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Commodity Monthly

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From demand weakness to supply destruction

Wed, Jan 7 2009, 10:45 GMT
by Arne Lohmann Rasmussen

Danske Bank A/S

After the collapse in commodity prices during the second half of 2008, we have seen a number of commodity prices move higher over the last two weeks. Oil has once again taken the limelight, rising from a year low of USD 34 a barrel to just below USD 50. But commodities like nickel and wheat have also jumped significantly. Prices have in general been moving higher in line with equities and improved risk appetite in financial markets. But we note that prices tend to be extra volatile round Christmas and New Year due to thin liquidity. An expected reweighting of commodity investment indices in favour of base metals like nickel, zinc and copper might also have pushed these base metals higher over the last couple of days. Looking into 2009, the big question is, of course, whether we are finally seeing an end to the six month long bear market in commodities, or are we just seeing a "dead cat bounce"?

We argue that commodities have in fact moved into a consolidation phase and that prices will end the current year at a somewhat higher level. The combination of production cut backs, lack of investment and improved economic growth during 2009 should in general lift sentiment, and not least improve the demand and supply balances going forward. We argue that 2008 was a year of "demand destruction" and that 2009 will be a year of "supply destruction" - most notably in crude oil, aluminium, nickel and zinc, and to a lesser degree in copper and agriculturals. But the commodity markets are in for another volatile year and the market might not be fully out of the woods yet. The next three months will most likely be characterized by relatively weak growth numbers and weak commodity demand. However, we expect the US economy to move out of recession during Q2. We stick to our forecast for e.g. oil, implying an unchanged price of approx. USD 50 a barrel for the next six months. But as the global economy recovers during the summer of 2009 we should see good support for commodity prices. Hence, we expect the oil price to end 2009 at USD 75. Remember, like equities, commodity markets are also forward looking. In our view, a very negative growth trajectory is already priced into commodities. The market seems to be forgetting that the next couple of quarters are going to see very accommodative economic policies on a global scale. It also seems to be overlooking the strong supply reduction seen recently in many commodities - most notably in oil, aluminium and steel.

Given our view that the global economy will recover during the summer boosted by aggressive monetary easing and fiscal stimuli, we recommend locking in 2009-2010 commodity exposure at the current level. Unfortunately, this view is also shared in the market and many commodity curves are currently trading in contango - that is forward prices are above spot prices. The DEC09 WTI crude oil is trading at USD 63 USD compared to USD 50 for the front-contract. But even taking the contango into account, we find value in hedging commodity exposure. That said, the strong contango in e.g. the oil curve does pose a risk on the downside for prices. Just as commodity prices might have "overshot" last year, it certainly cannot be ruled out that we will see some sort of "undershooting" this year as speculators are entering short positions to bet on an even more severe "global recession". And this bet is actually quite cheap at the moment due to the strong contango in the curve. You earn a significant positive carry entering a short position in the commodity market at the moment.

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Published on  Wed, Jan 7 2009, 10:52 GMT