A different tune: commodities de-couple from dollar

Commodities are playing to a different tune, with greater independence from the dollar allowing the individual fundamentals of each commodity to guide current price behaviour.

Hence, not only are we seeing unique trends across commodity segments, such as energy versus metals, but even within the segments themselves, with the metals in particular breaking previously strong inter-complex correlations.

This break has coincided with another surge higher in commodity prices, with both oil and copper reaching new all-time highs towards the end of the second quarter. Moving into the third quarter, we advocate an overweight position in energy, with acute refining shortages likely to push product prices to fresh highs, dragging crude oil prices above US$60 per barrel.

Following a sell off at the end of the recent second quarter, we repeat our positive view towards base metals from mid-2005 price levels. We are largely neutral towards the precious metal prices, although a divergence from the stronger dollar should allow some modest upside. We recommend an underweight position in the agricultural segment due to a significant price-driven supply surge, although within this segment we are positive on sugar.

The commodity that has gathered the most media coverage from its break from dependency from the euro-dollar exchange range has been gold. This is partly justifiable as gold was the commodity with the strongest correlation with the euro — often acting virtually as a proxy.

However, talk of gold benefiting from a mass move away from the euro as an alternative to the dollar and investing in gold as a safe haven are both fanciful and flawed.

The reality has been that, in euro terms, many other commodities have risen more significantly than gold. It is not argued — at least not yet — that oil is being used as an alternative currency, or copper, or sugar, but yet these commodities have performed at least as well as gold, if not much better, since the “no” votes to the European constitution in France and Holland sparked this correction and introspection of the euro.

The reality is that many commodity prices are rising impressively in non-U.S.-dollar terms. This is particularly important in the gold market, where participants, without the benefit of “proper commodity fundamentals,” have been aching for an alternative approach to trade the yellow metal.

Freed from the dollar, we believe “proper” commodities will see a much more divergent performance across the complex, based mostly upon actual and perceived fundamentals rather than on the macro-correlations approach that has been so popular for much of this commodity bull market.

Energy sector

Given the importance of the energy complex to investor interest in the commodities complex, we would expect the third quarter to see further interest in the asset class. However, the commodities bull market is no longer simply a “rising tide.” There is a growing bias towards commodities with low inventories and constructive near-term fundamentals.

Generally, 2005 has seen easier supply conditions, and inventory levels have either depleted at a slower rate or risen this year. However, as we have argued previously, there has not been a wave of supply growth in the industrial commodity complex due to a wide range of constraints right through the supply chain.

The agricultural commodities, in contrast, have seen a significant price-driven supply surge and this explains why we continue to be biased towards an underweight position in the agricultural complex.

The surge in oil and copper prices to fresh record highs has, inevitably, seen the return of allegations that such prices are simply the result of fund speculation. We continue to disagree. For oil, the evidence has been overwhelming that not only is the global economy continuing to grow strongly despite high prices, but that oil demand is still expanding rapidly, placing what is already a tightly stretched supply system under increasing pressure.

Given the constraints that exist in both the upstream and downstream sectors of the business and the lack of growth that is likely for the foreseeable future, one of the few ways to balance the oil market is for prices to rise to a level where demand begins to contract. There is little sign of that level yet being reached.

In the U.S., where consumers are most heavily exposed to fluctuations in gas prices because of the relatively low levels of taxation, gasoline demand has continued to remain at record levels, despite record prices. According to estimates, the 40% increase in U.S. gas prices over the past two years adds only US$30 to the cost of a 1,600-mile trip in a road van — which seems unlikely to be enough to change the holiday habits of a large swathe of U.S. citizens just yet.

Base metals

For copper, in a market that consumes more than 17 million tonnes of copper a year, global exchange warehouses at less than 75,000 tonnes represent the lowest absolute level of exchange warehouse stocks since December 1988. In such a marketplace, even a “normal position” can have an impact on the price and availability, and the line between entirely justifiable trading strategies and “speculation” is paper thin.

We believe a build-up in stocks outside official warehouses has occurred, but given the large backwardation, this amount should be limited.

The reality is that extremely low inventories and high prices is likely to mean that a very difficult and volatile period for commodity prices can be expected in general, and all market participants need to develop ways of accepting and trading within this environment.

Our commodity segment views in summary:

Energy — We expect another increase in the quarterly average for third-quarter crude oil prices, with market sentiment likely to be set by the slowdown in Russian output growth, by demand signals from the U.S. and China, and by the geopolitical risks surrounding Iran and Iraq. Refined product markets are likely to remain exceptionally tight. Recently the focus has been on distillate markets, where concern about availability recently pushed heating oil crack spreads to record highs for the time of year. More recently, gasoline prices have moved back up and we expect product prices to remain high and volatile for the foreseeable future. Although natural gas prices remain relatively high, a tight oil market will limit the downside, while a warm summer could deplete supplies, leaving the market vulnerable to cold winter weather.

Base metals — Despite slowing western world economies, we still see upside potential for the base metals, driven by robust Chinese demand and extremely low inventories. Consumers are under-hedged after a period of destocking, and with investor length having fallen at the end of the second quarter, we think price risk remains to the upside from mid-2005 levels. With base metals prices already having reached multi-year highs, risk/reward is now less attractive, but we see value further out on the price curves, especially in aluminum, where European capacity closures look likely amid rising power prices, while intensity of use is on the rise in China.

Precious metals — Long euro gold plays have taken over from the gold-silver ratio trade as the more popular fund trade in the precious metals complex. However, speculative length is approaching historical highs and, while we expect prices to push to fresh 2005 highs, we still expect this rally to be temporary in nature and for profit-taking to take gold prices significantly lower again, but probably not until the fourth quarter. Platinum is still preferred on a fundamental basis.

— The opinions presented are the author’s and do not necessarily represent those of the Barclays group. For access to all of Barclays’ economic, foreign-exchange and fixed-income research, go to www.barclayscapital.com.