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Wiktor Bielski, head of London research, VTB Capital
In the past three years, commodities have been locked in a tight and unrelenting bear market, reflecting pronounced weakening of underlying fundamentals as Chinese growth slowed, the eurozone slumped into crisis and the US stalled, while at the same time the capex cycle triggered by record prices in 2005-08 finally delivered promised supply growth.
This unfortunate conjunction resulted in the main global commodity indices (Dow Jones-UBS, Thomson Reuters CRB) retreating 25-30%, with the more cyclical LMEX index of base metals down 35%, while individual falls were even more pronounced as evidenced by spot coking coal prices down about 70% from 1Q11 highs to 1Q14 lows.
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The main driver of these falls was a near 40% reduction in measured commodity assets under management, from a peak of $525 billion in April 2011 to a recent low of about $325 billion, although these numbers inevitably understate the full extent of the liquidation as they exclude significantly larger OTC positions (in futures, derivatives and various structured products).
Indeed, according to global fund manager surveys at the start of this year, commodities, emerging markets, energy and materials were four of the five most under-owned sectors globally, with allocations to materials and commodities close to two standard deviations below the historical average.
Meanwhile, speculative funds mounted a number of aggressive short-selling attacks against the commodities complex, notably in 2H11 and 1H13, which culminated in record short positions in base and precious metals during these periods. All in all, a particularly difficult and challenging market for an extended period.
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However, there is now light at the end of the tunnel and commodity prices have started to mount a meaningful comeback in 2014 (Figure 1), with global commodity indices up 13-15% YTD following a recovery in steel and metal equities which started in mid-2013. From a fundamental perspective, three key factors support this comeback and signal a more positive outlook ahead, in our view:
1. Global manufacturing PMIs reached 30-month highs in 4Q13 with synchronised gains in Europe, the US, Japan and China, and despite a modest pullback since, due largely to one-off factors such as the extreme cold winter in the US, continue to presage accelerating industrial activity ahead (Figure 2).
Indeed, at VTB Capital we forecast global GDP growth of 3.2% YoY in 2014, up from 2.7% YoY in 2013, with a further increase to 3.6% in 2015.
2. Demand growth picked-up pace in 2013, with global steel consumption up 7.1% YoY, vs 4.5% YoY in 2012, while copper consumption was up 4.0% YoY, vs 1.3% YoY in 2012. We expect a further acceleration in 2014 (steel +7.5% YoY, copper +4.4% YoY), while supply growth is expected to start to slow in the next 12-18 months as the capex cycle has now peaked, and most producers of industrial commodities have signalled substantial cuts ahead, so that by 2016 growth capex is expected to be as much as 75% lower than at the peak last year.
Given that capex cycles in mining, for example, typically last 6-7 years, we don’t anticipate a meaningful increase in new project spending in the remainder of this decade. As a result, accelerating demand growth and slowing supply growth are likely to shift many markets from surplus to deficit in the next 12-24 months.
3. Inventories are in the bottom quartile of historic ranges in a number of key commodities (for example, US construction steel stocks at 40-year lows), or alternately they are intentionally held back from the market due to (often complex) financing or warehousing transactions, as financial investors have in many cases re-classified commodity stockpiles as financial assets, rather than raw materials to be used to manufacture industrial products.
As a result we expect growing physical market tightness and record spot premiums to develop in a number of industrial metals and raw materials, which should trigger higher prices ahead.
From a technical perspective, VTB Capital identifies four key supportive factors for commodities:
1. Prices have broken out of the strong three-year downtrends in place since the start of 2011 (Figure 3). Indeed even the longer-term downtrends in place since 2Q08 have also been broken to the upside.
2. Many commodity markets are in backwardation, with spot prices trading above futures prices and futures curves showing a negative slope. Backwardated markets develop where spot availability becomes tight due to sharpened expectations (or reality) of physical shortages. Given that we expect market deficits and slowing supply ahead, these backwardations are likely to become larger and more pervasive, in our view.
For investors, backwardated markets are very attractive since when positions are rolled forward, selling spot and buying forward at a discount creates a positive roll yield. Indeed, roll yields delivered an average return of 1.5% in 2013, and they are significantly more attractive in current markets. The Brent roll yield implies a 5% return over the next 12 months, while record backwardations in soybeans are offering returns of 20%.
Meanwhile, four out of the six main traded LME metals are in backwardation (copper, nickel, tin and zinc), while in the aluminium market physical spot premiums have reached all-time highs of up to $450/t, which recently represented an unprecedented 27% premium above the LME spot price (to secure immediate delivery).
3. Although they have fallen from the record levels in 2Q13, fund short positions still remain substantial in certain commodities, notably copper, and we expect fund short covering to provide upside impetus for prices once stops are triggered.
4. Net redemptions from passive index-tracking and commodity-linked ETFs totalled $50 billion in 2013, but YTD these have reversed with inflows of about $6 billion, which although modest hint at the potential for much larger increases ahead.
While commodity prices have started to recover, VTB Capital believes there is significant further upside potential simply to catch-up with the improvement in the global growth outlook signalled by PMI surveys. Indeed, base metal prices, the most economically sensitive of the commodities suite, have so far gained only marginally and are significantly lagging the pick-up in global PMIs (Figure 4).
While the correlation between PMIs and base metals is not always perfect, historically it has been very strong from a directional context, hence we expect base metals to show more substantial upward momentum ahead.
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Among the key commodities leading the recovery in 2014 have been nickel, palladium, Arabica coffee and wheat, all of which have been boosted by significant supply-side disruptions or substantial changes to expected production ahead.
Nickel prices have risen by about 50% YTD due to the introduction of a ban on Indonesia’s exports of unprocessed ore. While the ban itself had been signalled as long ago as 2009, it had been generally assumed that the ban would either not be introduced, or if it was that it would quickly fail or be negated by smuggling or other unauthorised exports. Instead, the ban has held firm and now most market participants expect it to remain fully in place until at least next year, and potentially for significantly longer.
As a result, supply-demand forecasts have been quickly adjusted and now signal substantial market deficits ahead (Figure 5), as China’s production of nickel pig-iron (NPI, which accounted for about 25% of global supply in 2013) is set to fall sharply (potentially by 30-40% in the medium-term). This sharp turnaround in the market outlook has attracted substantial fund buying, with LME open interest up more than 60% this year to new record highs (Figure 6).
Nickel therefore provides a particularly good example of the turnaround potential in commodities once the combination of fundamentals, technical factors and market sentiment become aligned to the upside.
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Any discussion of the outlook for commodities has to include some mention of China, the world’s largest consumer and the key to the rate of demand growth for the next 5-10 years. China’s key policy target in this period is to start to implement a successful transition from investment-led to consumption-led GDP.
VTB Capital believes that markets are significantly underestimating how long this will take and what steps are required to execute this process. Put simply, consumption requires consumers, who are simply defined as urban dwellers with a minimum GDP/capita of $15-20k, since below $15k spending is dominated by essentials, while above $20k discretionary spending on consumer goods becomes dominant.
Historical precedent shows that a minimum urbanisation level of 60-65% is necessary to reach a critical mass of consumers with this level of spending power. With urbanisation at 53.7% at year-end 2013, China needs to accelerate its urbanisation push to reach the critical threshold by its target date of 2020. This implies ongoing high investment and associated strong demand for industrial commodities (+5% YoY) and energy in the next 10 years to build the necessary housing, infrastructure and transport capacity to support a consumption-led economy, and also to continue to generate annually at least 10 million new jobs to support the new migrants/consumers.
Creation of a fully functioning financial system, market-based reforms, a focus on pollution and improving industrial efficiency, power and water capacity are other critical elements in the transition process, which will also help to support ongoing strong commodity demand.
VTB Capital therefore believes that China will continue to drive secular demand growth in commodities for the next 5-10 years, which when combined with slowing supply growth, generally low or constrained inventories and still underweight investor positioning is a particularly positive backdrop for the comeback in commodities prices to continue.
Indeed, we believe that short covering could result in significant rallies in 2014 as the fundamental outlook continues to strengthen, and we therefore recommend that investors start to address large underweight positions in the sector.