Once again, commodity prices are taking a beating. Since Wednesday the price of Brent blend crude oil has slumped by 7%. Over the last two months, copper has slipped 8%, and iron ore futures traded in China are down a precipitous 30%. Coming on top of data that showed the US economy grew by a meagre annualised 0.7% in the first quarter, and the recent tightening of China’s credit conditions, the latest slide in commodity prices has been interpreted by some as the harbinger of slower global growth. That is overly pessimistic. The current weakness in the commodity complex does not foreshadow any renewed weakness of demand. Rather it reflects more rational expectations of future supply-demand dynamics.
First, demand: Although Gavekal’s Will Denyer has recently expressed reservations about the health of the US economy, his bearish view is very much a minority position. In contrast, most observers—and the commodity markets—regard the first quarter’s weak growth as a seasonal aberration, and continue to forecast solid demand over the remainder of the year.
In China too, the outlook is benign. Sure, the authorities have recently moved towards an administrative tightening of credit conditions. But while that is likely to cool property sales, the drawdown of housing inventories over the last 18 months will ensure that activity in the all-important construction sector will remain brisk. As a result, no significant decline in China’s underlying demand for key commodities is likely.
With Europe’s cyclical upswing gaining momentum, and growth in the emerging economies of Asia looking increasingly self-sustaining, the global demand picture for commodities is thus undimmed.
So if the demand picture has not changed, the latest slide in commodity prices can only be attributable to a reassessment of supply conditions. Indeed, the slump in crude oil prices has come as traders have reevaluated the prospects of further supply cuts by the major OPEC producers. Although the cartel is set to extend the cuts agreed last November when it meets in Vienna in three weeks, no additional reductions are on the cards.
For Saudi Arabia, the world’s major low-cost producer, the production cutback implemented at the beginning of this year is beginning to feel uncomfortably reminiscent of the episode in the mid-1980s, when it also curtailed production in a bid to support prices. On that occasion, Riyadh’s cuts did little to push up prices, but they did allow other producers to seize market share.
This time around the big beneficiaries are US shale companies, which lost no time in ramping up production to take advantage of last year’s rebound in oil prices, and Saudi’s geostrategic rival Russia, which is currently pumping a record 11.5mn barrels a day and looks set to pump even more as summer sets in.
Any further OPEC production cuts would simply hand a gift to Saudi’s competitors. As a result, Riyadh will opt to safeguard its existing market share rather than attempt to push prices higher. As the market has come to terms with this reality, investors have trimmed their bullish oil bets. Net-long positions in Brent crude futures fell 30% over the two months to late April, with further liquidation propelling yesterday’s slide below US$50/bbl.
Futures liquidation also explains much of the ongoing rout in Chinese commodity prices. Underlying end-user demand for industrial commodities remains solid. But in recent months speculation on China’s commodity exchanges has run well ahead of reality, leading to a massive upside overshoot in futures prices.
Unnerved by the pace of financial speculation, the Chinese authorities have launched a regulatory crackdown over the last couple of months. Against a backdrop of record inventories, this administrative tightening has precipitated a 30% decline in iron ore prices since early March, with corresponding, although less spectacular, falls in other commodity prices.
As a result, the recent down leg in global commodity prices does not portend an ominous slowdown in global growth. Rather it represents a more rational view of commodity supply-demand dynamics on the part of financial markets. Outside the narrow commodity sector and resource-producing economies, it should, therefore, be regarded as an unalloyed positive, not something investors need to be worried about.
This article is reproduced by the kind permission of GavekalReseach. [Source: GavekalResearch - Tom Holland - May 5, 2017]
MitonOptimal House View:
“I have no issue with the analysis, but conclusions are always guesstimates at best – especially when you are trying to predict human behaviour!”
“Trying to interpret the implications of the global supply glut – and commodities is just one of these gluts – think of motor cars, air tickets, smartphones and computers, etc. As with oil, there is a surfeit of supply in many areas of the economy. Until that inventory is sold off, prices will remain under pressure.”
Andy Pfaff – Head of Commodities
