Riding out the slump: the outlook for commodities markets
January 2016 | FEATURE | ECONOMIC TRENDS
Financier Worldwide Magazine
The whys and wherefores of the current commodities markets slump is a tale of supply and demand trends and the resultant detrimental impact on cyclical commodities such as oil, crops and industrial metals.
Commodity prices have actually been on a downward trajectory since 2011 and, according to the Bloomberg Commodity Index, it was worst performing asset class of 2015 – operating at approximately 50 percent of the levels reached four years previously.
Compounding the doom and gloom proffered by Bloomberg is recent data from the S&P Goldman Sachs Commodities Index (GSG), which shows virtually all commodity classes (except cocoa) in freefall during 2015, with the worst-performing classes down almost 35 percent. In fact, Q3 2015 returns for commodities were the worst seen since 1970.
Furthermore, the global slowdown in demand for commodities has pervaded emerging markets and developing economies leading the International Monetary Fund (IMF) to revise its global growth forecast for 2016 – now 3.6 percent instead of the previously estimated 3.8 percent.
Boiled down, the commodities markets slump is a matter of demand and supply. Essentially, the global production of commodities has escalated while demand has plummeted due to a range of factors including unstable US and European economies, in addition to their developing counterparts, as well as the Chinese economic slowdown. China, the world’s largest commodity consumer, accounts for 14 percent of global oil imports and 58 percent of both soybean and iron ore global imports.
All in all, the commodities markets slump has certainly been striking, with opinions among analysts differing as to whether the bottoming out point has or is about to be reached and just what needs to be done to ride out the slump.
Detailing the downward trend
According to Cameron Belyea, a partner at Clayton Utz, among the major factors contributing to the downward trend in key commodities markets such as energy and precious and base metals are a tightening of monetary policies across developing countries, a consumer confidence crisis, environmental pressures and alternative sources of supply for manufacturing operations. “Temporary demand and policy imbalances have driven down prices in the same way that a decade of exuberant demand and loose liquidity drove pricing well above historical levels,” says Mr Belyea. “In the meantime, operating miners are chasing down costs or raising, when possible, production to right-size revenue and improve liquidity.”
For Andrew Hecht, chief analyst at Commodix.com, the weakness of the Chinese economy is the overriding reason for the malaise currently surrounding the global commodities landscape. “China was the major reason that a composite of over 30 raw material markets dropped by over 9 percent for the three months ending 30 September 2015. Every sector – be it precious metals, base metals, energy, soft commodities, grains and animal protein – moved lower. As of the end of Q3, commodity prices had dropped by more than 13 percent.”
Although undeniably a major factor, the fluctuating fortunes of the Chinese economy is but one of several key influences currently weighing on commodity markets, according to Jodie Gunzberg, global head of commodities at S&P Dow Jones Indices. Others include the strength of the US dollar, Organisation of the Petroleum Exporting Countries (OPEC) supply decisions and El Nino climate cycles. “While commodities have been under pressure, there are some potentially bright spots for commodities,” says Ms Gunzberg. “Although commodities are negatively correlated with the US dollar, not all commodities are hurt equally by the dollar. For example, petroleum is the most inversely related to the dollar with correlation of about -0.65, while some commodities are more driven by other factors such as the weather. Natural gas, livestock and agriculture have correlations of near zero from weather events like El Nino. That may be particularly powerful over the next year or two given the history of strong returns in agriculture following prior El Nino events.”
Resisting a commodities bear hug
When forecasting the future status of commodities and commodity prices, analysts recognise the distinct possibility of the sector entering into a protracted bear market. Others, however, express less bearish sentiments when contemplating the outlook for commodities. “Commodity prices have been in a bear market since they peaked in 2011,” notes Mr Hecht. “With few exceptions, raw material prices have been making lower highs and lower lows over the past four years. The downward trajectory has picked up steam in 2015 on a combination of Chinese economic weakness and strength in the US dollar, which is the reserve currency of the world and the pricing mechanism for most, if not all, raw materials.”
Mr Belyea believes that some commodities markets bottomed out a few months ago and that most minerals will shortly be back above the lows. “Capital markets seem to be pricing in growth. Movements in some resource exposed bonds having seen positive movements of +10 percent in recent months,” he says. “All of this is consistent with the September 2015 report by the Australian Office of Chief Economist (AOCE) which, despite the widespread downturn in commodity prices and the fact that Australian production is yet to peak, states that ‘the prospects for Australia’s resources and energy sector remain broadly positive’.”
The risk of a systemic crash
‘Too big to fail’ – a term normally used in the context of financial institutions, has also been adopted as a means of describing troubled commodities traders such as Glencore, Trafigura, Vitol and Noble. So, are these multinational commodities giants indeed too large to be allowed to fail, or are they genuinely under threat? “The current turmoil surrounding commodity trading and producing companies is the result of the increased debt burden they took on during the bull market in commodity prices,” claims Mr Hecht. “They are not too big to fail. In order to survive, they must now suspend dividends, cut expenses and production in order to raise cash and pay down debt. Global regulators are historically reactive rather than proactive; they only respond to systemic issues after the fact.” Those global regulators, including the Commodity Futures Trading Commission (CFTC) and the Organisation of Securities Commissions, need to be adequately prepared to respond to any risk of a systemic crash.
Overleveraged balance sheets need to be addressed, debts and offtake arrangements need to be restructured and equity must be raised to deal with short-term funding needs. “Presuming each of these entities are run by smart boards, turnaround experts will be engaged to plan out a gradual deleveraging and right sizing of business to meet the present market,” suggests Mr Belyea. “In the meantime, the market and its regulators should be slow to affect the important clearing house and liquidity functions performed by commodities traders.”
The Chinese effect on commodities
Although the Chinese demand growth slowdown, stock market volatility and currency devaluation is continuing to present challenging scenarios for commodities, consumption in the region remains high. However, low prices have been a catalyst for increased demand which has offset the growth slowdown thus far, especially in oil. “The competition for oil market share from China continues to drive the high oil supply from OPEC, though the currency devaluation has made it more expensive for China to import commodities – all else equal – that may change how much China buys,” explains Ms Gunzberg. “Low oil prices are now causing major producers in the US to pull back. Lower prices in other commodities like metals have also driven supply slowdowns that may begin the rebalancing and stabilisation of the commodity markets.”
Even as China is slowing, it will remain the dominant commodity buyer in the world by virtue of its population and growth, even though that growth is now at a point where an era of economic stagnation is almost expected. “The chances are that China will make investments in any commodity companies or producing assets that find themselves under pressure if they can buy them cheap enough,” points out Mr Hecht.
While concerns over the slowing economic growth in China is indeed one of the major reasons for the difficulties currently facing commodities markets across the globe, there are other significant contributory factors – international relations with Russia among them. “China’s weakness in the European economy has also contributed to decreasing raw material demand,” says Mr Hecht. “Sanctions and economic pressure on the Putin government in Russia has caused the raw material rich nation to sell more commodities. As prices fall, the Russians are likely to sell more commodities for cash flow purposes.”
Other commodity rich nations such as Australia and Brazil have seen their economies falter along with commodity prices. Brazil in particular is suffering, having enjoyed a China-driven commodity boom which is now going bust, sparking fears of a ‘lost decade’. But currency values have plunged as revenues from raw materials have decreased. However, as the US dollar strengthened, many of the costs associated with production in these nations have decreased, meaning that total production cost has declined. Lower energy prices have also reduced production costs for other commodities. This means that Australia and Brazil can sell more raw materials as the dollar price drops.
The prospects for commodities
Although commodities markets experienced a bounce in prices at the beginning of the fourth quarter of 2015, all indications are that the rally is purely short-term and selling pressures will return in 2016. Furthermore, in the medium-term, new lows are expected in many raw material markets.
For Mr Hecht, the four-year commodities markets downtrend remains intact. “In the long-term, years of very cheap money and low interest rates around the globe will eventually lead to an inflation spike,” he says. “Increasing inflation will ignite commodity prices in the long term. I also believe that volatility in markets will increase across all asset classes, including commodities over the months and years ahead. Each commodity has its own idiosyncratic characteristics. The El Nino episodes this year could cause agricultural prices to rise as weather disruptions affect crop output. Given the strength and importance of China, the global economy will reflect economic conditions in the Asian nation in the years ahead.”
The prospects for the commodities sector in the short, medium and long term will be largely determined by consumption levels. Indeed, the AOCE has forecast that commodities consumption will increase over the next four or five years, driven by factors such as urbanisation growth and the expansion of manufacturing in developing countries. “Miners should be seizing the moment and looking to growth through asset, merger or restructuring transactions, or at least positioning for stronger liquidity by deleveraging, renegotiating cost structures or increasing production,” urges Mr Belyea.
As commodities markets wave a hearty goodbye to an exceptionally weak 2015, the prospects for 2016 and beyond, although likely to remain volatile, are poised for a resurgence, perhaps having bottomed out. Indeed, a bounce-back may be just around the corner, providing a much-needed uplift for commodities.
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