Listen to this article
Francisco Blanch, Merrill Lynch’s head of global commodities research, will answer your questions in a live online debate on Monday from 2.30pm BST. Dr Blanch focuses on the analysis of commodity prices and derivatives, as well as commodities as an asset class.
Dr Blanch answered FT.com readers’ questions on the outlook for oil, metals and agriculture, commodity index strategies, the risks to crude oil prices in the next six months and whether Opec will regain significant market share in 2008.
Given the increasingly high price of oil and the deterioration of credit, how will this impact on Refiners in 2007-8 and the price of refined products?
Nick Rowan, UK
Francisco Blanch: We do not expect significant growth in refinery upgrading capacity around the world this year or next, suggesting that gasoline and heating oil margins will remain strong, on average, for another 18 months.
However, I also believe that refining margins will remain very volatile due to the increasingly complex refined product specifications, the low levels of petroleum product storage capacity around the world, and the extremely old refining system that the world is running on (mostly built in the 1970s). The deterioration in credit conditions coupled with crack spread volatility is a tough combination for refiners. However, commodity investors can still benefit from this environment by capturing the ”spikes” or the positive roll yields that RBOB gasoline or heating oil can offer via index investments.
Between 1970 and 1979, Gold appreciated seventeen times ( 50 to 850 ). And generally speaking, oil moved from low single digits to $40 per barrel, while the rest of the commodity complex soared. To date oil’s breakout above $40 has not precipitated such gargantuan moves (although gold has made an incipient gain). What is your ten year prognosis for the commodity complex, and, in particular, oil, gold, and the grains?
Neale Dobkin, Agawam, Ma, US
Francisco Blanch: There are many differences between the commodity super-cycle of the 1970s and the current commodity super-cycle: monetary policy has been more accommodative despite the commodity price increases, we have not seen any major commodity supply shocks yet (such as the one created by the Iranian revolution 27 years ago), there is less scope for commodity demand substitution, and there is no massive investment program in the horizon that could create a significant productive capacity overhang over the next five years.
Moreover, demand for commodities from emerging economies is incredibly strong and incredibly resilient, given the high prices. I do not have a 10 year forecast for commodity prices, but given the limited growth in supply across most markets I believe that oil, gold and grains prices will still have to increase substantially from the current levels in the next 10 years to slow down the healthy demand growth from emerging countries.
Will the modern trends in financial industry such as the consolidation of stock exchanges and introduction of algorithmic trading have a certain impact on the valuation of asset classes, including the commodities: oil, metals, etc?
Viktor O. Ledenyov, Ukraine
Francisco Blanch: I think that algorithmic trading will likely have a lot of positive impacts in the commodity markets. In particular, I think it will contribute to increase liquidity in commodity markets, possibly reducing wide bid-offer spreads and limiting the extreme events we see on commodity timespreads and options prices. However, I don’t think that algorithmic trading will necessarily affect the price equilibrium of commodity markets, as the underlying supply and demand conditions will always remain the primary driver of spot oil, copper or wheat prices, in my view.
What is your expectation regarding copper prices for industrial applications/usage and would you recommend any hedging of the purchase volumes in the near future?
Norbert Lipfert, Langen
Francisco Blanch: Our three month LME copper price forecast for 3Q07 is $7,200/t, and our forecast for 4Q07 to $6,650. For 2008, we expect prices to remain volatile but high as demand remains robust, averaging $6,963/t. Our supply/demand analysis indicates a substantial copper surplus over 2007-09 of 396kt, 332kt and 489kt, respectively. This is despite a substantial delay to the supply-side response that we have built in, the extensive disruption allowances (4 per cent refined cap in 2007) and our assumption of a continuation of positive demand growth in 2007.
The supply-side issues (such as strikes) still have the ability to create periods of temporary tightness, given the relatively low inventory levels, in our opinion. This will remain a key driver of volatility. Long-term supply issues remain. In particular, power restrictions and lack of water will put pressure (through higher costs and supply constraints) on Chilean copper production. Thus, if near-dated prices fall indeed below $6500/t, I would consider hedging.
What is your outlook for biofuels and grain prices?
Alexandre Ludolf, Brazil
Francisco Blanch: In the long-run, we are very positive on agricultural commodity prices due to the growing link to the biofuels market. As I have stated in a prior question, the world will need biofuels to fill the growing supply and demand gap in the transportation fuel sector. However, I don’t think that commodity returns from agriculture will be as good as commodity returns from energy or metals due to the fact that (a) agriculture commodity prices tend to be more mean-reverting than energy or metals and (b) agricultural roll yields tend to be negative due to the dominant ”contango” market structure in agriculture.
Nonetheless, I am very positive on agricultural commodity prices. The significant increase in ethanol demand is reshaping the US corn market. Corn usage for fuel alcohol is experiencing more than a 20 per cent increase this season to 2.15bn bushels, driving during the last six months. Another 1bn bushels of corn might have to be diverted for ethanol production next year.
US corn stocks are currently estimated to be at the lowest level in ten years, and global inventories the lowest in 20 years. Still, a very good crop in the US has helped ease pressures on prices in the last few months. Also, soybean oil competes with heating oil in North America. A potential reduction in the soy bean crop driven by the so-called ”crop-rotation” phenomenon” is giving support to soybean prices.
For commodity investors, we believe that livestock is perhaps a more attractive option to gain exposure to this sector due to the positive roll yields it can generate. Corn and other grains are important inputs to the livestock industry and we expect the industry to respond to the recent rally in grain prices by decreasing supply of cattle. Hence, livestock prices could start increasing soon. Live cattle futures could also generate positive roll returns from backwardation in coming months.
In the past, every time grains experienced an annual price increase of over 30 per cent, livestock prices appreciated by 10 per cent on average three-six months later
What is the best way for a private investor to access the commodities market? Will commodities offset stock market declines or can they both fall?
Richard Lowry, Ireland
Francisco Blanch: Commodities bear very little, or even negative, correlation with other asset classes, while generating strong positive returns over long periods of time. By adding commodity investments to a portfolio composed of traditional asset classes such as equities and bonds, investors increase the risk-adjusted returns of the broad basket of investments. In fact, the diversification benefits of a long position in commodities have actually increased in the last few years with the negative correlation between commodities and traditional assets being particularly high since January 2006.
Depending on your size as a private investor, the best way to access commodities is through either an exchange traded fund, a Trakr or a note (or potentially a futures contract, but do not forget to ”roll” out your position).
How realistic is the peak oil thesis? I myself have had conversations with some major physical traders who have dismissed it as simply hype, saying that there is always going to be enough crude around, and the recent spikes in prices are all due to the market’s and the media’s exaggerated reaction to certain figures and ideas. Given your knowledge of energy markets what’s your take on this and why is the market taking the path that it is?
Francisco Blanch: In my view, current crude oil prices are primarily being driven by supply and demand conditions today. Moreover, I do not think that peak oil theory matters much to short-term trading conditions, which is the reason why most traders do not take it very seriously. Longer-term, I think peak oil matters a lot, but I believe there is at least four times as much oil in the ground as we have extracted to date. As a result, I think we are still decades away from peak oil when we factor in oil bitumen, arctic reserves, oil shales and the upcoming biofuels.
Of course, the peak of ”conventional” crude oil production may be much closer, but I don’t think anyone really knows, as most of the ”conventional” oil sits within Opec, and members of the cartel have never been particularly transparent in this regard. To avoid dependence on the uncertain availability of conventional crude oil, we need higher-for-longer oil prices (possibly in the $70/barrel range), as this is the cost of producing biofuels, Canadian synthetic crudes and other alternatives to conventional fuel.
Are we seeing a breakdown in the link between oil and natural gas prices?
Francisco Blanch: I would not say there is a breakdown in the link between oil and natural gas prices, but rather a decrease in the degree of correlation between these two fuels. Oil prices have trended higher during the last four years primarily as a result of a very tight market for transportation fuels.
Meanwhile, natural gas prices have failed to catch up with oil both in the US and in the UK, the largest spot natural gas markets in the world, as industrial consumers looked for alternatives to highly priced hydrocarbons. Of course, transportation fuels are harder to substitute for, and this has created a big gap in prices between the two fuels.
Long-term, I believe in ”calorific value convergence” and I don’t see any reason why the gap between oil and natural gas should widen any further on a five-year view. In the short-run, competition between Europe and the US for LNG volumes could intensify in 2H07 as demand picks up seasonally, and I believe the gap between oil and natural gas prices will narrow this winter.
In your opinion how long is this commodities boom going to last? I am always sceptical when people say this time it’s different. Are we in fact going through a major structurally different period in regards to global natural resources, What’s different now compared to the last commodities boom?
Francisco Blanch: Commodity booms or commodity investment ”super-cycles,” as we like to refer to them, occur every 25 to 40 years, and there are always different factors driving them. In the most recent one, we are seeing strong demand growth in energy and metals commodities, primarily driven by China and other emerging markets around the world. This has been backed up by strong growth in developed economies, such as Europe and North America. With world GDP growth running at nearly 5 per cent, we are currently witnessing the strongest, steadiest, longest global economic cycle since the 1960s.
On top of this, we have a major investment backlog across most commodity sub-sectors after over 20 years of low and range-bound commodity prices. The way I like to think about this is that high prices are needed to attract investment into the commodities markets. Thus, you will only get a permanent downward correction in prices when the commodity markets become oversupplied. With resource nationalism on the rise and the limited investment that the sector is currently attracting, I think the cycle could last for at least five to 10 more years.
What is your short term and long term outlooks on gold? And what would be a good investment vehicle to use to invest in gold if seek a long term holding?
Francisco Blanch: Gold and silver remain our top picks in the metals space. With positive supply/demand fundamentals, coupled with a surging industry cost curve, increasing geopolitical risk, and the end of an aggressive Central Bank sell-down, gold looks likely to head back up towards $700/oz in 2H07.
The right vehicle to invest depends on whether you are a retail investor, or an institution. For retail investors, buying gold-related mining stocks, gold ”Exchange Traded Funds” or physical gold may be a good option. For institutional investors, the Merrill Lynch Gold Index (that I designed) or some of the other gold indices created by our competitors would be good options to access this market.
What is your outlook for WTI roll yield for the next 6 months and what are the key variables to consider?
Rob Shimell, London
Francisco Blanch: Roll yields in the oil market are primarily a function of the term structure of the WTI crude oil market. In contrast to the last two years, we expect roll yields to be positive for the next three to six months. In the last few weeks, the term structure of the WTI crude oil market has experienced a dramatic shift from a marked degree of contango into a modest degree of backwardation. In other words, the oil market is now providing a premium for immediate delivery, as opposed to a premium to store. Given our positive outlook on demand and the limited availability of Opec spot crude oil barrels, I believe that the oil curve could stay either flat or in mild backwardation (positive roll yield) during the next three to six months for three reasons:
First, inventories at Cushing have been drawing for two months and new storage capacity is scheduled to come on stream, reducing the marginal value of storage. Second, refineries are coming back from maintenance, possibly reducing crude oil inventory levels further. Third, we estimate that the lag between Opec’s production increases and the full pass-through to prices is about five months. Thus, even if Opec increases production in the coming weeks, it would still take months to replenish inventories in consuming regions, resulting in a positive roll yield.
Mr Blanch publishes The Commodity Strategist, The Energy Strategist and Global Energy Weekly, which examine global commodity and energy markets and provide a tactical view on the future direction of sector prices.
Prior to joining Merrill Lynch in April 2005, Dr. Blanch was an energy economist in the Commodities Research group at Goldman Sachs & Co. and consulted for the European Commission and other public and private organisations.