Commodity outlook rosy, cloudy, murky

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By Cees Bruggemans, Chief Economist of FNB.

After a sharp speculative shakeout last week in the commodity space, quo vadis (whereto next)?

Outlook for oil is rosy, base metals cloudy, precious metals murky and coal a special case (there may be others as well).

With China standing on its monetary brakes, it is not unreasonable to expect a more subdued price performance out of base metals for a while, though allow for specific demand/supply situations.

Longer term (beyond this year) the fundamental Chinese growth story is expected to stay strong, in addition to which India is approaching its resources constraint, in future increasingly becoming import dependent as well if its GDP growth were to remain in 7%-9% territory.

Oil was fired by many things in recent months, as much economic fundamentals as political premiums and speculative froth.

The froth was creamed last week, but the fundamentals stay very positive, with political premiums about supply security hardly yet ready to fade.

With world economic growth set to continue at 4%-5% for some years, given the attempt to narrow the large rich world output gaps and the continuing EM growth dynamics, oil demand is expected to keep growing at 2mbd annually.

In contrast, oil supply seems to be expanding at only 1mbd annually, indicative that the oil balance will keep tightening. There may still plentiful oil in the world today (as variously claimed by Saudi, Exxon and President Obama), but reserve buffers will be eroding, underpinning high oil prices.

The Arab world remains in flux, with as yet no clear indication how far the Arab Spring will progress and how Saudi may be affected. Until much greater clarity prevails, the relatively unstable nature of the region will likely keep demanding oil price premiums regarding supply security.

Coal is a special case. It is benefiting short-term from the high oil price and the Japanese quake disturbance of nuclear space. In addition, world growth of 4%-5% also fuels coal demand, giving an upward bias to prices.

A special factor is Chinese import demand, following major internal changes since 2009 in the Chinese coal industry, turning the country overnight into a major coal importer.

These changes, however, are aimed to get better Chinese production efficiencies, and the world is uncertain whether therefore China has only temporarily become a major coal importer, using global supply to facilitate its domestic restructuring, eventually returning to greater domestic reliance.

This obviously has implication for the likely trajectory of coal prices.

Then also there is India.

It makes longer term coal price prospects uncertain.

Precious metals outlook is murky, meaning a high water mark could be near (after which could follow a long cyclical slide) or there could still be substantial upside potential.

The case for threading cautiously is based on a strong global growth performance of 4%-5%, with rich countries with large output gaps steadily succeeding in witling these down and eventually normalizing their monetary stances without inflation mishaps.

The main actor here is the US. It has now self-sustaining growth, its employment levels are gradually rising (from very low participation levels), deflation risk has become negligible and its core inflation is gradually lifting towards a more acceptable range.

At some point these processes will have progressed enough for the Fed to start dismantling its many emergency policy supports.

Indications are that the Fed will end quantitative easing (QE) after June. Indeed, it may already start to slowly run down its bloated balance sheet by not reinvesting bond runoff.

That change would amount to a minor policy tightening.

Actually increasing interest rates from zero will commence later, but probably not that far out in the future, the betting ranging from an early 2012 to an early 2013 start.

As US monetary policy starts to tighten in response to better growth and resource use, one would expect a change in fortune for the Dollar.

For long the Dollar has been an adjustment facilitator while the Fed was providing maximum emergency support, reaching new record trade-weighted lows only recently.

A change in the Fed policy stance will likely be accompanied by a Dollar bottoming and eventual partial recovery. When it does, one would expect both higher US rates and firmer Dollar to provide headwind to most commodity prices.

Thus getting beyond the growth and inflation scares of recent times in the presence of monetary normalization could be taken as an end to special circumstances boosting precious metal prices.

Recent margin requirement increases for silver were aimed at restraining excessive speculative leverage risk, in the process not only pulling back the silver price from elevated levels but also setting in motion a general commodity price pullback from generally overheated speculative levels.

Such technical changes, however, are not expected to be the main driver of commodity prices beyond the short term. Fundamentals are likely to reassert their influence ere long.

Whereas precious metals still have some upward potential in coming months before the change in Fed policy stance gets underway, and eventual topping out can be expected UNLESS other risk factors maintain the upward bias in precious metal prices.

Here one thinks of debt playouts in Europe, but also in Japan and the US, and the manner in which this could still eventually shape monetary policy in an inflationary sense.

The rich country debt playouts are likely to take many years still, with serious risk of dislocation remaining for some while. This may have direct effects on precious metal prices (enhancing its safe haven status in uncertain risky times) and indirectly via lingering suspicions inflation will be part of debt resolution.

This aside of any other sources of shock not as yet identified.

If the world were to evolve its debt problems in shock-like fashion, even at times pressing monetary policy into service to assist the playout, precious metal prices may still have substantial upward potential this decade before reaching their high water mark.

It remains to be seen which of these realities will eventually play out. European sovereign and banking debt problems appear politically difficult to resolve and may well eventually cause greater Euro strains and fallout.

Its eventual impact on precious metal prices is difficult to predict.

The longer term US debt situation could be resolved relatively easily, except it too harbours major political disagreements regarding the future make-up of American life and the role of the state.

Still, Americans have a reputation of doing the right thing, if only after exhausting all other alternatives (Churchill, and he should know).

The American debt problem may therefore become resolved eventually, if after the 2012 US presidential election, and probably not without some market threatening (along the lines of what played out in 2H2008).

This could also be a “short-term” precious metal booster (and crucially delay or slow the Fed’s exiting and normalization process). But eventually this watershed will come and go and the American Republic fully back in business, with precious metal risk premiums eroding.

Yet another source of shock is the Arab Revolt (and eventually a Chinese Awakening perhaps, too). If oil supply risk premiums were to drastically rise in coming quarters/years, not so much fired by climate change and ‘peaking oil’ but simply by supply disruptions, a still high growth environment could trigger major energy price surges and inflation fallout.

For a while this could boost precious metal prices, until fading away eventually (as many times in the past).

Thus the world is currently facing performance fundamentals (growth, inflation, monetary policy) and structural risks (debt, oil, politics) which are likely to shape various commodity prices differently, depending on their peculiar demand/supply balances.

On this score, agricultural commodities are in a league of their own, though also shaped by some of these forces (global middle class demand growth, natural supply disruptions, monetary support or headwinds, political shocks, energy displacement).

Source: Cees Bruggemans, FNB, May 9, 2011.

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