NO CASE FOR A COMMODITY BULL MARKET FOR SOME TIME TO COME

Over the last few months we have seen lot of commodities rally in line with the stock markets and improving sentiments on economic growth prospects. The weakness of the US Dollar has also helped the cause and we have seen commodities like copper and oil led this rally. In fact oil prices have more than doubled since hitting a level of $ 32 to the barrel to $ 71 to the barrel now. Similarly copper has moved up by more than 60% and has led the base metals rally. Commodities like steel have not seen a big rally in prices, but stabilization in their prices. A large number of agri commodities have also rallied a lot over the last four months.

This phenomenon is leading to a fear in the markets that this is the start of a new bull market in commodities which is likely to cause a comeback of inflation and will lead to higher interest rates. This phenomenon carries the risk of causing stagflation i.e. inflation with low growth. I have thought about this issue a lot and my strong view is that there is going to be no long term upward trend in commodities for some time to come. Although we have seen commodities rally sharply from their bottoms after reaching severe over sold conditions, a sustainable up move is doubtful.

The reasons for the same are two fold. The first factor is that there is likely to be very low to negative economic growth in a large part of the Western developed world and Japan for an extended period of time. Given the combination of a defunct financial system, low savings rate, high unemployment, high fiscal deficits combined with low growth it is very difficult to believe that there is going to be sustainably high growth in the US and Europe. Japan, given its export dependence will also not grow at any appreciable pace. As such 50% of the world economy is likely to stagnate over the next five years. This is in contrast with what happened in the 2003-07 period where there was a global boom and every economy of the world grew. This created huge demand pressures and supply increases took time to build up. These factors finally led to a boom in commodities and high inflation. Out of the remaining 50% of the world, around 25-30% is likely to grow at any decent pace and would include countries like India, China, and Brazil etc. Thus in the next phase of growth over the next five years there will be low demand pressures.

The second major factor is that the commodity boom saw a lot of capacity getting added in commodity industries across the board and as such today there is huge over capacity in most industrial metals and oil. Let’s look at some statistics –

Oil

-Net loss of demand for the year 2009 for crude oil is likely to be 4.3 million barrels a day, nearly 5% of total demand.

-OECD company stocks have gone upto 62 days of consumption well above its target of 52 days. These excess supplies are likely to persist atleast till the middle of next year.

-OPEC spare capacity is likely to persist above the level of 5 million barrel per day till the year 2013, a spare capacity below 5 million barrels per day would cause a price up tick. The current spare capacity is around 7.5 million barrels per day.

-Tankers and ships full of crude oil bought earlier in the year with the expectation of higher prices are floating around at various places in the world. Lot of this will come for selling at signs of weakness in the markets.

Copper

The global copper market was in a surplus of 133000 tonnes in the first four months of the current year vis a vis a deficit of 161000 tonnes in the same period last year according to the world bureau of metal statistics.

Global production of copper was up 0.2% in the same period and consumption was down 4.6%

Withdrawal of copper from LME warehouses has virtually come to a stop and a build up of inventory is expected going forward

Aluminum

Aluminum was in a surplus of 591000 tonnes in the same period vis a vis a surplus of 170000 tonnes last year

Aluminum stocks in LME warehouses stand at a record 4.3 million tonnes

Most consuming industries of Aluminum are in deep recession

The statistics for steel are more dismal where the surplus capacity in steel is around 32% globally and demand in lot of market has just collapsed. For example demand in the UAE is expected to be 4 million tonnes vis a vis 7 million tonnes last year.

Global steel output fell 21% in May from a level of 121 million tonnes to 95 million tonnes

Such a huge overcapacity in steel will need atleast 3-4 years for the balance in the markets to be restored.

A big driver for the up move in most of these commodities has been restocking by China, which is expected to ease off going forward.

Encouraged by higher prices, a few metal producers have started to reverse earlier cutbacks. Also a large number of project that had got stalled due to the financial crisis have now started construction and significant supplies are likely to come on steam over the next two years.

However prices of agri commodities are difficult to predict as they are more dependant on weather patterns and shift between different crops. As such some agri commodities might be in a bull market and some in bear going forward.

The current bull move of most commodities lies in the restocking demand that has come up after most companies, countries, consumers etc. reduced inventories in light of the global financial crisis and falling commodity prices. The actual demand pick up is yet to materialize.

The only counter point to the entire argument is that US Dollar over the medium term is likely to decline substantially in value and traditionally there has been a very high linkage of US Dollar weakness and commodity price up moves. However the degree of the up moves at different time frames has been very different. As such even though dollar weakness might support commodity prices, it is unlikely to push them significantly higher given the real concerns on demand and a huge oversupply situation in most industrial metals and oil over the next 2-3 years. Or maybe the kind of dollar weakness that most investors expect (including me) might not materialize.

In conclusion I expect that commodity prices will be rangebound with a stable to downward bias in the medium term.