The Opportunity in Weak Commodity Prices

Commodity prices in the markets – especially for crude oil — continue to face headwinds from excess supply and uncertainties about divergent monetary policies. But nascent positive trends give commodity markets a more balanced outlook, in our view.

Looking into the end of the year and into 2015, we feel investors should use the recent price pullbacks to take commodity allocations towards their long-term target allocations. We recommend an allocation split evenly between a broadly diversified position and another in energy (crude oil, refined products, and natural gas).

For the past two months, investor anticipation of new and large monetary policy stimulus in Europe and Japan has rallied the U.S. dollar and raised the cost of raw materials in local currencies. In addition, worries about excess commodity supplies accompany slipping global economic data.

We think the impact of these factors is overdone. During the coming weeks, expectations for dollar strength should moderate. The excess supply problem also seems to be resolving, especially in base metals, where miners are cutting production quickly and global markets are gradually rebalancing.

The crude oil market is particularly concerned about excess oil supply and the strong U.S. dollar. After touching $115/barrel in June, the price of benchmark European Brent crude oil fell by $35/barrel by early October, finishing below $100 for the first time since political turmoil erupted in Egypt in 2011. The decline seems unjustified based on our supply and demand outlook, and we advise investors to be careful about assuming $80/barrel oil prices are here to stay. For example, the last $12 of oil price declines came as the dollar also declined this month.

It is also risky to assume that OPEC and U.S. supply will become permanent sources of excess supply. Extra U.S. production does not add much to new excess supply. If OPEC would only cut by 500,000 barrels per day (1.5% of their daily output), it could effectively erase the contribution of this year’s gain in U.S. production. So why doesn’t OPEC cut? For perspective, oil prices are still in their four-year trading range of $80-$120 per barrel, and the collapse from $90 came quickly – possibly too quickly for OPEC’s factious members to form a consensus. Since the mid-1980s, OPEC has tried to steady oil prices, and potential price spikes are material risks – for example: if the Libyan production recovery falters and ISIS threatens large production facilities.

Our monthly review of the major commodity sectors follows next:

Energy: Energy prices continue to drag on concerns of excess crude oil supply and weak seasonal demand. However, seasonal petroleum and natural gas demand is poised to pick up, and consumption is still growing globally — especially from strong Chinese automobile sales — and should accelerate with improved global economic growth next year. We revised lower our 2014 year-end target for West Texas Intermediate crude oil to $90-$95 per barrel to account for temporary uncertainty and expect a rebound into year-end, followed by single-digit 2015 returns.

Base metals: Base metals prices have fallen with the rising U.S. dollar, and weakening global manufacturing demand and falling real estate prices in China have sapped the construction consumption of industrial metals. However, 2015 global demand prospects look better, and miners are slashing output faster than we previously thought they would.

Precious metals: Demand for platinum and palladium for catalytic converters has supported these markets somewhat, but no supply-demand rebalance is likely for gold and silver, which remain vulnerable to potentially higher U.S. interest rates sooner rather than later. Investors should use any gold or silver price rebound to reallocate into a diversified commodity position.

Grains: The wet weather in the U.S. Midwest has slowed the harvest and boosted the soil conditions for wheat planting. As a further negative for price, robust foreign demand for corn and soybeans may fail to counteract excess supply and the strong dollar and put U.S. farmers at a competitive disadvantage.

Soft commodities (primarily tropical agricultural products): Sugar and cotton prices are weighed down by large global supplies and record global production, but coffee, cotton, and cocoa face drought-related supply constraints in Brazil, Australia, and Africa. Moreover, U.S. producers are not the largest of all these products, so the dollar’s strength is not uniformly negative.

Live cattle and hogs: Cattle and hog prices have fallen back from recent highs on signs that feed costs may soon decrease encouraging larger herds. However, strong foreign demand and tight supplies may keep prices elevated in the near term.

Investment recommendations

We believe the worries about slow global growth are overdone and that assumptions of sustained excess commodity supply ignore the production reductions already in progress in metals, as well as the potential for OPEC to cut its production significantly.

We lowered our year end 2014 target last week, after Saudi Arabia announced it would not immediately adjust its production. Our new target is $90-$95/barrel, down from $101-$105/barrel for U.S. West Texas Intermediate crude oil.

We would still be neutral commodities overall and continue to expect seasonal factors to give natural gas and petroleum a boost towards our target in the coming weeks.

Source : Barrons

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