Outlook 2016: Commodities
After five years of declines, the commodity bear market is long in the tooth and we certainly expect bullish surprises, when they occur, to trigger strong recovery rallies in 2016 and beyond.
11 January 2016
Commodity investors suffered in 2015 as major headwinds continued, primarily the strengthening dollar and the weakening Chinese economy.
In the energy market, the new Saudi-led OPEC market share policy drove oil prices much lower than many expected, while weather played an unusually important role too, reducing demand for both oil and gas in the US and Europe and supporting near-record production of grains and oilseeds worldwide (to date the effects of the record-breaking ‘El Niño’ have been benign).
Looking ahead, three key catalysts for bullish surprises can be highlighted:
- Geopolitics: historically important to commodity investors but now almost completely forgotten. It is a matter of time before disruption to commodity trade flows occurs again – most likely energy or food-related in the Middle East and/or Russia. In the past quarter, Turkey joined the list of countries in dispute with Russia, while pressure on Saudi Arabia’s rulers continues to grow.
- US dollar: with currencies being difficult to forecast, the confident consensus of further dollar gains seems inappropriate, even foolish, especially when observing the Federal Reserve’s tortuous interest-rate deliberations. When the dollar turns, commodities could surge.
- Supply/demand balances: this extended period of declining prices is setting the stage for a return to supply/demand balance across a range of commodities. Distress amongst miners and energy producers accelerated in Q4 and the inevitable adjustment to supply will likely be extended. US natural gas, which has recently been trading below the cost of production of even the most efficient producers, is a prime example.
Energy looks like the sector with the greatest potential for price appreciation in 2016, although risks remain in the short-term.
The big surprises for the oil market in 2015 came on the supply side: first, production in the US and other non-OPEC nations held up much better than expected; and second - more significantly - OPEC production actually increased, led by Saudi Arabia and Iraq.
With oil priced at $35/barrel, it is more likely than ever that US production will fall steeply in 2016, and commence declines in many other regions too.
Further potential gains from OPEC producers – primarily Iran but possibly Libya too – will be insufficient to outweigh non-OPEC declines in the medium-term.
Assuming global demand continues to grow at a modest rate, therefore, it is logical to forecast a solid price recovery as the year progresses.
The problem for oil remains in the short-term.
The recent disastrous OPEC meeting, which confirmed a production “free-for-all” (no quotas nor overall target), gives rise to the possibility of higher OPEC output in Q1 2016.
The favourable shift in the supply-demand balance that we foresee in 2016 could, therefore, be delayed.
Thus further downside risk remains in the short-term but an eventual strong recovery towards $60 (i.e. +70%) appears inevitable once supply gains have peaked out.
Mild weather killed any chance of a rising US natural gas price in recent months.
However, there is a clear shortage of gas developing in the medium-term (1-2 years) – a bullish outlook reinforced by the recent fall in price.
We project a severely undersupplied market by the end of 2016, offering gains of 30-40% on a 12-month view.
EU gas could also benefit from renewed Russia-Ukraine tensions.
The outlook for base metals remains dominated by China.
We remain cautious, although the potential exists for short-covering rallies, particularly in nickel.
Base metals stabilised recently as short positions were covered due to signs of supply adjustment.
However, a constructive view will not be justified until we can be confident Chinese demand has bottomed, or supply cuts are deep enough to engineer deficits and inventory drawdowns.
We are some way from this point and thus we believe prices can still make new lows.
Potential downside remains highest in copper; largest upside potential is in nickel.
In China we face a backdrop of a still-high investment/GDP ratio, high housing inventory and limited deleveraging.
As a result, the risk that demand again disappoints market expectations in 2016 is high.
However, as the central government makes aggressive efforts to reduce overcapacity in 2016, the reduction of credit to loss-making productive capacity will become an important offset to weaker demand.
Indeed, announced closures in the zinc and copper industries, combined with closure of high-cost, small-scale supply is leading to a tightening in underlying concentrate markets.
Supply-side behaviour highlights that we are much closer to the bottom of this cycle than a year ago.
Aggressive debt cutting, cancelled dividends, and spot prices below costs of production all suggest a clearing market.
In 2016 gold could benefit from an increase in geopolitical or macroeconomic concerns, or from any weakening of the dollar.
In gold, a key question is whether the market’s focus will shift in 2016 from its recent obsession with US interest rates and the dollar to a focus on demand and supply.
Although this is likely to be delayed, a greater focus on US real rates is probable; recovering inflation will keep real rates suppressed, supporting gold.
We also believe the macro risk environment is underestimated; gold could gain anytime there is increased pressure on major equity indices, stress in high-yield markets or a further ratcheting up of China’s financial crisis.
Platinum fundamentals remain neutral. A very weak rand (moving from 11.5 to over 15 to the dollar in 2015) has delayed supply adjustments in South Africa (70% of global platinum mine supply).
Moreover, investor sentiment was seriously impacted by the VW scandal (implies less demand for diesel vehicles) and sizeable ETF liquidations followed in September/October.
The impact of the VW scandal, however, is likely to be less than initially feared.
Nevertheless, the market is carrying high inventories; evidence of inventory draws and confidence that the market is in deficit ex-investor demand is a pre-requisite for a sustainable price recovery.
2016 is expected to be a turnaround year for major agricultural commodities, and prospects for price rises in some are already good: rapeseed, palm oil, cocoa, sugar and rubber.
Three key themes will be supportive for agricultural markets in 2016:
- Weather: the strong El Niño, currently being experienced, will likely turn into La Niña in 6-12 months. Periods of La Niña are typically associated with lower agricultural yields.
- India: current planting difficulties for grains, oilseeds and sugarcane could result in the country turning into a major importer of agricultural commodities once again.
- China: meat production fell recently and could result in a rise in pork and poultry imports.
The negative fundamentals for the grains and oilseeds markets (i.e. large global crops and inventories, export competition, slowing Chinese demand, freight disadvantage for US products and the strong US dollar) are continuing, but are now largely factored into prices.
The fundamentals for vegetable oils are turning bullish due to lower palm oil yields and growing Indian imports.
We expect palm oil to continue to be the outperformer in the oilseeds subsector, followed by European rapeseed and Canadian canola.
We rate cocoa as neutral-to-bullish as low supplies are balanced by lower grinding.
The coffee market should continue to trade sideways barring any changes in the prevailing weather in Latin America or in other major growing countries, though we favour Arabica compared to Robusta, where stocks remain high.
Fundamentals for sugar, which rose 20% in Q4 2015, are turning supportive for prices given crop reductions in some major producing countries and there are expectations of a global deficit in 15/16, the first in six seasons.
An increasing number of animals, growth in their average weight and low US exports shaped the negative picture for meats in 2015.
Bearish factors appear now to be reflected in prices and we expect these markets to trade sideways during Q1 2016.
However given the fall in Chinese meat production, a sudden increase in imports of pork and poultry is likely in 2016 and could well be bullish for this subsector, especially if the dollar weakens.
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