Investors should be warned not to overreact to movements in commodities markets, as the fundamentals paint a picture of constraints on supplies and surprisingly strong demand, writes Investec fund manager George Cheveley.
With eurozone crisis concerns dominating and economic indicators showing world growth will slow over the coming months, commentators have become increasingly bearish on the outlook for commodity demand.
As a result, prices for many commodities have fallen sharply. This is a logical response to the challenges faced by industries around the world as many companies review their capital expenditure and working capital levels, postponing developments and destocking where possible.
Although many companies have December accounting year-ends and this makes a lot of sense in the current environment, there is a danger that the market overreacts to these signals, particularly in individual commodities.
Commodity prices are determined by many constantly changing factors but the fundamental balance of supply and demand is critical in deciding if prices should be higher or lower.
Thus, while the outlook for demand may be weakening, if the supply picture is already weak or deteriorating then prices may not fall as far or for as long as might initially be expected.
This could certainly be the case for some commodities currently, for example, copper.
The world looks as though it is now on a slower but steady recovery, and it has looked so for some time. Global GDP has been growing rather than experiencing a downturn into severe recession.
In the US the key drivers of growth, including retail spending and the housing market, came in stronger than expected and leading indicators remain marginally positive.
Key Chinese growth drivers, which lean to industrial production, paint a similar picture.
The purchasing managers’ index, a measure of manufacturing activity, is indicating slowing but positive growth, as are Chinese leading indicators.
Equally important, China posted a second month of inflation declines with the October consumer price index coming in at 5.5% down from the year-to-date peak of 6.5% set in July.
Falling inflation will allow China to enter into a more stimulative monetary policy that aims to support global GDP and commodity demand.
Premier Wen Jiabao has already opened the door to that possibility, stating that officials will make adjustments at a ‘suitable time and by an appropriate degree’ and will maintain ‘reasonable’ growth in money supply.
Demand for commodities
Against this economic backdrop, fundamental demand for commodities remains generally robust but it is important to note that there are significant divergences within commodity sub-sectors.
For example, global crude oil markets as a whole remain remarkably resilient when compared with other global commodity and equity markets. The fundamentals of crude markets remain exceptionally tight, with global demand remaining robust while light sweet oil supply disruptions continue from Libya and the North Sea.
Spare capacity remains extremely tight at levels of around 2.7% in the face of flat US and EU demand and 7% Chinese-demand growth, and fears of a sharp global oil demand reduction as a result of the continuing global economic slowdown have still to be confirmed by the underlying data.
Thus far in 2011, Brent crude oil has averaged just over $111/barrel (£71/bl) and some moderation in prices is expected in the near term.
Our assumption of $100/bl for the long-term reflects the tightening supply/demand fundamentals plus higher marginal costs of supply.
Outlook for metals
In base and bulk metals there has also been diversity of returns across different commodities.
Copper prices have been highly volatile in the past few months, having rebounded recently. Demand growth has slowed in many parts of the world, although in China, which represents 36% of global refined copper demand, there are signs of imports picking up as consumers have finished destocking and need to match purchases to current use.
As third quarter production reports showed, supply has been struggling as many of the world’s larger mines have been missing budget production rates. This has been a theme for several years as mines have struggled to keep up with strong demand growth. After several years of mining the highest grades to maximise volumes, these mines are now suffering the consequences.
Given supply disruption, low copper stocks and an increase in Chinese buying during the past quarter, fundamentals supported performance in October, with copper prices rising by 13.8% (in dollar terms) during the month.
However, the slowing global economy, alongside sustained concerns about a credit shock, means industrial commodity consumers remain cautious, with sentiment affecting other industrial metals. Spot prices for iron ore, for example, fell by 9.4% (in dollar terms) during October.
The picture for coal
With winter approaching in the northern hemisphere, Chinese utilities have been keen to build up coal stocks in the event of severe weather.
High imports from Indonesia, which supplies lower quality coal to China, are being balanced by supplies of higher quality coals from Australia. However, with China’s coal stocks now back above 20 days’ consumption, demand has softened in the short term and prices are drifting, with spot prices now well below recent contracts.
Next year, recovering demand from Japan’s power and cement plants as the rebuild and recovery begins, growing Indian demand from coastal power stations, and strong German demand should support prices. Supply remains relatively good and should be able to keep up.
The main upside risk would be more heavy rains in Australia given the record rainfall in Queensland in October. A recurrence would tighten metallurgical coal supply and tighten higher quality thermal coal markets.
Weak dollar helps gold
Market sentiment has had an impact on gold, with unanswered questions over the eurozone agreement potentially supporting prices.
Even if the focus of financial markets shifts from Europe to the US, the US debt situation is also inherently US dollar-bearish and gold is likely to rally on this dollar weakness.
Other supporting factors for gold include strong physical demand from China, although this may be offset by an expected reduction in Indian bullion demand in the aftermath of the Hindu festival of Diwali.
Central bank buying has also strongly underpinned gold prices for some time.
In a normal environment, the near-term outlook would benefit from two historically prevalent trends: first, the year-end cycle colloquially known as the Santa rally; and second, the presidential cycle.
At a high level, the long-term driver of both these cycles is stimulative fiscal or monetary policy during these times.
However, current political and economic forces have removed this impetus and the political situation is likely to become only more uncertain.
That is because by this time next year, many European countries will have fresh political leaders in place, the US electorate will be heading to voting booths and the new Chinese leadership will be in the process of transitioning in.
However, for the time being, the EU sovereign credit crisis should be contained and the fundamental picture will persist along with heightened market volatility.
Protection will bring rewards
In this uncertain environment, investors who protect themselves from sharp pull-backs, focus on fundamentals and invest in supply-constrained commodities with a focus on stable, low-levered and strong cash-generating companies will be rewarded.
Integral to this strategy is ensuring an investment portfolio has higher than average liquidity to help protect against pull-backs, to adjust investment strategy rapidly if the fundamental picture changes, and to be able to take advantage of times and sectors that present exceptional value.
George Cheveley is co-portfolio manager of the Investec Enhanced Natural Resources fund which has returned 18.6% since its launch in May 2008, compared with a loss of 0.7% in the LCI MSCI World/Energy/MSCI World/Materials (50:50) index.