The recent reversal in commodities appears to have been triggered by an unwinding of speculative positions. The likelihood that the price decline was primarily investor-led and not fundamentally-based is supported by the fact that a number of disparate commodities, including grains and crude oil, peaked within a few days of each other before selling off. The decline in investor demand for commodities also coincided with a USD rally and a resurgence in interest in paper assets.
It is interesting that commodities weakened in the face of ongoing financial sector stress as an important element in the commodity rally for much of the last 12 months, has been the search for a safe harbour by investors. The decline in speculative long positions held in oil highlights the degree to which some investors liquidated long positions. Speculators were long crude oil to the tune of 115 million barrels on the New York Mercantile Exchange in mid-March. The long position fell to 30 million barrels by the end of June and turned briefly negative in August; long positions are now a modest 11 million barrels. The Dow Jones-AIG commodity index estimated that as much as $175-$185 billion was invested in commodity indices at the end of March.
While there are no hard figures, this number is now undoubtedly lower. US crude oil inventories were running at a substantial 20-25 million barrels below the five-year average for most of this year, but recent build-ups now put stock levels near the five-year average. Despite the rise in US inventories, however, global stocks do not appear to have grown much, suggesting that buoyant developing economies absorbed most of the increase in supply. This also implies that oil prices may not decline too much further from current levels.
Evidence of an advancing economic slowdown in the OECD world is a fundamental reason for the commodity sell-off. The driver, however, of global commodity demand is no longer the advanced, but the emerging world. Although these countries still account for the bulk of the marginal increase in demand, growth in emerging-world commodity off-take is slowing, at least compared with the rapid pace of the last few years.
This moderation in demand is complemented by improved supply prospects in a number of commodities. Saudi Arabia, the world's largest oil exporter, has increased output recently, possibly for fear that prices near $150 per barrel would eventually dent demand. According to the International Energy Agency, Opec has increased production as Saudi output has risen to more than 9.45 million barrels per day. The kingdom has also brought new giant fields on stream as other Gulf producers have continued to expand capacity. Crude oil prices have since dropped, despite the Russian incursion into Georgia and the temporary suspension of the 1mbpd Baku-Tiblisi-Ceyhan pipeline after attacks by Kurdish separatists. Just before the recent correction, the International Energy Agency stated that oil prices were still too high given the fundamentals. The oil markets also reacted only modestly to the possibility of hurricane-related supply disruptions in the Gulf of Mexico.
The oil price decline may be limited, however, as more hawkish members of Opec, such as Venezuela and Libya, are calling for a cut in output to stop oil prices falling further, recommending that prices remain above $100 per barrel. When Opec last cut production, early last year, prices subsequently doubled in just over a year. In addition to oil, other commodity supply prospects have improved. These include improved growing conditions in North America and record harvests in major food-producing emerging nations, as well as increased mine output. The China National Grain and Oils Information Centre recently raised its 2008 output forecasts for soybeans, corn and rice. That said, it is believed that the fundamental argument for higher commodity prices is still compelling and has been well examined. Mine supply of industrial metals is rising, but the industry is facing severe bottlenecks in equipment, infrastructure and human capital.
On a fundamental level, economic growth in the emerging world is expected to remain strong, and this may prove key for commodities. As long as emerging market growth does not dramatically fall - and there is no sign that this is going to happen - commodities should be supported as the investor exodus abates.
The outlook for inflation will also influence commodity prices, in particular, gold and precious metals, traditionally seen as hedges against inflation. It is worth noting that normally Consumer Price Index (CPI) inflation typically rises during a hard landing, at least initially, before declining significantly later in the cycle. It could be that the US may be at this point. Furthermore, there are growing indications that despite high headline inflation, falling prices have already arrived within the non-financial corporate sector, due to a lack of corporate pricing power.
Although CPI inflation hit a 17-year high in July, non-financial corporate prices fell 0.1 per cent in the year to quarter 1, 2008 and are estimated to have fallen further to -0.9 per cent in quarter 2, which would make it the lowest reading since 1950. This lack of pricing power helps explain the absence of second-round impact from higher food and energy prices. Corporations simply cannot pay higher wages because they lack pricing power. If investors recognise a break in inflationary pressures, they may be tempted to continue to off-load commodities.
• This report was compiled by the marketing department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
It is interesting that commodities weakened in the face of ongoing financial sector stress as an important element in the commodity rally for much of the last 12 months, has been the search for a safe harbour by investors. The decline in speculative long positions held in oil highlights the degree to which some investors liquidated long positions. Speculators were long crude oil to the tune of 115 million barrels on the New York Mercantile Exchange in mid-March. The long position fell to 30 million barrels by the end of June and turned briefly negative in August; long positions are now a modest 11 million barrels. The Dow Jones-AIG commodity index estimated that as much as $175-$185 billion was invested in commodity indices at the end of March.
While there are no hard figures, this number is now undoubtedly lower. US crude oil inventories were running at a substantial 20-25 million barrels below the five-year average for most of this year, but recent build-ups now put stock levels near the five-year average. Despite the rise in US inventories, however, global stocks do not appear to have grown much, suggesting that buoyant developing economies absorbed most of the increase in supply. This also implies that oil prices may not decline too much further from current levels.
Evidence of an advancing economic slowdown in the OECD world is a fundamental reason for the commodity sell-off. The driver, however, of global commodity demand is no longer the advanced, but the emerging world. Although these countries still account for the bulk of the marginal increase in demand, growth in emerging-world commodity off-take is slowing, at least compared with the rapid pace of the last few years.
This moderation in demand is complemented by improved supply prospects in a number of commodities. Saudi Arabia, the world's largest oil exporter, has increased output recently, possibly for fear that prices near $150 per barrel would eventually dent demand. According to the International Energy Agency, Opec has increased production as Saudi output has risen to more than 9.45 million barrels per day. The kingdom has also brought new giant fields on stream as other Gulf producers have continued to expand capacity. Crude oil prices have since dropped, despite the Russian incursion into Georgia and the temporary suspension of the 1mbpd Baku-Tiblisi-Ceyhan pipeline after attacks by Kurdish separatists. Just before the recent correction, the International Energy Agency stated that oil prices were still too high given the fundamentals. The oil markets also reacted only modestly to the possibility of hurricane-related supply disruptions in the Gulf of Mexico.
The oil price decline may be limited, however, as more hawkish members of Opec, such as Venezuela and Libya, are calling for a cut in output to stop oil prices falling further, recommending that prices remain above $100 per barrel. When Opec last cut production, early last year, prices subsequently doubled in just over a year. In addition to oil, other commodity supply prospects have improved. These include improved growing conditions in North America and record harvests in major food-producing emerging nations, as well as increased mine output. The China National Grain and Oils Information Centre recently raised its 2008 output forecasts for soybeans, corn and rice. That said, it is believed that the fundamental argument for higher commodity prices is still compelling and has been well examined. Mine supply of industrial metals is rising, but the industry is facing severe bottlenecks in equipment, infrastructure and human capital.
On a fundamental level, economic growth in the emerging world is expected to remain strong, and this may prove key for commodities. As long as emerging market growth does not dramatically fall - and there is no sign that this is going to happen - commodities should be supported as the investor exodus abates.
The outlook for inflation will also influence commodity prices, in particular, gold and precious metals, traditionally seen as hedges against inflation. It is worth noting that normally Consumer Price Index (CPI) inflation typically rises during a hard landing, at least initially, before declining significantly later in the cycle. It could be that the US may be at this point. Furthermore, there are growing indications that despite high headline inflation, falling prices have already arrived within the non-financial corporate sector, due to a lack of corporate pricing power.
Although CPI inflation hit a 17-year high in July, non-financial corporate prices fell 0.1 per cent in the year to quarter 1, 2008 and are estimated to have fallen further to -0.9 per cent in quarter 2, which would make it the lowest reading since 1950. This lack of pricing power helps explain the absence of second-round impact from higher food and energy prices. Corporations simply cannot pay higher wages because they lack pricing power. If investors recognise a break in inflationary pressures, they may be tempted to continue to off-load commodities.
• This report was compiled by the marketing department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.