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Commodity Monthly

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Commodity supply under pressure

Wed, Nov 5 2008, 14:03 GMT
by Danske Research Team

Danske Bank A/S

We saw a record fall in commodity prices in October. Energy prices together with copper were particularly hard hit and declined by more than 30% over the month. Other metals and agricultural commodities were affected to a lesser extent but it is still quite difficult to find a commodity that did not post a double-digit decline in percentage terms over the month. There can be little doubt that the escalation of the financial crisis and growing evidence that the global economy is heading for - or in fact is already in - a global recession is very tough on commodities. The setbacks we have seen in global PMIs have been astonishing. In October the important US ISM dropped to 38.9 - the lowest level since 1982. The decline in the ISM, which has been mirrored in global PMIs, suggests even weaker global growth in the coming months than previously thought by most forecasters. Hence, the global outlook in the short term does not bode well for even a stabilisation in commodity prices.

On top of the weaker growth numbers we could add closure of long commodity positions both from speculators and investors, but also from businesses that closed down loss-incurring commodity hedges entered in the summer when the outlook for commodities was very different from today. Just as speculative activity might have added to prices in the first half of 2008, it cannot be ruled out that the opposite is now happening. Speculators are entering short positions to bet on a severe 'global recession'. Hence, just as commodity prices might have 'overshot' earlier in the year, it certainly cannot be ruled out that we are now seeing some sort of 'undershooting'. But that said, it is not the main explanation behind lower prices. The main reason is the unprecedented weakening of the global economy due to the escalating financial crisis.

The financial crisis and significantly lower commodity prices are now starting to have a strong effect on supply. Base metals like nickel and aluminium are now trading well below marginal costs, and many producers are incurring a loss and have started to close down production. Industry sources estimate that 7% of nickel and 4-5% of aluminium production capacity is currently shut down. In that respect, the OPEC cut of 1.5% seems quite modest. But even more importantly, across the commodity board we are seeing several producers postponing or outright cancelling new investments. In that respect, the pressure in several commodities might reappear in 2010-12 when the global economy hopefully rebounds. We still think that the commodity market during 2009 will start to focus on this issue.

All in all, we are of the view that the combination of supply cutbacks and commodity prices below marginal costs will mean an end to the price slide for commodities. In that respect, the recent apparent stabilisation in financial markets with higher equity prices and slightly tighter credit spreads should also act as a stabilising factor for commodity prices. Commodity prices are also expected to be some of the first assets to react to the first incipient signs of better times ahead. However, positive newsflow could be some way off and one should expect high volatility over the next couple of months. But all in all we do recommend considering hedging commodity exposure at the current price level - not least given that many commodities are now 'eating' into cost curves. We think the market is 'fishing' for a bottom when it comes to commodity prices.

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Published on  Wed, Nov 5 2008, 14:03 GMT