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Commodities buck cyclical shakedown

OpinionsCommodities buck cyclical shakedown

While the S&P500, cryptocurrencies and bond prices fell last month, commodities posted gains. The S&P500 volatility index is now back to its normal territory after a protracted period of being subdued. Cyclical commodities like industrial metals however, continue to trade higher on firm fundamentals. Gains were not homogenous in commodities: the unsustainable rise in oil prices in January faltered in February and palladium has begun to unwind, coming closer to parity with platinum after consistently trading above since October 2017.

As China re-opens after the New Year celebrations, better quality data from the largest consumer of commodities will come due. Year-on-year comparisons of data from China in the months of January and February are very difficult because the timing of lunar New Year is not the same each year on the Georgian calendar. However, the Caixin China manufacturing purchasing managers index indicates that manufacturing output hit a 13-month high in January, setting a strong scene for industrial metals.

The commodity complex was aided by a softer US Dollar. However, Federal Open Market Committee minutes (released after the cut-off of data in this report), indicate the US central bank is ready to raise rates faster than the market had previously assumed. That could lead to US Dollar appreciation if other central banks fail to reflect a similarly strong policy message.

  • Rock bottom? After capitulating in 2017, agricultural prices are picking up momentum in 2018. Prices have fallen so low that any hint of ‘good news’ appears to spark a rally.
  • Industrial metals continue to outperform based on strong fundamentals. Despite the onslaught of the global equity market correction, industrial metals recouped their initial losses as fundamentals prevailed. Ongoing supply deficits for most metals coupled with strong demand bode well for the sector.
  • The energy complex was a drag on commodity performance last month. A return to more normal weather in the US dampened natural gas prices while oil gave back unsustainable gains from January. The only area of the energy complex to post an increase was the price of carbon as environmental regulation is expected to address a glut in permits.
  • Silver prices to play catch up as fundamentals improve. The gold to silver ratio is currently at 81 (as on 16 February 2018), its highest level since April 2016. We expect silver prices to catch up owing to the continued strength in the industrial cycle and a constrained mine supply. Although the fundamentals remain strong : ongoing supply deficits and buoyant auto sales in China, we would not rule out further price correction from current levels given the sharp run up in prices in 2017.

Please find ETF Securities’ Commodity Monthly Monitor for Feb/Mar 2018 with charts on the left.

Sector Overview

Agriculture

  • Although inventories are at elevated levels for most grains, the United States Department of Agriculture’s (USDA) reduced estimate for global corn and soy production have been seen as a catalysts for price.
  • Cocoa rallied 10.7% last month. While good weather has generally helped the crop and we are seeing strong exports from West Africa, the presence of Cocoa Swollen Shoot Virus (CSSV) in Cote d’Ivoire could limit the regions producing capacity in future years as maintenance programmes need to be undertaken.
  • Wheat prices rose despite the USDA revising up its global supply forecasts. Worries about damage to the winter crop in the US still appear to lend support to the price of the grain.

Industrial Metals

  • As one of the most cyclically exposed sectors, industrial metal prices declined initially in the onslaught of the global equity market correction in early February. However, all industrial metals led by nickel, recouped their losses, ending in positive territory as fundamentals prevailed. The unveiling of the US$1.5tri infrastructure plan over the next 10 years by President Trump lent buoyancy to the industrial metals complex.
  • Nickel was the best performer among industrial metals. The growth associated with electric vehicle batteries is expected to play a role in demand for nickel that currently only accounts for 3% of total demand. Added to that, roughly 50% of the current nickel mine supply is suitable for battery use as the low grade nickel products are inadequate for battery manufacturing, raising the need for further production as global nickel inventories declining.

Energy

  • Natural gas prices declined 18.2% as the cold weather snap from January faded.
  • The US$70/bbl oil price environment in January proved to be unsustainable – as we have long argued – as US supply increased in response to high prices. Oil rig counts in the US have risen for the past four weeks, oil production has risen for five consecutive weeks and crude inventory is rising once again. In fact US oil production rose to over 10.27mn barrel per day last week (the highest since weekly records began in 1983 and higher than the monthly data that began in 1920). Futures market positioning in oil still looks overly stretched with net longs in Brent contracts more than 2 standard deviations above its 5 year average and net longs in WTI contracts more than 3 standard deviations above its 5 year average.
  • Carbon prices reached the double-digit territory for the first time in six years as the European Union is finally expected to address the glut in carbon permits this year.

Precious Metals

  • The slump in global stock markets lent an initial tailwind to gold prices. Coupled with that the higher than expected inflation figures in the US bolstered gold appeal as a hedge against inflation. Gold prices remain very sensitive to the US dollar price movements. So far, the weaker US dollar has positively influenced gold prices over the period. However as the Fed continues to raise policy rates, we expect the US dollar to appreciate and therefore put gold under pressure. Silver prices lagged behind by 2.3% over the period. The gold to silver ratio is currently at 81 (as on 16 February 2018), its highest level since April 2016. We expect silver prices may catch up owing to the continued strength in the industrial cycle and a constrained a mine supply.
  • Platinum rose 1.2%, leaving behind its sister metal palladium down 4.8% during the period. Recent data from the European Automobile Manufacturers’ Association (ACEA) highlight new car registrations in the EU rose by 7.1% year-on-year. However the percentage of diesel cars as a proportion of all new cars registered declined by 33%. This is likely to weigh on platinum, known for its use in pollution abatement technologies in diesel cars different to palladium used in gasoline cars. Meanwhile Chinese car sales rose 11.6% (dominated by gasoline cars) over the prior year according to China Association of Automobile Manufacturers (CAAM). This supports the demand outlook for palladium known for its high dependence on the auto sector (80%). Added to that, Johnson Matthey expects platinum to remain in a surplus and palladium to extend its supply deficit for the 7th year in a row. Although the fundamentals remains strong : ongoing supply deficits and buoyant auto sales in China, we would not rule out further price correction from current levels given the sharp run up in prices in 2017.

Technical Overview

Positioning

  • Positioning in cocoa swung to net long from net short last month. After a 40% decline in price in 2016 and 2017, investors are feeling confident that prices can’t fall that much more. With cocoa growing concentrated in Africa (70%), any common shock could see prices rise.
  • Following the USDA’s revisions for global corn and soybean production, positioning in futures markets swung to net long, following five months of being net short in the case of corn and a month of being net short in the case of soybeans.
  • Speculative financial investors have retreated noticeably from precious metals over the period. Silver net long positioning posted the sharpest decline of 80% owing to an 18% rise in shorts coupled with a 16% decline in long a positioning.
  • Positioning in natural gas futures pared back 55%, increasing the net shorts to 105,468 contracts.

Inventories

  • Rising copper inventories are reflecting the build-up in production at two of the largest copper producers – Chile and Peru. The International Copper Study Group (ICSG) also expects global mining copper production to rise 2.5% this year, owing to availability of more copper concentrate and higher production of refined copper.
  • The price gap of aluminium contracts traded on the Shanghai Future’s Exchange (SHFE) versus the London Metals Exchange (LME) drove Chinese producers to sell more aluminium. Higher aluminium exports from China coupled with rising global aluminium production (up 2% over the prior year) led to a build-up in inventory levels over the period.
  • Lead and zinc stocks declined over the period owing to tight supply on the global lead and zinc markets. In the latest update by the International Lead and Zinc Study Group (ILZSG), the supply deficits for both lead and zinc markets were revised significantly higher. Meanwhile weaker tin exports from Indonesia, down 35% over the prior year, resulted in lower LME tin stocks.

Curve Dynamics

  • Sugar and cocoa are currently providing a small positive roll yield in the front month. All other agricultural commodities are in backwardation with an average negative roll yield of 1.8%.
  • Aluminium and Zinc futures have moved into backwardation over the past month. Zinc is currently posting a positive roll yield of 0.5% and is backwardated across the whole curve. In contrast, the aluminium curve is backwardated just at the very front-end, yielding 0.5%.
  • Brent oil futures remain in backwardation, providing a positive roll yield of 0.5%. Curve backwardation is deemed an important part of OPEC’s strategy to help drain global inventories.

Technicals

  • Coffee is currently trading 7.2% below its 200 day moving average as prices declined last month. Prospects for good crop this year have increased as an El Niño weather pattern makes it likely that heat damage will be reduced.
  • Industrial metals rose 3.3% on average ending the period above both the 200 and 50-day moving average (dma), reflecting the broad optimism within the sector despite the recent equity market correction. Nickel and Zinc are leading the pack with prices are trading 25% and 17% above their 200-dma respectively. The strong momentum is likely to keep prices elevated in the near term.
  • Both Brent and WTI contracts are still trading above their respective 200 day moving average prices, indicating they have a lot further to fall if their prices mean-revert.