The Hindu Business Line : Signals for commodity boom to continue in 2006

A STRONG performance of the commodity markets around the world in 2005 has raised expectation of a similar dream run in the current year too. Whether the boom will sustain or not, time will tell. However, tracking factors that are known to impact the market can be helpful to an extent, in unravelling the market's mysterious dynamics.

Based on the global demand and supply situation for a range of commodities covering energy, base metals, precious metals and agricultural goods, there is broad consensus that significant gains could still be expected in 2006 for annual average prices, in particular energy and metals prices.

There is also the suspicion that the broad upward trend in commodities may be coming to an end. So, what are the points to watch in early 2006?

In its latest report on market outlook and main commodity themes for early 2006, Barclays Capital Commodities Research has the following to say: Investment flows into the market would be a decisive factor. Currently, hedge funds positions in commodities suggest that there could be greater volatility in the market than before. Hedge funds are heavily exposed, both long and short. Funds are very long on precious metals and agricultural commodities, neutral in industrial metals and short in energy. Demand for strategic commodity investments is expected to stay high. In 2005, such investment topped $80 billion. Retail and institutional interest in gold has already climbed sharply in early 2006. Surveys have suggested that strategic investors would raise their exposure in 2006 and beyond.

Economic activity looks positive around the world. In the US, economic growth is expected to be above trend and energy demand is still growing. With retail prices falling back sharply, gasoline demand has strengthened again.

In China, better balanced growth points to strong prospects in 2006. While fixed asset investment and retail sales are stabilising at high levels, strong rebound to China's car sales is evident. Oil import growth will accelerate in 2006 and depleting stocks will be rebuilt. In Europe and Japan, the industrial outlook has strengthened decisively as manufacturing activity expands. German business climate is at its best since the year 2000.

Currencies need to be watched. Dollar weakness would add further strength to commodity prices. The usual inverse relationship between the dollar and commodities was broken in the second half of 2005. During the year, strong commodity fundamentals offset the influence of rising dollar. More dollar weakness is expected in 2006. According to Barclays Capital, the year-end target for the dollar is 1.26 versus the euro.

Geo-politics is another area of concern as perception of risk is getting ratcheted up again. Iraq oil production and export continue on their downward trend, while sabotage attacks in that country worsen. Reports of Iran planning to restart nuclear fuel add to uncertainty and concerns.

Russian reliability as energy supplier is becoming suspect.

Supply-growth and uncertainties relating to supply need to be watched closely. Costs of bringing new supply on-line are soaring. Oil supply is struggling to meet demand. The upward trend in oil refinery construction costs is accelerating. Forecasts of copper mine output got slashed in 2005 and cuts are already made in 2006. Costs of building new copper mine capacity have risen dramatically in past 12 months. Very little growth in global oil refining capacity is scheduled for 2006.

While oil production growth may continue to disappoint, further cuts in forecasts of metal supply growth could be in store.

The vulnerability to shock may well be the defining feature of the market for 2006. In key metals and energy sectors, the cushion of spare capacity and inventory is rather low. For instance, OPEC spare crude oil production capacity has fallen to less than one million barrel per day. Metals inventory is at its lowest level since late 1980s.