Monday, May 11, 2015

"...commodity rally...too far/too fast...steep dnwd…warning...investors across all asset[s] monitor closely."

"...The first half of Q2 has seen a strong rally develop in commodities prices. Brent crude oil is up 24% (after performing flat in Q1), copper 12% and even gold has risen a little. Despite the fact that agricultural commodities and livestock prices have continued to be weak, the S&PGSCI spot price index has made its best start to a year since 2011, up 8% in the year-to-date.
Although the price rebound is directly benefitting commodity index investors much less then the spot price gains might suggest (because the high cost of carry has reduced total returns), the strength of the commodity recovery is greatly influencing global growth expectations and movements in other asset classes.
  • Just as the steep decline in oil prices in late 2014 kicked-off concerns about the health of the global economy, the recovery is being viewed by some market observers as a strong indicator that growth prospects may be improving faster than markets had expected, especially as it is heavily focused on energy and industrial metals.
  • The recovery in oil prices, in particular, is helping to allay concerns that important parts of the global economy might slip into a deflationary spiral. As investors have become more confident about the future (or at least less pessimistic), many of the deflation-axed positions built up earlier this year, especially in fixed income markets, are being unwound.
Consequently, the commodity price rally has been an important influence on the recent pickup in global bond yields.Although these remain low versus historical levels some of the recent action has been eye-catching (US 10y treasury yields and the 10y BUND are both up about 45bp since mid-April, to reach year-to-date highs) and it is hard to imagine that the moves would have been quite as aggressive without the big move up in commodities, particularly oil.

So for many reasons the answer to the question: “will the commodity price rally continue?” is particularly important at this juncture. Our view is that it will prove very tough to make further significant gains in commodity prices from here unless supply/demand conditions improve very fast indeed. In our view, prices for key commodities like oil, copper and gold, have already hit levels that would not be justified until later in H2, ie, following a longer sustained period of improving fundamentals than we have seen in H1 to date.
Indeed the risks are growing that the commodity price rally has moved too far ahead, too fast and that a steep downward adjustment could be just around the corner. In our view, there are several warning signs in commodities markets that we would advise investors across all asset classes to monitor closely. 
China looks fragile. China’s commodity demand has had a reasonably strong start to the year with oil demand up 7.2% and copper up 4% in Q1. However, these figures are at odds with downbeat IP data (Figure 3) and imports have probably been boosted by stockpiling, especially for strategic commodities like oil and copper. April data released on Friday showed reasonably healthy import levels for these two commodities, but iron ore and soybeans were weak. The risk is that domestic demand and commodity imports could fall back as Q2 progresses.

Supply is still exceeding consumption. In particular, it still does not appear that the supply cuts necessary to balance the oil market are being made fast enough. Although there has been some slowing in the rate of US supply growth and a rapid decline in the rig count, offsetting that is the fact OPEC production has risen by 500kb/d since the start of the year to 31m b/d. If OPEC maintains that output level through Q2, then even with a further slowing in US oil production, the oil balances of the major forecasting agencies (and our own) indicate that global oil stocks will rise more quickly in Q2 than in Q1 (Figure 4) and to continue climbing through to year-end at least.

The oil price recovery may encourage some US producers to restart. EOG, often viewed as one of the best positioned independent US shale oil companies, said this week that if oil prices “stabilise at the $65 level” (less than 10% above current levels) it is prepared for “strong double digit” output growth in 2016. Moreover, the flattening of the WTI futures curve will add to the incentive for producers to gradually bring on drilled, but uncompleted wells. Neither the current trajectory of oil prices nor production looks sustainable to us in such a scenario. Something will have to give.

Finally there is a huge disconnect between price action in physical markets where differentials are signalling oversupply and futures markets where all looks rosy. Financial drivers have been key in this commodity rally, with short-covering driving part of it, but fresh longs being drawn in. Net speculative length in Brent crude has doubled since the start of the year to its highest level since data collection began in 2011. In copper the LME net long position has grown by 60% since the start of the year and on COMEX copper, speculators have swung rapidly from short to long… ."

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