After commodities suffered a steep sell-off last week, many investors are asking whether this marks a turning point for the asset class after posting a fifth year of gains in 2006.
Kevin Norrish, director in the commodities research team at Barclays Capital and respected analyst in the sector, answers your questions on whether this holds true below.
What is your outlook on the Canadian oil sands?
Christopher Lacich, Youngstown, Ohio US
Kevin Norrish: Although in theory Canada’s oil sands reserves are vast there are huge constraints on the speed at which they can be developed and are unlikely to contribute more than a few hundred thousand barrels per day to incremental oil supply. Getting oil from tar sands is very energy intensive using large amounts of natural gas and needs an oil price of $60 per barrel to make it economically viable.
In addition there are already significant logistical constraints already slowing the rate of development of Canadian oil sands including shortages of equipment and labour.
A more general point is that the oil market’s dependence on Opec oil supply is likely to continue growing even at current prices. It is within Opec countries that most of the low cost oil reserves exist and recent experience has shown that oil production in the many of the mature production zones in non-Opec countries such as the UK, Norway, the US and even Mexico is falling faster than expected.
Many market participants, including Opec expect non-Opec supply growth to move up substantially this year though recent history suggests this is unlikely. It’s worth watching this particular component of supply quite closely in 2007 and if it is falling below expectations as we expect it to, the chance of a big move up in oil prices will increase.
What are the major drivers for the current gold price increase and favourable outlook? Is the jewellery market in the Middle East and Asia, which is a function of the increasing affluence of this part of the world, a major contributor, and what is the attraction of this inert metal?
John Forster, Wellington, New Zealand
Kevin Norrish: The main reason for holding gold is as a currency bet in our view.
Whether or not you have a long position in gold this year should depend very much on your view of the dollar since the negative correlation between gold and the value of the dollar versus major currency pairs such as the euro and the dollar is very strong and likely to remain so.
We do not view gold as benefiting from the same factors that have pushed up base metals prices however. The important factor here is that spending on gold is discretionary. Countries like China and India do not need gold for their industrialisation process and will only buy it if local consumers want it and perceive it to be good value.
If prices rise too fast buying interest from these major consuming countries tends to fall away. Further ahead, as living standards rise and the financial sector becomes more sophisticated, demand for gold both for jewellery and as an investment tends to decline.
Could you please give a view on commodities in a cyclical context: where we are in a long , medium and short term cycles? Given your background in agricultural commodities, how would you expect them behaving relative to energy related commodities? Would a strategy of buying the laggards there make sense ? Would you expect some hot money moving there?
Youri Vorobiev, Zurich
Kevin Norrish: Our view is that there are a number of commodities in which investment on the supply side was far too low in the 1990s and that problem has been exacerbated over the past few years by the rapid growth in Chinese demand.
However it is really only in the energy and metals sectors that long-term constraints to the supply side exist. New projects in both these sectors are hampered by long lead times, rapidly escalating costs and shortages of skilled manpower. In addition many of the large companies have fewer major projects than in previous cycles, whilst in energy it is difficult for most of the big companies to operate in the areas where the resources are located, such as the CIS and the middle east.
We do not see the same constraints in agriculture where it is much easier to make relatively low-cost incremental additions to supply. That is why we would urge investors to be cautious about heavily weighting their agricultural exposures just because prices in this sector have lagged behind.
That said, we do see strong long-term cases for corn and wheat, cotton to some extent as well.
The sharp sell off in base metals and the higher than expected payroll figures don’t somehow seem to go together. If the economy is expected to have a soft landing rather than a crash as previously speculated, shouldn’t the metals consolidate and rather start their move up instead of this continuous fall? Where do you see precious metals headed from here?
Kevin Norrish: Last week’s US data was stronger than expected pointing to solid jobs growth and suggesting consumer spending should stay strong. The housing sector is also showing signs of bottoming. We think that the base metals sell-off is overdone in relation to market fundamentals but reflects bearish sentiment and a slow start to consumer buying.
We expect to see a sold rebound in prices before long. Inventory levels for most metals are still very low and the front end of the metals price curves are in backwardation, suggesting that the underlying picture for metals availability is still very tight.
Do you think the negative performance of the GSCI and other commodity indices last year is causing some investors to reduce their exposure to commodity indices and this in turn is contributing to the recent sell-off in metal and energy prices? Plus do you think that investors are prepared to become more selective in their commodity investments rather than take the passive index approach?
Kevin Morrison, Financial Times
Kevin Norrish: We estimate that the increase in investment specifically in commodity indices slowed last year to around $10bn, taking the total to somewhere around $80bn from virtually nothing at the start of the decade. That $80bn is a tiny number if you compare it with the total amount of funds held by institutional investors in stocks and bonds, which run into well over the $40 thousand billion mark.
The evidence is that the demand for commodity investments is still very strong from many different types of investors and there were some very important fresh allocations made by high profile institutional investors late in 2006. However the sector is maturing in terms of the different types of investment available.
The big growth recently has been in structured commodity products that can be tailored for investors to include smaller groups of commodities and which also shift the exposure to different part of the price curve, thus insulating investors from some of the volatility at the from end.
What is the ratio of real (based on economic demand) and financial (including speculative) commodity transactions on a global scale? Could over-trading and leveraged speculation justify part of last year’s price increases?
Apostolos Constantinidis, Athens, Greece
Kevin Norrish: There has been a big increase in non-commercial market participation in all commodity markets over the past few years as commodities have grown in popularity as an alternative asset to diversify equity and bond dominated financial portfolios. Our view is that whilst these new inflows to the markets have added some additional price upside, it is commodity market fundamentals that are still the most important driver of price.
There are two main types of investment activity in commodity markets - long-term strategic investment by pension funds and other institutions and shorter term “tactical” trading by hedge funds.
Taking each of these in turn, the institutional inflows mainly follow general commodity indices which spread the investments between all the major commodity sectors. The important point here is that whilst many of the bigger markets such as copper and oil which feature in these indices have performed strongly over the past two to three years, the performance of many other markets in which the inflows are very large in relation to market size have not done nearly as well. In particular the agricultural and livestock sectors have both been relatively weak and even the recent pick up in agriculture has been restricted to those sectors such as corn and wheat where poor harvests and rapidly increasing demand for use in alternative fuels and from China is causing fundamentals to improve very fast.
The other important point about institutional investment is that because it is long-term for use in portfolio diversification it is unlikely that there will be substantial liquidation of positions simply because of a few quarters of underperformance.
The impact of tactical investment by hedge funds in commodity markets can also be overplayed. Again the share overall of these participants in the commodity markets tends to be relatively small. For example according to the US Commodity Futures Trading Commission non-commercial net long positions in the oil market have never exceeded more than 20 per cent of US oil futures market open interest. In addition these types of market participant do not always get it right. Most hedge funds were short of oil when it made its big gains in 2004 and 2005, and many were short of copper as it set all-time highs in early 2006.
What is your view on nickel and zinc prices in 2007?
Colin, Perth, Australia
Kevin Norrish: We continue to see upside potential in a number of metals markets this year, although percentage gains which in 2006 were in the 30-130 per cent range will be much lower, more likely in the range of 5-20 per cent over 2006’s annual averages. Zinc and nickel markets look especially tight for the first half of this year and with inventory levels exceptionally low, both markets are extremely vulnerable to any supply disruptions.
Demand for these metals are driven by the global steel industry in which both metals are important coating and alloying elements. Steel demand is increasingly dominated by China where infrastructure growth and general construction activity should remain robust in our view during 2007.
In other commodity sectors we see significant upside in oil markets from current levels, gold also has the potential to move higher should the dollar weaken and oil prices recover. Within the agriculture sector we see considerable upside potential to corn and wheat markets.