Commodities

How the second half will be for commodities this year

Pravin Chandrasekaran | Updated on July 23, 2014 Published on July 23, 2014

Cocoa may bet the only agri commodity with a bullish story.SHUTTERSTOCK.COM/THANWAN SINGH PANNU

It will support lower prices, volatility and pose challenges to all market participants



Commodity markets are generally perceived to be fraught with risk given the volatility commodity prices demonstrate. And 2014 has been a year of contrasts. The year began with an extremely bullish situation in the grain and oilseed markets, pushing prices to new highs. In addition, the weather premium was built into prices of fears of El Niño striking later this year. Low inventories of some commodities such as soyabeans exacerbated conditions.



Mid-year, everything has turned around. The weather has been extraordinarily good in the North American continent. The dry and hot conditions expected in South America that could have pushed the sugar prices higher has not turned out as bad as feared. Rainfall from the Indian monsoon isn’t great, but it isn’t that bad either. Overall, the weather premium has now been taken out of the market. Next, in an ex-post manner, we witnessed that with high prices there was demand destruction last year, resulting in a build up of inventories this year. Combined with that inventory, higher production levels are now pushing prices down in these markets. In addition to the rather cookie cutter story of weather, supply and demand, let us also consider some other events that are shaping the markets.



First, crises in Syria, Iraq, Israel and Ukraine besides the Indonesian elections seem to be have had little impact on the crude oil market. Volatility is at 15 per cent, and Brent crude is in a contango. Both of these events are a function of large supply of crude oil.



Second, most of the agricultural markets do not have a bullish story for the rest of the year, barring cocoa. We could see some sudden upswings in cocoa, especially supported by a robust global demand. Grains, oilseeds, sugar etc. look neutral to bearish.



Third, the story of tightening in monetary policy in the US has been pervasive for many months now, but one hasn’t seen this happening yet. That being said, it is more of a question when will it happen and not whether it will happen. In general, lower interest rate regimes endorse higher commodity prices and higher interest rates push commodity prices down. This is a generic statement based on cost of holding inventories and assuming all commodity ownership is fully debt financed. Thus, we should see interest rates rise, commodity prices fall, and the dollar appreciate.



Fourth, while a fall commodity prices should enhance demand structure, this may not happen very soon. The first effect of rising developed market interest rates will be a depreciation of currencies of commodity-importing countries. This means the importing country’s income effect will surpass the price effect in the short run, creating demand destruction further and pushing the prices further down.



Fifth, there have been many inventory finance and repo deals in China that the Chinese government wants to unwind. The unwinding of structured finance transactions will lead to a fall in commodity prices.



In summary, we will see second half of the year to support a lower commodity price and volatility regime, posing challenges to all market participants. Traders will find it difficult to make returns. Consumers will buy short-term, leading to under-hedging. Importing countries will find it difficult to manage the currency depreciating effects on the import bills. Commodity exporting countries will find it difficult to generate revenues will lower prices. Financial institutions will find lower commodity deal flow.



All the above sound pessimistic, but there is an opportunity here to capitalise. The key to overcome this short run situation is to have a vision and focus on the longer-term picture now. This will be a great time to invest in commodity assets, build capacities for future, shut down units for maintenance, and invest in Data Science!



(The writer is based in London and is the founder and Managing Director of OpalCrest (www.opalcrest.com).)

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Published on July 23, 2014
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