unplanned outage or a stronger than initially expected demand could contribute to a spike in petroleum products price volatility during this period despite weak seasonal demand.

According to Bloomberg, global refining activity has already declined by 2.0 million b/d since its high of August and could decline further by 1.3 million b/d by the first half of October, when the refining maintenance season is expected to peak. Refining activity is then expected to gradually increase. In the meantime, distillate crack spreads are likely to move higher, driven by lower than usual inventories in the US. Despite the larger than expected build in distillate inventories last week, they remain at the lowest level since 2004 for this time of the year. The US distillate stock-to-use ratio is also at a relatively low level at 37 days, close to last year’s level and down 10% from the 5-year average. The likely acceleration of the economic activity in China and in the US in the second half of the year could lead to stronger demand for diesel, which has strong links to the economic activity. Diesel is also benefiting from coal shortages in India as blackouts are boosting the use of diesel-fired generators. The diesel crack spreads could hence face some more important upside pressure in the coming weeks as refining activity declines.

Base metals prices overreacted to the downside on trade data

Base metals have been the best performing commodity sector since the beginning of the year, despite the fact that the Chinese economy is growing at a weaker than initially expected pace. This has been caused by tighter fundamentals for most base metals. Copper has been the exception as reflected by its underperformance within the sector. The strong performance of nickel, zinc and aluminium, which rose by 30.7%, 9.3% and 7.4% respectively year-to-date, has indeed been driven by a tighter supply/demand balance. These metals had suffered from low prices these previous years, leading to a decline in supply in the form of capacity reductions or, like in Indonesia, a ban on ore exports.

Moreover, demand for these metals also increased, leading to lower inventories. In the case of aluminium, stronger automobile sales in China and in the US contributed to an increase in the demand for the metal. Aluminium inventories at major exchanges fell by 14% since their high made in mid-2013. Zinc inventories at major exchanges also fell by 41% since early 2013. This contributed to disconnect these base metals from signs of weaker economic activity in China. The HSBC Markit manufacturing PMI fell in August 2014 to 50.2. The Li Keqiang index – which tracks bank loans, electricity and rail freight volume, also fell in July to the lowest level since June 2012. This was one of the major drivers behind the underperformance of copper prices, which remained strongly linked to the health of the Chinese economy.

But the China factor has started again to affect the other base metals. Last week, Chinese data were negative as imports and industrial production growth declined, increasing concerns about the Chinese economy. Furthermore, Li Keqiang, the Chinese Premier, made a speech at the Summer Davos Forum in Tianjin and seems to have failed to offer new solutions to stimulate growth. These factors contributed to the decline in prices of base metals. Those which performed well until then – aluminium, nickel and zinc – were hit the worst last week, indicating that the China factor is back. Aluminium, nickel and zinc prices fell over the week by 3.4%, 6.1% and 4.9% respectively. Nickel prices were also hit by the decreasing likelihood of a rapid implementation of a ban on ore exports in the Philippines.

However, the market may have overreacted. Fundamentals for these three metals remain tight. Moreover as these metals have reconnected with the Chinese economic activity, they are likely to benefit from the acceleration of the Chinese economy, which we expect in the fourth quarter. The downward price movement last week is therefore offering interesting entry opportunities to build long positions on base metals.

Dry weather in Asia may not be sufficient to lift agricultural prices

El Niño has not materialised so far. The meteorological event would have brought drier than normal weather to South East Asia and wetter weather in South and North America. According to the Australian government it has still a 50% probability to occur before year-end. This could have a major impact on agricultural markets. However, Asian countries are already facing dry weather, which is having a major negative impact on the crop.

Dry conditions in the eastern states and Western Australia should contribute to a decline in the total winter crop production by 12% in 2014-15 to 38.6 million metric tonnes (mt). According to the Australian government, the June to August 2014 rainfall was below average over large parts of the cropping zone in Western Australia, Victoria, central Queensland, and the southern cropping region of New South Wales. The 2014-15 Australian wheat crop’s forecast was revised lower by 10% to 24.2 million mt, down from last year’s level at 27 million mt. While Australia is among the world’s top 5 exporters of wheat, this may only mitigate the impact of the bumper wheat crop in Europe. The Australian cotton crop’s estimate has also been revised lower by 29% as the dry weather should lead to lower yields. Australian cotton output may reach 580’000 mt, down from a previous forecast of 820’000 mt made in June 2014. This would be the smallest crop in 5 years and a sharp decline from last year’s level of 890’000 mt. The impact of the dry weather is likely to be more important than usual due to lower irrigation water supply. In 2013, Australia was the world’s third largest exporter of cotton behind the US and India.

Australia is not the only country hit by dry weather. In China, the government decided to reduce the use of water for irrigation due to low water availability in some regions. This is expected to have a negative impact on the Chinese crops. Wheat planting in China could decline by about 51’000 hectares this autumn. Corn output could also decrease by 2.2% y/y to 213.8 million mt due to the droughts in Liaoning, Jilin, Inner Mongolia and Henan. This may nonetheless be the second largest crop ever recorded, which may lead to a surplus of 27.3 million mt, despite the expected rise in domestic consumption of 7 million mt. The wheat and corn markets are still expected to face a major surplus this year due to bumper crops in the US and in Europe, more than offsetting lower output in Asia. Thus, current dry weather in Asia and consequent decline in crop for some agricultural commodities may not be sufficient to lift agricultural prices higher.

Chart of the week: Falling bullish sentiment on commodities indicating oversold conditions

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