Commodities and Brexit — 5 things to watch

A Leave vote would weigh on commodities prices through the US dollar and the impact on risk appetite

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As the UK begins voting in the EU referendum here are five things to watch in the commodities world.

Gold

It’s a widely-held view among investors that gold would be among the big beneficiaries of a Brexit. Some analysts reckon the price could rise by as much as 10 per cent to $1,400 after a vote to leave as nervous investors pile in looking for safe places to park cash.

But there are also reasons for thinking gold, a good barometer of risk, could suffer, at least in the near-term.

How markets react to Thursday’s vote is a huge unknown but one thing investors have learnt since the financial crisis is how quickly liquidity can dry up and impact markets.

“In previous episodes of severe financial markets stresses gold has been positively correlated with other assets, at least for a short time, as liquidity dries up, spreads widen and margin calls proliferate,” says Tom Kendall, analyst at ICBC Standard Bank.

With investors having amassed a near record long position in gold ahead of the vote, any sell-off could be sharp if short, warns Mr Kendall.

If there is a clear vote to remain, however, bullion will come under pressure although the precious metal is likely to find support from other uncertainties such as the outcome of the US election and the pace of global economic growth.

“Concerns over negative real rates, the US election and Chinese debt levels are also worrying investors,” says George Cheveley, co-manager of the Investec Global Gold fund. “Whilst the referendum has had an influence on gold prices in the last two weeks, the effect has been small compared to the impact of US interest rate and US dollar moves over the past few months.”

Oil

The UK makes up just 1.6 per cent of world oil demand, so crude should not be too affected by a Brexit vote, many traders think. But some analysts think the market is being blasé.

The oil market, while primarily driven long term by supply and demand, can be heavily influenced in the short term by currency moves and traders’ risk appetite. In the event of a Brexit the US dollar is expected to strengthen sharply, weighing across dollar-denominated commodities as they become more expensive for holders of other currencies.

There may also be a flight to safety — in such a sell-off oil tends to get dumped by the fast-money in favour of assets like gold. The Greece crisis in 2012 helped trigger a near 30 per cent drop in the oil price, albeit from a level well above its current price of $50 a barrel.

Demand is also not entirely removed from the equation. While the UK’s 64m people consume only 1.6m barrels a day — compared to 19.6m b/d in the US, the world’s largest oil consumer — the total EU bloc covers more than 500m people and accounts for almost 15 per cent of global oil demand (12.5m b/d). A Brexit is expected to be followed by greater uncertainty across the EU, probably hampering growth in an area where oil demand was already declining for much of the past decade.

Energy Aspects, a London-based consultancy, forecast that Brexit could drive oil prices down to “the low 40s” from near $50 a barrel currently given the “weakness in physical crude markets.”

“The uncertainty will continue to rattle financial markets, not just for the potential slowdown in UK and European economic growth if the UK voted to leave, but also due to the possibility it would trigger similar referendums in other European countries such as France, the Netherlands, and Sweden, threatening the foundations of the 28-country bloc,” said Energy Aspects.

Natural gas

As one of the few commodity contracts still denominated in sterling, UK natural gas could be volatile on Friday. If Britain votes to stay sterling would probably rally against the euro, something that would weigh on the benchmark National Balancing Point contract — an important reference price for the European gas market. If the opposite happens the NBP contract could rise sharply, impacting other gas markets that are closely tied to the UK such as the Netherlands.

Cocoa

Cocoa traders are also on high alert. That’s because the chocolate-making ingredient is traded on both sides of the Atlantic, with the London contract denominated in sterling and the New York equivalent in dollars.

A Brexit vote and a sharp fall in sterling would cheapen the London cocoa contract’s value for dollar buyers, hence boosting the contract in the short term. This in turn could lead to arbitrageurs selling the dollar based contract. A rally in the pound could lead to the opposite move.

“All-else equal, a sharp slide in the pound against the US dollar upon a Brexit vote should be negative for cocoa prices [traded] on the Intercontinental Exchange, in our view,” say analysts at Citigroup.

Industrial Metals

Aluminium, copper, zinc and other industrial metals closely track the movements in the US dollar. As such, a vote to leave would hit prices if the US dollar strengthened. A reduction in risk appetite would also weigh on industrial metals for a time.

Copper has shown the most sensitivity to the US dollar in the run-up to the referendum so in theory it should be hit hardest by a vote to leave. But with a record number of bets against copper on Comex, the US-based metals exchange, some Brexit concerns are already priced in.

“The currency factor will impact the metals most sensitive to the dollar and the general wave of risk aversion those with . . . the weakest fundamentals,” said analysts at Société Générale this week.

As for base metals pricing, there would be little impact from a vote to leave. Mainland Europe does not have a competitor to the London Metal Exchange — which plays a pivotal role in setting global metal prices. On the demand side of the equation, it is China not Europe that is the world’s biggest consumer of metals.

In summary . . .

Overall, a Brexit can be expected to weigh on commodities prices through their linkage to the US dollar and impact on risk appetite.

“A look back at previous major risk-off events shows commodities underperform during periods of significant macro/political uncertainty, at least over the short term,” say analysts at Citi.

“This macro impact could be compounded in this case, given that Brexit carries additional risk for the commodities in the form of US dollar appreciation.”

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