I picked up an interesting observation this week in a report from commodity analysts at Danske Bank (not part of the Super Cycle religion). Having conducted a historical analysis into economic cycles and commodity prices, the analysts observed that commodities used to be late-cycle performers during cycles, but in more recent times they have grown to become early cycle performers.
I like this type of research. Too many experts treat history like an exact copy of the future, while to the contrary, circumstances and contexts are constantly evolving. That's why "Sell in May and go away" no longer works (see what happened this year) and that's why commodities, as we have discovered over the past months, have been strong performers this early in the cycle: they have moved up the time-scale.
To put it in a more academic framework: were we to divide one economic cycle into four clearly distinguishable phases they would be called recovery, growth, slowdown and downturn. It used to be that commodities performed best during periods of growth and economic slowdown. That has now moved forward, making the recovery and growth phases of the economic cycle the two top phases for commodities.
What this implies is there should be more to come yet, as we've arguably only had the recovery so far this year, which only now moving into the transition phase that should see economies across the world start expanding again. However, the real world never follows any textbook guidelines and Danske Bank analysts, in another report, predict prices for commodities are likely to continue rising in the early months of 2010.
But as we move through next year, say the analysts, headwinds will likely build for commodities, especially in the second and third quarters, making price prospects gradually and increasingly tougher.
As world economic growth experienced its nadir in the first half of 2009, one can expect the numbers should still look promising in the first half next year (idem dito for corporate profits), but as the year matures some real progress will then have to be booked, or disappointments will start becoming reality again.
But there's more to this story than meets the eye at first.
Analysts at US Global Investors also did some excellent research lately. While their historical data analysis focused on the price and prospects of oil, I think we can safely assume their work is important for the understanding of commodities in general.
Say the analysts at US Global Investors: the market tends to look at oil from a rather narrow viewpoint, one that, loosely formulated, is determined by how much of it we can get out of the ground and how much demand is out there to buy and consume it. And whenever there's a terrorist plot or geopolitical tension that could possibly impact on supply or trade in oil we price in a risk-premium.
But here too the market dynamics have changed. In more recent years the driver behind oil markets has become less about supply and demand and more about how much spare production capacity there is across the world.
But above all, reports US Global Investors, history shows the price of oil has a strong correlation with the US dollar, as well as with money supply across the globe, as well as with infrastructure spending. And now a new important factor has emerged: the rise and rise of a new middle class in emerging economies.
All these factors have contributed a great deal to price movements for oil throughout the years.
Say US Global Investors analysts: the underlying dynamics for global oil changed in 2006 when -completely hidden to most of the world- for the first time in history the contribution to global GDP (as measured in USD) by the middle class in emerging countries (including the Middle East) exceeded the contribution to global GDP by the US. As you would expect, the difference between both contributions has widened further since and next year should simply see a continuation of what appears to be an ever widening gap.
In general, point out these analysts, the world population is much better off than used to be the case even as recently as the year 2000. One stand out feature from the changing consumption patterns in developing economies is that most purchases are done in cash, while in developed economies, with the US being the prime example, the majority of all consumer purchases involves credit.
This is why, say these analysts, the lack of credit will be less of an impediment to further growth and changing consumption patterns in emerging countries, unlike the developed countries where the scarcity of credit should keep a lid on economic expansion.
But don't underestimate the impact of money supply. According to US Global Investors' analysis, global money supply pre the collapse of Lehman Brothers was contracting and this caused economies to freeze and demand and prices for commodities to fall off a cliff. Post the Lehman disaster, however, we have landed in the opposite situation: money supply is expanding, and strongly so.
While the world's focus seems limited to what happens in developed countries such as the US and the UK in terms of increasing the supply of money, the analysts point out the average increase in the M2 measure of money supply in the G7 thus far stands at 7.5%. The number for the US is 9.5% year-on-year. Canada stands out with an increase of 14.2%.
The average money growth in emerging economies, however, has been far greater. China beats everyone with an increase of 25.7% year-on-year, but what about India (20.5%), Indonesia (18.4%), Brazil (16.9%) and Mexico (14.7%)? You'll notice that all these numbers are far greater than those in the developed countries.
Oil, and commodities in general, respond very favourably to extra supply of money in the global economy. There has been plenty of it over the year past.
Interestingly, analysts at Danske Bank have tried to model what an appropriate price level for commodities would be at this point of the economic cycle -which in their view is the early stage of economic growth- and their admittedly incomplete and flawed model came up with the suggestion that prices overall might have run up a bit higher than where they should be, but not dramatically so.
The best way to view all of the above, argue analysts at US Global Investors, is that prices for oil, and commodities in general, will remain supported at much higher levels than used to be the case. It does not mean that prices will only rise and rise and rise into eternity.
In fact, one can easily build a case in support of Danske Bank's prediction of growing headwinds throughout 2010 (which in essence can also be formulated as: less and less support) as central bankers will increasingly start looking into winding back the enormous stimulus that is flowing through global economies, and with the US dollar possibly going through a phase of recovering strength from the moment US interest rates start rising.
US Global Investors is bullish on oil and copper, with the latter seen returning to US$4 per pound sometime in 2010. Its forecast for crude oil, in year-average terms, stands at US$75/bbl in 2011, and a little less for 2010. This, explain the analysts, doesn't mean the price won't go higher at various times, but it is likely such temporary spikes won't prove to be sustainable.
The analysts also highlighted a strong seasonal pattern for oil prices, one they label "unusually predictable". In essence, this pattern means that investors who are long oil between December-May each year make far better returns most of the time compared with the remaining June-November period. Their message is thus: use the anticipated price weakness in December to get settled.
Commodity analysts at GSJB Were, proud members of the Super Cycle Commodities Club, updated their price forecasts this week. The exercise was, as admitted in the research update, simply a catch-up exercise as most prices have risen higher than thought possible. Mind you, their last update occurred in September.
GSJBW believes prices for commodities are inflated, as in: they have drifted too far off from underlying market fundamentals. Picture this: GSJBW is a long standing favourite of platinum, which the analysts believe is the most supply-constrained commodity of all. Yet, platinum remains the only one that is still trading at a price below the analysts' long term average price assumption of US$1500/oz.
Nobody ever said predicting prices for commodities was easy!
Most commodities have rallied pretty much in line with each other this year, but if Danske Bank's prediction of increasing headwinds proves correct, one can assume that differences across the complex will become more apparent next year and differences in performance should be the result.
GSJBW's preferred exposures are, in order of preference, metallurgical coal, iron ore, platinum, copper, gold and thermal coal. The broker states that on a twelve-month horizon, the fundamentals look absolutely unattractive for aluminium, nickel and zinc.
Danske Bank believes oil can surge to US$90 per barrel over the next three months, but that is likely to prove unsustainable. The analysts have an average price forecast for 2010 of US$83/bbl, which is higher than US Global Investors.
Copper is expected to rise steadily throughout next year, with an average price forecast of US$6900/t. In general, it appears Danske Bank is more optimistic than GSJB Were for most commodities, including aluminium, zinc and nickel.
GSJB Were is at present even worried about the immediate price prospects for copper, widely regarded the stand out among base metals. The analysts suggest the fundamentals for all base metals simply look "weak". Whether we will see a big correction remains yet to be seen, advocate the analysts, as that will be dependent on overall investor behaviour and funds flows.
None of these analysts mentions the revaluation of the Chinese currency as a potential new factor in the game. China remains an ever-important factor when it comes to commodities. The Chinese government is expected to put a lid on speculative commodities buying, but we have as yet to find out what will happen when the renminbi is allowed to appreciate again against other currencies. Will the jump in purchasing power lead to an equivalent jump in Chinese purchases?
With these thoughts I leave you all this week.
Till next week!
Your editor,
Rudi Filapek-Vandyck
(as always firmly supported by the Ab Fab team at FNArena)
