Is there value to be found in commodities?

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Commodities have seen very strong growth over the last few years, underpinned by demand from the fast developing economies of China, India, Brazil and others.

However, copper - a bellwether for industrial commodities - has recently seen a dip in prices. Is this a buying opportunity, or a sign that the commodities super-cycle is coming to an end?

What about other commodities, such as food and oil? In which particular commodities is there value to be found?

Lastly, there has been substantial growth in financial products allowing private investors to buy into commodities. Does the arrival of retail investors underline the strength of the commodities market, or signal the end of the boom?

Paul Horsnell, head of commodities research at Barclays Capital, answered your questions live online on Monday December 10.

The last significant commodity boom was event-driven (Yom Kippur) this one seems to be demand driven (China, India...). However, demand seems overblown - how does one determine whether this recent boom is a bubble or a genuine fundamental, long-lasting cycle?
Eric Guichard, Washington

Paul Horsnell: I’m not sure I would see the 1970s boom as event driven. Prior to the price rise, global oil demand had been rising at 7% per annum for a decade, and spare capacity was all but completely gone. Prices were far too low in 1973, and war simply provided the catalyst for a necessary increase. In the 1967, war the geopolitics were just as volcanic, but spare capacity at that point meant that prices did not have to rise significantly.

This boom is driven by two main factors. First supply side weakness in key commodities resulting from a lost decade in the 1990s when prices were low and investment in capital and people fell far below what was needed. Second, a demand shock which, in the case of oil, reached its zenith in 2004. Since then, demand has grown at a moderate pace, but it has continued to grow even the face of higher prices. Overall, I think the main evidence that there is more than a bubble going on is the rise in long-term prices, massive cost inflation for projects, and the weak supply side response to higher prices in several key commodities.

The boom in commodities is clearly being driven by the demand of several developing nations, the biggest of which is China. What is your evaluation of the Chinese economy and its future path in terms of its effect on commodities?
Paul Wickert, Milwaukee, WI, USA

Paul Horsnell: We are expecting the Chinese economy to stay robust in 2008, with the main question marks at this stage as to the pace of growth relating more to developments into 2009. China (as well as India) is still at a very low level of resource use per capita, and appears set to us to be the key determinant of demand growth into the longer term across a broad sweep of commodities.

I believe we are in the early stages of a housing depression, and a major growth slowdown in the US that will spread to the rest of the world. Commodity prices will fall, not rise, because demand will be too weak to allow cost increases to be passed along to consumers. Is there any way commodities could rise in that scenario?
Shawn McFarlane, St. Paul, Minnesota, US

Paul Horsnell: In that scenario, the key question is the extent to which a US slowdown is contagious across the key emerging markets. For the past three years, OECD demand in general (US demand in particular) for many key commodities, including oil and base metals, has been flat to falling.

Prices have risen strongly for three years in the face of that weakness for two reasons. First, there have been supply side problems that have driven some prices, i.e. demand is not always the most powerful force. Second, demand growth from emerging markets, and China and India in particular, have more than compensated for OECD demand weakness.

So prices can very plausibly rise in those commodities with strong supply-side drivers, or if emerging markets remain more robust. Oil prices would be likely to be more robust than base metals, and some slowdown scenarios would also be positive for the key precious metals.

How much of the rise in commodity prices can be attributed to the decline in the dollar?
Daniel Mufson, Berlin

Paul Horsnell: There is a significant direct impact from the dollar on precious metals prices, although even in that sector it is not necessarily a dominant factor. However, for other commodities I think that the impact of dollar weakness has perhaps been a bit exaggerated. Most commodities have hit price highs in all major currencies, with the primary determinants being supply and demand issues across base metals, energy and agriculture.

Are precious metals on a long term bull market? If so, what is your target price for gold in this cycle?
T. Ramakrishnan, Richmond

Paul Horsnell: Although the price paths of precious metals are linked to some extent, some of the metals such as platinum and palladium have very different fundamental stories. We see platinum prices reaching new highs next year buoyed by above-ground stocks continuing to fall to record lows, as well as the market retaining its supply/demand deficit again next year, coupled with strong investor and physical demand.

However palladium’s poor fundamentals – with supply outpacing demand by over a million ounces for the sixth consecutive year in 2008 – coupled with the speculative overhang is seen as capping the upside potential for palladium prices.

Gold’s fundamental and external drivers look set to remain positive at least for the first part of next year and we are forecasting an average price for 2008 of $830/oz. Beyond that, the future path of the dollar, geopolitical risks, mining costs, physical demand and inflationary concerns will be key factors to watch. But with reports of the average cash costs rising to $550/oz it would be unsustainable to return to the price levels witnessed at the start of this decade. Overall, seeing $1000 in this cycle should not ruled out.

What are your predictions for oil and gas prices in 2008?
Antony Sommerfeld, London

Paul Horsnell: Even if the macroeconomic background was not very supportive, oil markets appear to be tight enough already to lead us to expect a further increase in the annual average of oil prices. WTI crude oil has averaged just over $70 so far in 2007, and I think a very conservative forecast would add another $10 or so to that average in 2008. That would be within another very wide range during the year, and I would expect to see prices move above $100 at points next year. For US natural gas, the forecast is an average of $7.75 per mmbtu, which is about 10% higher than the 2007 average.

Is it unreasonable to think that the price of CBOT wheat could rise to $11 within the next 3 to 4 months?
Steven Stengel

Paul Horsnell: The current price of CBOT wheat is just over $9 per bushel, so $11 is getting close. However, I think the time left to spike much higher is beginning to run out. The market is beginning to turn its attention to the huge rise in the acreage under wheat that is expected next year, as farmers switch from other crops due to the price rise. Overall, the price outlook for wheat in 2008 is a little downbeat compared to current levels, but that switch of acreage is likely to benefit the prices of other crops. In particular, we think that corn and cotton prices will rise next year thanks to switch to wheat. So it is not impossible that wheat could mount a final surge higher, but the clock is ticking rather loudly.

Regarding history, there are different stages in a secular bull market and I think now is the time for softs (cocoa, sugar, and coffee) and grains. Do you agree?
Ab de Jonge, The Netherlands

Paul Horsnell: We are little more cautious on softs at the moment, at least relative to grains. We view grains prices in general as being fundamentally poised for strong gains on the back of market tightness. Inventories are extremely low across most of these markets while the promulgation of biofuels coupled with strong demand from China has added new dimensions to the demand dynamics of these markets.

We view the softs with more caution as these markets at this stage continue to be driven more by supply side factors. Sugar would be the exception to that, as while the near term outlook for the market is not very strong owing to the supply surge this year, although looking forward prices can be expected to strengthen due to their link to the energy complex via ethanol.

What is the impact of the significant growth of financial products (e.g. ETFs – exchange traded funds) on commodities? Do you anticipate that individuals will participate more in commodities investing going forward due to greater choice of investment vehicles?
Mary Rivas, Los Angeles, US

Paul Horsnell: Yes, they represent a cheap and accessible way of investing that has not been available before, both for individuals and institutions. There are now over $4bn under management in commodity exchange traded funds on the London Stock Exchange alone, and a range of different commodity ETF’s are available on many different regional exchanges and continue to grow rapidly.

In the event that China decelerates its commodity demand, can that be counter-balanced by Brazil’s own demand growth?
Carlos, Brazil

Paul Horsnell: Not yet. If anything, this decade has seen Brazil emerge as a key factor on the supply side for several key commodities (e.g. oil and soybeans) as well as its traditional role as a force in coffee and sugar. At the moment, China is almost a whole order of magnitude larger than Brazil on the demand side of most commodities and is growing much faster.

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