Oil and Italy were the main themes last month.
Oil and Italy were the main themes last month.
Macro Letter – No 82 – 01-09-2017
Does the rising price of industrial metals herald the beginning of the next commodity super-cycle?
In a 2012 paper for the United Nations/DESA – Super-cycles of commodity prices since the mid-nineteenth century – Bilge Erten and José Antonio Ocampo review the literature on the theory of Commodity Super-Cycles and go on to suggest that the current cycle began in 1999. Here is an extract from their concluding remarks:-
The decomposition of real commodity prices based on the BP filtering technique provides evidence of four past super-cycles ranging between 30 to 40 years. For the total real non-fuel commodities, these cycles have occurred (1) from 1894 to 1932, peaking in 1917, (2) from 1932 to 1971, peaking in 1951, (3) from 1971 to 1999, peaking in 1973, and (4) the post-2000 episode that is still ongoing. These long cycles, which possess large amplitudes varying between 20 to 40 percent higher or lower than the long-run trend, are also a characteristic of sub-indices. Among the agricultural indices, the tropical agriculture exhibits super-cycles with much larger amplitude relative to non-tropical agriculture. The amplitudes of super-cycle components of real metal and crude oil prices are comparable to those of agricultural products in earlier parts of the twentieth century, but they become much more pronounced and strong in the latter parts of the century. The presence of co-movement among non-fuel commodity indices is supported by the correlation analysis across the entire sample, and a marked co-movement between oil and non-oil indices is present for the second half of the twentieth century.
Another important finding of the paper is that, for non-oil commodities, the mean of each supercycle has a tendency to be lower than that of the previous cycle, suggesting a step-wise deterioration over the entire period in support of the Prebisch-Singer hypothesis*. This finding applies especially to tropical and non-tropical agricultural prices, as well as metals in previous cycles. An exception to this rule is that of metals during the current super-cycle, when the mean last cycle is higher than the preceding one; however, the contraction phase of this cycle has not even began yet, which can lower the mean of the whole cycle in the upcoming years. Another way of capturing these trends is through long-term trends, with tropical agricultural prices experiencing a long severe long-term downward trend through most of the twentieth century, followed by non-tropical agriculture and metals. The duration of the long-term downward trends across all non-fuel commodity groups is on average 100 years. The magnitude of cumulative decline during the downward trend is 47 percent for the non-fuel commodity prices, with recent increases of around 8 percent far from compensating for this long-term cumulative deterioration. In contrast to these trends in non-oil commodity prices, real oil prices have experienced a long-term upward trend, which was only interrupted temporarily during some four decades of the twentieth century.
The recent commodity price hike of the early twenty-first century has commonly been attributed to the strong global growth performance by the BRIC economies, and particularly China, which is particularly metal- and energy-intensive. Based on the VECM results, it is found that super-cycles in the world output level are a good predictor of the super-cycles in real non-fuel commodity prices, both for the total index and sub-indices. This finding confirms that the global output accelerations play a major role in driving the commodity price hikes over the medium run. Therefore, the ongoing commodity price boom could last only if China and other major developing countries are capable of delinking from the long period of slow growth expected in the developed countries.
* Prebisch-Singer hypothesis – suggests that over the long run the price of primary goods such as commodities declines in proportion to manufactured goods.
What is clear from this research is that commodities are far from homogeneous. A strong trend in industrial metals may not coincide with a strong trend in tropical soft commodities or North American grains. Nonetheless, the idea of the super-cycle is beguiling, because it ties the demand for all commodities to economic growth. The Russian economist Nikolai Kondratiev (1892-1938) developed a theory of Long Waves in the early 1920’s. He discarded exogenous factors, such as wars and revolutions, in favour of endogenous drivers, like technological advances and capital accumulation. The Austrian economist Joseph Schumpeter took these ideas further, developing his theory of ‘Creative Destruction’.
From Theory to Practice
Enough of the theory, where are we now? To answer this I will start with one of my favourite charts, one which regular readers have seen before:-
This chart shows commodity prices between 1850 and 2005, adjusted for inflation. Schumpeter’s theory of Creative Destruction looks compelling; periods of high commodity prices spur innovation which leads to a lowering of prices in response to productivity gains.
Since 2008 the Bloomberg Commodity Index has weakened:-
Source: Bloomberg, Financial Times
The above chart – which is not inflation adjusted – shows the current commodity super-cycle since January 1999. The meteoric rise, the impact of the Great Recession of 2008-2009, the subsequent rebound, as QE kicked-in, and the continuation of the downward trend, marking a complete retracement of the upward move from 1999 to 2008, are all clearly evident. Now a number of commodities have begun to rise simultaneously.
Has the period of creative destruction run its course and permanently reduced supply? Or is the current rebound merely a shorter-term correction which, through higher prices, will encourage new capital investment in productivity enhancing techniques which will rapidly lower those prices once more – 17 years, after all, would make this the shortest super-cycle to date? To answer these questions we need to consider the state of the world economy, especially the growth potential of emerging and developing countries.
The Global Economy and Commodity Demand
Global economic growth has been muted during the past decade. The chart below shows World GDP growth from 1999 to 2015:-
Source: Trading Economics, World Bank
Recent data – and forecasts – from the IMF, suggest that drivers of global growth are changing. Here is an extract from the IMF WEO for July:-
The pickup in global growth anticipated in the April World Economic Outlook remains on track, with global output projected to grow by 3.5 percent in 2017 and 3.6 percent in 2018. The unchanged global growth projections mask somewhat different contributions at the country level. U.S. growth projections are lower than in April, primarily reflecting the assumption that fiscal policy will be less expansionary going forward than previously anticipated. Growth has been revised up for Japan and especially the euro area, where positive surprises to activity in late 2016 and early 2017 point to solid momentum. China’s growth projections have also been revised up, reflecting a strong first quarter of 2017 and expectations of continued fiscal support. Inflation in advanced economies remains subdued and generally below targets; it has also been declining in several emerging economies, such as Brazil, India, and Russia.
The IMF goes on to opine that, despite the stable outlook for 2017/2018, global growth remains below pre-crisis levels for the majority of advanced economies and, more importantly, for commodity-exporting emerging and developing countries. These tentative conditions seem unlikely to favour the beginning of a sustained upswing in commodity prices, nonetheless, prices, especially for industrial metals, have shown impulsive strength. The chart below compares the Bloomberg Commodity sub-indices over the past year, industrial metals appear to be the only game in town:-
Even these sub-indices mask some individual trends. Palladium, a constituent of the precious metals index, made a 16 year high at $945/oz. on 29th August – up 122% from its January 2016 low. Lesser known PGMs, Ruthenium and Rhodium are both up more than 60% in the nine months to May 2017. Copper, the bellwether of industrial metals tested $3.08/lb, its highest since October 2014. LME 3 month Aluminium traded $2,121.75/ton, the highest since February 2013 and 3 month Zinc traded $3,179.50/ton, its highest level for a decade.
Mining companies have rallied in the wake of these higher prices. Market commentators argue that a combination of tight supply and increased demand, especially from China – whose growth forecast was revised from 6.2% to 6.7% by the IMF last month – are the principal near-term factors behind the rally. Additional factors include the relative weakness of the US$ and a, widely anticipated, more hawkish, central bank stance on interest rates.
A fascinating analysis on the relationship between Chinese growth and commodity prices is contained in this article from Jodie Gunzberg of S&P – Chinese Demand Growth Lifts Every Commodity:-
Overall the S&P GSCI only moves in the same direction as Chinese GDP growth changes in about 57% or 26 of 46 years. However, when the Chinese GDP growth is split into rising and falling periods, commodity returns seem to be more influenced by rising growth than slowing growth. Of the 46 years, growth rose 19 times with 15 or 79% positive annual commodity returns. The slowing growth years were much less influential, driving down commodity performance in only 11 of 27 years, or in 41% of time. Though, big negative years like in 1976, 1981, 1986, 2008, and times with consecutive years of falling growth like in 1997-98, 2013-15 seemed to bring commodities down.
Ms Gunzberg goes on to look at the breakdown by sub-sector, finding that only Livestock and Agricultural commodities which fall in response to a decline in Chinese GDP growth. The table below, which drills down to the behaviour of individual commodities, is particularly instructive:-
Source: S&P Dow Jones Indices
Some industrial metals, such as Lithium – used in the manufacture of lightweight car batteries – have seen a dramatic increase in underlying demand. It has risen from a low of $62/ton in February 2016 to $122/ton this week. However, an entire range of other industrial metals has also witnessed rising prices over the past 12 months:-
Source: Trading Economics, Infomine
In an attempt to answer my initial question I quote from PWC – Mine 2017 – Stop, Think…Act –
In 2016, traditional players continued balance sheet bolstering to calm the market and stop the angst associated with financial distress. A heavy emphasis was placed on shedding debt. The brakes were firmly applied to exploration activities which continued to shrink, and what little was undertaken was generally allocated to “safe” jurisdictions. Capex fell dramatically again, by a further 41 percent, to a new record low of just $50 billion, and there was a lack of significant greenfield projects announced or commenced. Production was generally flat. While the Top 40 faced external headwinds in the form of increased oil prices, prudent cost control measures ensured operating expenditure was constrained. Traditional miners were rewarded with a strong upswing in their market cap, and earned some breathing space. Many planned disposals were called off in response to better market conditions. The exception to this was the 11 Chinese companies within the Top 40. China defied conventional industry behaviour and invested at the bottom of the cycle. Indeed, the most significant asset buyers among the Top 40 were Chinese companies.
In the short term, shareholders may appreciate the strengthening of balance sheets and increases in share prices. But the industry will need to execute a longer term vision or it will remain at the mercy of commodities speculators. Shareholders will demand performance from the existing asset base, culminating in dividends, or they will simply reallocate their capital if the mining sector cannot provide a long-term growth vision. There is clearly a divergence in thinking between Chinese companies and the rest of the Top 40 as their goals are different and Chinese capital is more patient. China aside, the old guard have donned hard hats, high viz jackets and steel-capped boots in a bid to protect themselves from the pitfalls of the recent past. Praise should be given for the efforts to repay debt, innovate and adopt new efficiency measures – all of which have helped to curb costs and restore credit ratings and investor trust. But where will this thinking take the industry if a “playing it safe” attitude to investment prevails in the future? We argue that it will lead back to old habits of lavish spending in a boom followed by a wave of write-offs during the bust that inevitably follows.
Balance sheet clean-ups require discipline and much hard work has been done. We witnessed the tailing-off of impairments, the avoidance of any new bankruptcies, the absence of any significant streaming transactions and the general passing of distress. The market rightly applauded this, reinstating a positive gap between market caps and net book values that was absent in 2015. Healthier price-to-earnings (P/E) multiples returned. And, even as price growth slowed early this year, valuations continued to rise until April. This provides a platform for the industry to act into the future. What we failed to see was significant action on the future direction of the Top 40, at least by the traditional players. We’ve called the industry out in the past for reacting to short-term price movements, and thankfully this did not happen in 2016. Is the pause an indication of longer term thinking by the industry? One major (Rio Tinto) may think so. Recognising the long-term, cyclical nature of the industry, it has publicly stated that its new CEO has a “10-year mandate…Emerging market companies, who are also focused on new world minerals, are increasingly integrated. In the traditional markets, we are seeing new players seeking to secure supply and even calls by stakeholders for BHP to get on board the battery train. It remains to be seen if a major will pivot in this direction. What will be the results of this reflection for the remainder of 2017? Will action come in the form of investment in greenfield projects, M&A or technology? The latter, we think, simply cannot be ignored. Aside from the completion of new projects, none of the majors has signalled bold intentions for future growth. But who could blame them when early 2017 has heralded further volatility in prices and the subsequent reversal of some of the 2016 gains. Few things are certain in this industry, but we know that China is unwavering in its strategy, shareholder activism is rising, government interventions are becoming more commonplace and new players are disruptive. Will the industry also act, or simply react?
Conclusion and Investment Opportunities
It is too early to predict the beginning of a new up-trend in the next commodity super-cycle, however, mining companies, outside of China, have reduced capital expenditure over the last few years and, given the long lead times in the mining industry, the current uptrend in prices is probably a function of supply constraints, emanating from a lack of investment, combined with a marginal increase in global demand. I believe, however, that this trend can continue for some while. Inflation in the US and Europe remains subdued, deflation remains a near and present danger in Japan; therefore the major Central Banks are likely to maintain a low interest rate regime. The current long economic expansion will continue for a while yet.
During the last major uptrend in commodity prices, China was the main source of additional demand. Since announcing their 12th Five Year Plan in March 2011, China has adopted a policy of ‘Rebalancing’ towards domestic demand, away from mercantilist export oriented growth. Under this new regime, the services sector should expand faster than manufacturing and demand for raw materials, such as industrial commodities, should decline structurally. July saw the publication of a new paper from the IMF – Financial Development Resource Curse in Resource-Rich Countries: The Role of Commodity Price Shocks – it develops some of the ideas contained in the Prebisch-Singer hypothesis. I suspect the Chinese authorities have known the advantage of diversifying their economy away from basic materials from many years. Barring a significant increase in demand from other emerging and developing economies, such as India, the current up-trend in industrial metals is likely to be relatively short-lived, another year to 18 months should see new capital expenditure deliver increased supply. Prices will diminish.
Individual industrial commodities, such as Cobalt and Lithium, will see higher prices, even from their current elevated levels, due to structural demand increases. Other industrial commodities will be more likely to revert to mean as new supply meets global demand over the next couple of years.
Macro Letter – No 81 – 21-07-2017
Has Bitcoin come of age?
Bitcoin (BTC) came into existence in January 2009. It was not the first ‘cryptocurrecny’ and there are now an estimated 950 competitors, with new ICO’s ‘Initial Coin Offerings’ appearing almost daily.
BTC’s closest rival in terms of coins in circulation is Ethereum (ETH). The chart below shows how these currencies % of total market capitalisations has waxed and waned:-
I want to concentrate on BTC since it remains the market leader with a total circulation of $33bln (reference BTCUSD 2000) whilst the outstanding issuance of its nearest rival ETH is $16bln.
Below is a four month chart of BTCUSD, its price has fallen by almost one third in just over a month:-
The recent price action needs to be seen in a broader context. The price has increased from less than BTCUSD 1000 in late March. On April 1st the Japanese authorities officially recognised BTC for the first time: perhaps, this was the catalyst for its spectacular rise.
The subsequent precipitous decline in price may be related to a proposed software change to be introduced on 21st July, known as SegWit, which is discussed in Cryptocurrency Value: Growing Pains or Something More? By Ryan Shea – here’s the rub:-
SegWit2x software, which introduces SegWit while doubling the block size to 2MB, will be released on July 21. More than 80% of the network hash rate has agreed to run the SegWit2x code, which suggests that the solution to increasing bitcoin’s scalability will be enacted smoothly.
However, it is also possible that the hard fork required to increase the block size leads to a bifurcation of bitcoin into two separate currencies –something that would unquestionably trigger a sharp price correction by undermining the bitcoin brand. (The key date by which a split can be avoided is August 1 when BIP148 activates – this represents the last opportunity for miners to accept Segwit2x and thereby avoid a chain split resulting in the creation of two parallel bitcoins.)
There have been victories and defeats during the evolution of BTC, as it has evolved from an obscure novelty to a serious contender for investors seeking a store of value. The price volatility reflects these uncertainties but it is not demonstrably different from the volatility seen in several commodity markets.
For a security, commodity or a currency to gain credence, among financial market operators, it needs to offer a store of value, liquidity and convertibility. If can achieve these attributes it should have collateral value, by which I mean, BTC should be capable of being borrowed or lent. This is already happening. Some cryptocurrency exchanges are offering a rate of interest on term deposits and others offer the opportunity for holders of BTC to lend their currency to traders who wish to borrow it, primarily to sell the currency short. Whilst there is not really a ‘risk-free rate’ for BTC an interest rate term structure is beginning to emerge as the table below, derived from a number of exchanges, shows:-
There may well be other exchanges offering a variety of differing interest rates. but this, I hope, provides a snapshot of the current environment.
The other aspect of financial deepening which will help BTC come of age is the development of a derivatives market. I believe the arrival of exchanges for BTC futures and options is a very positive signal.
The futures exchanges include Okex, CryptoFacilties, BitMEX, BitVC, Coinut and Deribit which also offers options – there may be several others. Today (Monday 17th July) I have taken some snap shots of the futures and options pricing from Deribit.
With the BTCUSD spot price at 2027, the July future (expiration 28th July) traded at a discount of $12 ($2015) this is known in futures parlance as a backwardation. The September contract (expiration 29th September) was, by contrast, trading at a premium, or contango ($2070). Because of high demand from leveraged traders to borrow US$ to buy BTC the forward/futures price of BTCUSD normally trades at a premium (contango). The current environment is unusual, the forced liquidation which has fuelled the recent collapse in the price has led to, what is likely to be a temporary, backwardation. John Jansen – CEO of Deribit – explained the anomaly during a recent interview:-
…when the market is bullish, US$ interest rates spike up and BTC interest rates go down: uses want to borrow USD to buy BTC. In other words, short USD and go long BTC…there is an overall tendency for speculators to be long, therefore, the arbitrage traders are short BTC (lending out their USD) or short the future. USD interest rates are, therefore, normally higher than BTC rates which explains the contango in BTCUSD futures prices.
…on BTC platforms, annualized interest rates on US$ are on average maybe 20%…which would imply that the future should trade at a 20% annualized contango. Arbitrage traders take the other side of the trade…but get paid for their trouble.
Over time I expect the BTC market to become more efficient and the natural relationship for BTC futures should (other things equal) eventually become a small backwardation, reflecting the 1.5% differential between lower US$ and higher BTC interest rates. There are a number of arbitrage opportunities for those who want to dig deeper, but remember credit risk, both in terms of counterparties and exchanges, together with risks surrounding convertibility are nuanced. It may not be the free-lunch you perceive it to be.
This brings me to the BTC option market. The prices in the table below are again from Deribit:-
I regret the resolution this table is less than I’d like but it shows some important features. Firstly, implied volatility is trading at a substantial premium to historic volatility. The chart below shows the evolution of historic volatility and the BTC price over the last three months:-
The July option series expires on 28th but the mid-market implied volatility for the September 29th expiration is not significantly lower – implied call volatility stands at 97%, for puts it is 85%. At this stage in the development of the BTC options market, I suspect the majority of the buyers are speculative traders rather than desperate hedgers, but option market-makers are wise to build in a margin of safety given the tendency of the underlying market price to gap lower or higher: delta and gamma hedging is challenging with these price swings. The bid/offer spreads on the options are also wide, another reflection of the nascent nature of the marketplace.
A final measure of immaturity – or perhaps I should say, opportunity – which the option market reveals, may be found in the shape of the volatility surface. The chart below is extrapolated from the mid-market implied volatilities in the table above:-
In a liquid options market one would normally expect the lowest implied volatility to be at-the-money – around the $2000 strike price. In the chart above the nadir of volatility is around the $1900 strike, a level breached briefly last weekend.
Conclusions and investment opportunities
Cryptocurrencies have captured the imagination of many new participants, from geeks to gold bugs, but, as BTC achieves greater legitimacy, the market will deepen and mature. The adoption of scalable technology to deal with the exponential increases in trading volume is a part of this process. The acceptance of distributed ledger technology across other parts of the financial services sector will also be supportive.
From a technical perspective the price of BTC has corrected by around 50% – since March it has risen from under $1000 to $3000 and is now back around $2000 (Monday 17th July). In absolute terms it has fallen by just over one third. This is a healthy price correction, typical of the price action witnessed from time to time in more liquid and established commodity markets: US Natural Gas springs to mind.
As an investment, the argument for holding BTC is more tenuous. It is a currency with no government or central bank to underwrite its value, however, the expansion of the BTC monetary base is strictly controlled, making it more like a hard currency, such as we had during the Bretton Woods era, as opposed to the endlessly debased fiat currencies we are inveigled to consider of value today.
Currencies have no implicit yield but BTCUSD currently offers a theoretical positive carry of around 1.5%. As mentioned above, this relationship is currently distorted by the demand to borrow US$ to buy BTC by leveraged traders. Any investment in an asset which has no earnings and pays no dividend/coupon/interest must by its nature be a trading asset. However, strategies such as high frequency, robotic, liquidity provision and long term, trend following, are among a number of exciting trading opportunities for the active BTC operator.
The fundamentals driving BTC investment revolve around: investor distrust in fiat currencies, loathing of government intervention in asset markets and belief in the tenability of cryptocurrencies as a lasting store of value both from a technical and regulatory perspective. These fundamental drivers of valuation have, in the past and will in the future, cause sudden repricing’s. Outside of these seismic episodes, the price of BTC will be driven by capital flows. With liquid currency pairs like EURUSD, the economic fundamentals of both geographic regions are of equal importance. This is unlikely to be the case for BTC for the foreseeable future. BTC volatility eclipses the majority of its developed currency peers; its true value, whilst it is becoming gradually clearer, will remain ephemeral for some time to come.
Macro Letter – No 80 – 30-06-2017
The gritty potential of Fire Ice – Saviour or Scourge?
On June 6th Japan’s Ministry of Economy, Trade and Industry (METI) announced the Resumption of the Gas Production Test under the Second Offshore Methane Hydrate Production Test this is what they said:-
Concerning the second offshore methane hydrate production test, since May 4, 2017, ANRE has been advancing a gas production test in the offshore sea area along Atsumi Peninsula to Shima Peninsula (Daini Atsumi Knoll) using the Deep Sea Drilling Vessel “Chikyu.” However, on May 15, 2017, it decided to suspend the test due to a significant amount of sand entering a gas production well.
In response, ANRE advanced an operation for switching the gas production wells from the first one to the second one for which a different preventive measure against sand entry is in place. Following this effort, on May 31, 2017, it began a depressurization operation and, on June 5, 2017, confirmed the production of gas.
Sand flowing into the well samples has been a gritty problem for the Agency for Natural Resources and Energy – ANRE since 2013. They continue to invest because Japan relies on imports for the majority of its energy needs, especially since the reduction in nuclear capacity after the Tōhoku earthquake and tsunami in 2011. It has been in the vanguard of research into the commercial extraction of Methane Hydrate or ‘Fire Ice’ as it is more prosaically known.
Methane hydrates are solid ice-like crystals formed from a mixture of methane and water at specific pressure in the deep ocean or at low temperature closer to the surface in permafrost. For a primer on Methane Hydrate and its potential, this November 2012 article from the EIA – Potential of gas hydrates is great, but practical development is far off – may be instructive but a picture is worth a thousand words:-
Source: US Department of Energy
During the last two months there have been some important developments. Firstly the successful extraction of gas by the Japanese, albeit, they have run into the problem of sand getting into the pipes again, which poses an environmental risk. Secondly China has successfully extracted gas from Methane Hydrate deposits in the South China Sea. This article from the BBC – China claims breakthrough in mining ‘flammable ice’ provides more detail. The Chinese began investment in Fire Ice back in 2006, committing $100mln, not far behind the investment commitments of Japan.
Japan and China are not alone in possessing Methane Hydrate deposits. The map below, which was produced by the US Geological Survey, shows the global distribution of deposits:-
Source: US Geological Survey
For countries such as Japan, South Korea and India, Methane Hydrate could transform their circumstances, especially in terms of energy security.
Estimates of global reserves of Methane Hydrate range from 10,000 to 100,000trln cubic feet (TCF). In 2015 the global demand for natural gas was 124bln cubic feet. Even at the lower estimate that is 80 years of global supply at current rates of consumption. This could be a game changer for the energy industry.
The challenge is to extract Methane Hydrate efficiently and competitively. Oceanic deposits are normally found at depths of around 1500 metres. Even estimating the size of deposits is difficult in these locations. Alaskan and Siberian permafrost reserves are more easily assessed.
Japan has spent $179mln on research and development but last week METI announced that they would now work in partnership with the US and India. The Nikkei – Japan joining with US, India to tap undersea ‘fire ice’ described it in these terms, the emphasis is mine:-
Under the new plan, Japan will end its lone efforts and pursue cooperation with others. The country has been spending tens of millions of yen per day on its tests. By working with other nations, it seeks to reduce the cost.
A joint trial with the U.S. to produce methane hydrate on land in the state of Alaska is expected to begin as early as next year. Test production with India off that country’s east coast may also kick off in 2018.
The new blueprint will define methane hydrate as an alternative to liquefied natural gas. Based on the assumption that Japan will be paying $11 to $12 per 1 million British thermal units of LNG in the 2030s to 2050s, the plan will set the target production cost for methane hydrate over the period at $6 to $7.
In the shorter term METI hope to increase daily production from around 20,000 cubic metres/day to around 56,000 cubic metres/day which they believe will bring the cost of extraction down to $16/mln BTUs. That is still three times the price of liquid natural gas (LNG).
Here is the latest FERC estimate of landed LNG prices/mln BTUs:-
Source: Waterborne Energy, Inc, FERC
You might be forgiven for wondering why the Japanese, despite being the world’s largest importer of LNG, are bothering with Methane Hydrate, but this chart from BP shows the evolution of Natural Gas prices over the last two decades:-
Japan was squeezed by rising fuel costs between 2009 and 2012 only to be confronted by the Yen weakening from USDJPY 80 to USDJPY 120 from 2012 to 2014. If Abenomics succeeds and the Yen embarks upon a structural decline, domestically extracted Methane Hydrate may be a saviour.
Cooperating internationally also makes sense for Japan. The US launched a national research and development programme in 1982. They have deep water pilot projects off the coast of South Carolina and in the Gulf of Mexico as well as in the permafrost of the Alaska North Slope.
As deep sea drilling technology advances the cost of extraction should start to decline but as this 2014 BBC article – Methane hydrate: Dirty fuel or energy saviour? explains, there are a number of risks:-
Quite apart from reaching them at the bottom of deep ocean shelves, not to mention operating at low temperatures and extremely high pressure, there is the potentially serious issue of destabilising the seabed, which can lead to submarine landslides.
A greater potential threat is methane escape. Extracting the gas from a localised area of hydrates does not present too many difficulties, but preventing the breakdown of hydrates and subsequent release of methane in surrounding structures is more difficult.
And escaping methane has serious consequences for global warming – recent studies suggest the gas is 30 times more damaging than CO2.
Given the long term scale of the potential reward, it may seem surprising that the Japanese have only invested $179mln to date, however these projects have been entirely government funded. Commercial operators are waiting for clarification of the cost of extraction and size of viable reserves before entering the fray. Most analysts suggest commercial production is unlikely before 2025. With the price of Natural Gas depressed, development may be delayed further but in the longer term Methane Hydrate will become a major global source of energy. Like the fracking revolution of the past decade, it is only a matter of when.
The history of fracking can be traced back to 1862 and the first patent was filed in 1865. In the case of Fire Ice, I do not believe we will have to wait that long. Deep sea mining and drilling technologies are advancing quickly in several different arenas. The currently depressed price of LNG is only one factor holding back the development process.
Conclusions and investment opportunities
Predicting the timing of technological breakthroughs is futile, however, the US energy sector is currently witnessing a resurgence in profitability. In their June 16th bulletin, FactSet Research estimated that Q2 profits for the S&P500 will rise 6.5%. They go on to highlight the sector which has led the field, Energy, the emphasis is mine:-
At the sector level, nine sectors are projected to report year-over-year growth in earnings for the quarter. However, the Energy sector is projected to report the highest earnings growth of all eleven sectors at 401%.
This sector is also expected to be the largest contributor to earnings growth for the S&P 500 for Q2 2017. If the Energy sector is excluded, the estimated earnings growth rate for the index for Q2 2017 would fall to 3.6% from 6.5%.
The price of Brent Crude Oil has been falling but the previous investment in technology combined with some aggressive cost cutting in the recent past has been the driving force behind this spectacular increase in Energy Sector profitability. Between 2014 and 2016 Energy Sector capital expenditure fell nearly 40%. I expect a rebound in capex over the next couple of years. It may be too soon for this to spill over to commercial investment in Methane Hydrate, but developments in Japan and China during the past two months suggest a breakthrough may be imminent. The next phase of investment may be about to begin.
Macro Letter – No 64 – 28-10-2016
Saudi Arabian bonds and stocks – is it time to buy?
The sovereign bond issue
The Saudi Arabia’s first international bond deal raised $17.5bln. They tapped the market across the yield curve issuing 5yr, 10yr and 30yr bonds. The auction was a success – international investors, mostly from the US, placed $67bln of bids. The issues were priced slightly higher than Qatar, which raised $9bln in May, and Abu Dhabi, which issued $2.5bln each of 5yr and 10yr paper in April.
The Saudi issue appears to have been priced to go, as the table below, showing the basis point spread over US Treasuries, indicates. According to the prospectus the Kingdom of Saudi Arabia (KSA) want to tap the US$ sovereign bond market extensively in the future, raising as much as $120bln; attracting investors has therefore been a critical aspect of their recent charm offensive:-
|Issuer||5yr Spread||10yr Spread||30yr Spread||Bid to Cover|
The high bid to cover ratio (3.8 times) enabled the Kingdom to issue $2.5bln more paper than had been originally indicated: and on better terms – 40bp over, higher rated, Qatar rather than 50bp which had been expected prior to the auction.
The bonds immediately rose in secondary market trading and other Gulf Cooperation Council (GCC) issues also caught a bid. The Saudi issue was also unusual in that the largest tranche ($6.5bln) was also the longest maturity (30yr). The high demand is indicative of the global quest for yield among investors. This is the largest ever Emerging Market bond issue, eclipsing Argentina’s $16.5bln offering in April.
The Aramco IPO
Another means by which the Kingdom plans to balance the books is through the Saudi Aramco IPO – part of the Vision 2030 plan – which may float as much as 5% of the company, worth around $100bln, in early 2018. This would be four times larger than the previous record for an IPO set by Alibaba in September 2014.
An interesting, if Machiavellian, view about the motivation behind the Aramco deal is provided by – Robert Boslego – Why Saudi Arabia Will Cut Production To Achieve Vision 2030:-
As part of the implementation of this plan, Saudi Aramco and Shell (NYSE:RDS.A) (NYSE:RDS.B) are dividing up their U.S. joint venture, Motiva, which will result in Saudi’s full ownership of the Port Author refinery. Aramco will fully own Motiva on April 1, 2017, and has been in talks of buying Lyondell’s Houston refinery.
I suspect Motiva may also purchase U.S. oil shale properties (or companies) that are in financial trouble as a result of the drop in prices since 2014. According to restructuring specialists, about 100 North American oil and gas companies have filed for bankruptcy, and there may be another 100 to go. This would enable Aramco to expand market share as well as control how fast production is brought back online if prices rise.
By using its ability to cut production to create additional spare capacity, Aramco can use that spare capacity to control prices as it wishes. It probably does not want prices much above $50/b to keep U.S. shale production to about where it is now, 8.5 mmbd. And it doesn’t want prices below $45/b because of the adverse impact of such low prices on its budget. And so it will likely adjust its production accordingly to keep prices in a $45-$55/b range.
Although I authored a series of articles stating that OPEC was bluffing (and it was), I now think that Saudi Arabia has formulated a plan and will assume the role of swing producer to satisfy its goals. It can and will cut unilaterally to create excess spare capacity, which it needs to control oil prices.
This will make the company attractive for its IPO. And by selling shares, Aramco can use some of the proceeds to buy U.S. shale reserves “on the cheap,” not unlike John D. Rockefeller, who bankrupted competitors to acquire them.
The Saudi’s long-term plan is to convert Aramco’s assets into a $2 trillion fund, which can safely reside in Swiss banks. And that is a much safer investment than oil reserves in the ground subject to external and internal political threats.
Whatever the motives behind Vision 2030, it is clear that radical action is needed. The Tadawul TASI Stock Index hit its lowest level since 2011 on 3rd October at 5418, down more than 50% from its high of 11,150 in September 2014 – back when oil was around $90/bbl.
As a starting point here is a brief review of the Saudi economy.
The Saudi Economy
The table below compares KSA with its GCC neighbours; Iran and Iraq have been added to broaden the picture of the oil producing states of the Middle East:-
|Country||GDP YoY||Interest rate||Inflation rate||Jobless rate||Gov. Budget||Debt/GDP||C/A||Pop.|
Source: Trading Economics
In terms of inflation the KSA is in a better position than Iran and its unemployment rate is well below that of Iran or Iraq, but on several measures it looks weaker than its neighbours.
Moody’s downgraded KSA in May – click here for details – citing concern about their reliance on oil. They pointed to a 13.5% decline in nominal GDP during 2015 and forecast a further fall this year. This concurs with the IMF forecast of 1.2% in 2016 versus 3.5% GDP growth in 2015. It looks likely to be the weakest economic growth since 2009.
The government’s fiscal position has deteriorated in line with the oil price. In 2014 the deficit was 2.3%, by 2015 it was 15%:-
Source: Trading Economics, SAMA
Despite austerity measures, including proposals to introduce a value added tax, the deficit is unlikely to improve beyond -13.5% in 2016. It is estimated that to balance the Saudi budget the oil price would need to be above $79/bbl.
At $98bln, the 2015 government deficit was the largest of the G20, of which Saudi Arabia is a member. According to the prospectus of the new bond issue Saudi debt increased from $37.9bln in December 2015 to $72.9bln in August 2016. Between now and 2020 Moody’s estimate the Kingdom will have a cumulative financing requirement of US$324bln. More than half the needs of the GCC states combined. Despite the recent deterioration, Government debt to GDP was only 5.8% in 2015:-
Source: Trading Economics, SAMA
They have temporary room for manoeuvre, but Moody’s forecast this ratio rising beyond 35% by 2018 – which is inconsistent with an Aa3 rating. Even the Saudi government see it rising to 30% by 2030.
The fiscal drag has also impacted foreign exchange reserves. From a peak of US$731bln in August 2014 they have fallen by 23% to US$562bln in August 2016:-
Source: Trading Economics, SAMA
Reserves will continue to decline, but it will be some time before the Kingdom loses its fourth ranked position by FX reserves globally. Total private and public sector external debt to GDP was only 15% in 2015 up from 12.3% in 2014 and 11.6% in 2013. There is room for this to grow without undermining the Riyal peg to the US$, which has been at 3.75 since January 2003. A rise in the ratio to above 50% could undermine confidence but otherwise the external debt outlook appears stable.
The fall in the oil price has also led to a dramatic reversal in the current account, from a surplus of 9.8% in 2014 to a deficit of 8.2% last year. In 2016 the deficit may reach 12% or more. It has been worse, as the chart below shows, but not since the 1980’s and the speed of deterioration, when there is no global recession to blame for the fall from grace, is alarming:-
Source: Trading Economics, SAMA
The National Vision 2030 reform plan has been launched, ostensibly, to wean the Kingdom away from its reliance on oil – which represents 85% of exports and 90% of fiscal revenues. In many ways this is an austerity plan but, if fully implemented, it could substantially improve the economic position of Saudi Arabia. There are, however, significant social challenges which may hamper its delivery.
Perhaps the greatest challenge domestically is youth unemployment. More than two thirds of Saudi Arabia’s population (31mln) is under 30 years of age. A demographic blessing and a curse. Official unemployment is 5.8% but for Saudis aged 15 to 24 it is nearer to 30%. A paper, from 2011, by The Woodrow Wilson International Center – Saudi Arabia’s Youth and the Kingdom’s Future – estimated that 37% of all Saudis were 14 years or younger. That means the KSA needs to create 3mln jobs by 2020. The table below shows the rising number unemployed:-
Source: Trading Economics, Central Department of Statistics and Economics
If you compare the chart above with the unemployment percentage shown below you would be forgiven for describing the government’s work creation endeavours as Sisyphean:-
Source: Trading Economics, Central Department of Statistics and Economics
Another and more immediate issue is the cost of hostilities with Yemen – and elsewhere. Exiting these conflicts could improve the government’s fiscal position swiftly. More than 25% ($56.8bln) of the 2016 budget has been allocated to military and security expenditure. It has been rising by 19% per annum since the Arab spring of 2011 and, according to IHS estimates, will reach $62bln by 2020.
The OPEC deal and tightness in the supply of oil
After meeting in Algiers at the end of September, OPEC members agreed, in principle, to reduce production to between 32.5 and 33mln bpd. A further meeting next month, in Vienna, should see a more concrete commitment. This is, after all, the first OPEC production agreement in eight years, and, despite continuing animosity between the KSA and Iran, the Saudi Energy Minister, Khalid al-Falih, made a dramatic concession, stating that Iran, Nigeria and Libya would be allowed to produce:-
…at maximum levels that make sense as part of any output limits.
Iranian production reached 3.65mln bpd in August – the highest since 2013 and 10.85% of the OPEC total. Nigeria pumped 1.39mln bpd (4.1%) and although Libya produced only 363,000 bpd, in line with its negligible output since 2013, it is important to remember they used to produce around 1.4mln bpd. Nigeria likewise has seen production fall from 2.6mln bpd in 2012. Putting this in perspective, total OPEC production reached a new high of 33.64mln bpd in September.
The oil price responded to the “good news from Algiers” moving swiftly higher. Russia has also been in tentative discussions with OPEC since the early summer. President Putin followed the OPEC communique by announcing that Russia will also freeze production. Russian production of 11.11mln bpd in September, is the highest since its peak in 1988. Other non-OPEC nations are rumoured to be considering joining the concert party.
Saudi Arabia is currently the largest producer of oil globally, followed by the USA. In August Saudi production fell from 10.67mln bpd to 10.63mln bpd. It rebounded slightly to 10.65mln bpd in September – this represents 32% of OPEC output.
There are a range of possible outcomes, assuming the OPEC deal goes ahead. Under the proposed terms of the agreement, production is to be reduced by between 1.14mln and 640,000 bpd. Saudi Arabia, as the swing producer, is obliged to foot the bill for an Iranian production freeze and adjust for any change in Nigerian and Libyan output. The chart below, which is taken from the Federal Reserve Bank of Dallas – Signs of Recovery Emerge in the U.S. Oil Market – Third Quarter 2016 make no assumptions about Saudi Arabia taking up the slack but it provides a useful visual aid:-
Source: EIA, OPEC, Dallas Fed
They go on to state in relation to US production:-
While drilling activity has edged up, industry participants believe it will be awhile before activity significantly increases. When queried in the third quarter 2016 Dallas Fed Energy Survey, most respondents said prices need to exceed $55 per barrel for solid gains to occur, with a ramp-up unlikely until at least second quarter 2017.
Assuming the minimum reduction in output to 33mln bpd and Iran, Nigeria and Libya maintaining production at current levels, Saudi Arabian must reduce its output by 300,000 bpd. If the output cut is the maximum, Iran freezes at current levels but Nigeria and Libya return to the production levels of 2012, Saudi Arabia will need to reduce its output by 623,000 bpd. The indications are that Nigeria and Libya will only be able to raise output by, at most, 500,000 bpd each, so a 623,000 bpd cut by Saudi Arabia is unlikely to be needed, but even in the worst case scenario, if the oil price can be raised by $3.11/bbl the Saudi production cut would be self-financing. My “Median” forecast below assumes Nigeria and Libya increase output by 1mln bpd in total:-
|OPEC Cut ‘000s bpd||KSA Cut ‘000s bpd||KSA % of total OPEC Cut||Oil Price B/E for KSA/bbl|
Many commentators are predicting lower oil prices for longer; they believe OPEC no longer has the power to influence the global oil price. This article by David Yager for Oil Price – Why Oil Prices Will Rise More And Sooner Than Most Believe – takes a different view. His argument revolves around the amount of spare capacity globally. The author thinks OPEC is near to full production, but it is his analysis of non-OPEC capacity which is sobering:-
…RBC Capital Markets was of the view oil prices would indeed rise but not until 2019. RBC says 2.2 million b/d of new non-OPEC production will enter the markets this year, 1.3 million b/d next year and 1.6 million b/d in 2018. Somehow U.S. production will rise by 900,000 b/d from 2017 and 2019 despite falling by 1.1 million b/d in the past 15 months and with rigs count at historic lows. At the same time RBC reported the 124 E&P companies it follows will cut spending another 32 percent in 2016 from 2015, a $US106 billion reduction.
…The Telegraph ran it under the title, “When oil turns it will be with such lightning speed that it could upend the market again”. Citing the lowest levels of oil discoveries since 1952, annual investment in new supplies down 42 percent in the past two years and how the International Energy Agency (IEA) estimates 9 percent average annual global reservoir depletion, the article stated, “…the global economy is becoming dangerously reliant on crude supply from political hotspots”. “Drillers are not finding enough oil to replace these (depletion) barrels, preparing the ground for an oil price spike and raising serious questions about energy security”.
Depletion of 9 percent per year is about 8.6 million b/d. Add demand growth and you’re approaching 10 million b/d. How do the crystal ball polishers of the world who see flat oil prices for the foreseeable future figure producers can replace this output when others report $US1 trillion in capital projects have been cancelled or delayed over the rest of the decade?
The last ingredient in the oil price confusion in inventory levels. OECD countries currently hold 3.1 billion barrels of oil inventory. That sounds like lot. But what nobody reports is the five-year average is about 2.7 billion barrels. Refinery storage tanks. Pipelines. Field locations. Tankers in transit. It’s huge. The current overhang is about 6 days of production higher than it has been for years, about 60 days. So inventories are up roughly 10 percent from where they have been.
Obviously this is going to take a change in the global supply/demand balance to return to historic levels and will dampen prices until it does. But don’t believe OECD inventories must go to zero.
…The current production overhang suppressing markets is only about 1 million b/d or less depending upon which forecast you’re looking at. Both the IEA (Paris) and the EIA (Washington) see the curves very close if they haven’t crossed already. Neither agency sees any overhang by the end of the next year.
…OPEC has no meaningful excess capacity. Non-OPEC production is flat out and, in the face of massive spending cuts, is more likely to fall than rise because production increases will be more than offset by natural reservoir depletion.
Since this article was published OECD inventories have declined a fraction. Here is the latest EIA data:-
|OPEC Crude Oil Portion||30.99||31.76||32.45||33.03|
|Total World Production||93.35||95.81||96.04||97.01|
|OECD Commercial Inventory (end-of-year)||2688||2967||3049||3073|
|Total OPEC surplus crude oil production capacity||2.08||1.6||1.34||1.21|
|Total World Consumption||92.55||94.04||95.33||96.67|
Whether or not David Yager is correct about supply, the direct cost to Saudi Arabia, of a 623,000 bpd reduction in output, pales into insignificance beside the cost of domestic oil and gas subsidies – around $61bln last year. Subsidies on electricity and water add another $10bln to the annual bill. These subsidies are being reduced as part of the Vison 2030 austerity plan. The government claim they can save $100bln by 2020, but given the impact of removing subsidies on domestic growth, I remain sceptical.
The Kingdom’s domestic demand for crude oil continues to grow. Brookings – Saudi Arabia’s economic time bomb – forecast that it will reach 8.2mln bpd by 2030. By some estimates they may become a net importer of oil by their centenary in 2032. Saudi oil reserves are estimated at 268bln bbl. Her gas reserves are estimated to be 8.6trln M3 (2014) but exploration may yield considerable increases in these figures.
The Kingdom is also planning to build 16 nuclear power stations over the next 20 years, along with extensive expansion of solar power generating capacity. Improvements in technology mean that solar power stations will, given the right weather conditions, produce cheaper electricity than gas powered generation by the end of this year. This article from the Guardian – Solar and wind ‘cheaper than new nuclear’ by the time Hinkley is built – looks longer term.
According to EIA data US production in July totalled 8.69mln bpd down from 9.62mln bpd in March 2015. A further 200,000 bpd reduction is forecast for next year.
The table below, which is taken from the IEA – Medium Term Oil Market Report – 2016 – suggests this tightness in supply may last well beyond 2018:-
Source: IEA – MTOMR 2016
According to Baker Hughes data, US rig count has rebounded to 443 since the low of 316 at the end of May, but this is still 72% below its October 2014 peak of 1609. This March 2016 article from Futures Magazine – How quickly will U.S. energy producers respond to rising prices? Explains the dynamics of the US oil industry:-
Crude oil produced by shale made up 48% of total U.S. crude oil production in 2015, up from 22% in 2007 according to the Energy Information Administration (EIA), which warns that the horizontal wells drilled into tight formations tend to have very high initial production rates–but they also have steep initial decline rates. Some wells lose as much as 70% of their initial production the first year. With steep decline rates, constant drilling and development of new wells is necessary to maintain or increase production levels. The problem is that many of these smaller shale companies do not have the capital nor the manpower to keep drilling and keep production going.
This is one of the reasons that the EIA is predicting that U.S. oil production will fall by 7.4%, or roughly 700,000 barrels a day. That may be a modest assessment as we are hearing of more stress and bankruptcies in the space. The EIA warns that with the U.S. oil rig count down 76% since the fall of 2014, that unless capital spending picks up, the EIA says that U.S. oil production will keep falling in 2017, ending up 1.2 million barrels a day lower than the 2015 average at 8.2 million barrels a day.
The bearish argument that shale will save the day and keep prices under control does not fit with the longer term reality. When more traditional energy projects with much slower decline rates get shelved, there is the thought that the cash strapped shale producers can just drill, drill. Drill to make up that difference is a fantasy. The problem is that while shale may replace that oil for a while, in the long run it can never make up for the loss of projects that are more sustainable.
OPEC might just have the whip hand for the first time in several years.
The chart below, taken from the New York Federal Reserve – Oil Price Dynamics Report – 24th October 2016 – shows how increased supply since 2012 has pushed oil prices lower. Now oversupply appears to be abating once more; combine this with the inability of the fracking industry to “just drill” and the reduction in inventories and conditions may be ripe for an aggressive short squeeze:-
Source: NY Federal Reserve, Haver Analytics, Reuters, Bloomberg
But, how sustainable is any oil price increase?
Longer term prospects for oil demand
Source: Trading Economics
In the short term there are, as always, a plethora of conflicting opinions about the direction of the price of oil. Longer term, advances in drilling techniques and other technologies – especially those relating to fracking – will exert a downward pressure on prices, especially as these methods are adopted more widely across the globe. Recent evidence supports the view that tight-oil extraction is economic at between $40 and $60 per bbl, although the Manhattan Institute – Shale 2:0 – May 2015 – suggests:-
In recent years, the technology deployed in America’s shale fields has advanced more rapidly than in any other segment of the energy industry. Shale 2.0 promises to ultimately yield break-even costs of $5–$20 per barrel—in the same range as Saudi Arabia’s vaunted low-cost fields.
These reductions in extraction costs, combined with improvements in fuel efficiency and the falling cost of alternative energy, such as solar power, will constrain prices from rising for any length of time.
Published earlier this month, the World Energy Council – World Energy Scenarios 2016 – The Grand Transition – propose three, very different, global outlooks, with rather memorable names:-
They go on to point out that, despite economic growth – especially in countries like China and India – global reliance on fossil fuels has fallen from 86% in 1970 to 81% in 2014 – although in transportation reliance remains a spectacular 92%. The table below shows rising energy consumption under all three scenarios, but an astonishing divergence in its rise and source of supply, under the different regimes:-
|Scenario – 2060||% increase in energy consumption||% reliance on oil||Transport % reliance on oil|
Source: World Energy Council
The authors expect demand for electricity to double by 2060 requiring $35trln to $43trln of infrastructure investment. Solar and Wind power are expected to increase their share of supply from 4% in 2014 to between 20% and 39% dependent upon the scenario.
As to the outlook for fossil fuels, global demand for coal is expected to peak between 2020 and 2040 and for oil, between 2030 and 2040.
…peaks for coal and oil have the potential to take the world from stranded assets predominantly in the private sector to state-owned stranded resources and could cause significant stress to the current global economic equilibrium with unforeseen consequences on geopolitical agendas. Carefully weighed exit strategies spanning several decades need to come to the top of the political agenda, or the destruction of vast amounts of public and private shareholder value is unavoidable. Economic diversification and employment strategies for growing populations will be a critical element of navigating the challenges of peak demand.
The economic diversification, to which the World Energy Council refer, is a global phenomenon but the impact on nations which are dependent on oil exports, such as Saudi Arabia, will be even more pronounced.
Conclusion and investment opportunities
As part of Vision 2030 – which was launched in the spring by the King Salman’s second son, Prince Mohammed bin Salman – the Saudi government introduced some new measures last month. They cancelled bonus payments to state employees and cut ministers’ salaries by 20%. Ministers’ perks – including the provision of cars and mobile phones – will also be withdrawn. In addition, legislative advisors to the monarchy have been subjected to a 15% pay cut.
These measures are scheduled to take effect this month. They are largely cosmetic, but the longer term aim of the plan is to reduce the public-sector wage bill by 5% – bringing it down to 40% of spending by 2020. Government jobs pay much better than the private sector and the 90/90 rule applies –that is 90% of Saudi Arabians work for the government and the 10% of workers in the private sector are 90% non-Saudi in origin. The proposed pay cuts will be deeply unpopular. Finally, unofficial sources claim, the government has begun cancelling $20bln of the $69bln of investment projects it had previously approved. All this austerity will be a drag on economic growth – it begins to sound more like Division 2030, I anticipate social unrest.
The impact of last month’s announcement on the stock market was unsurprisingly negative – the TASI Index fell 4% – largely negating the SAR20bln ($5.3bln) capital injection by the Saudi Arabian Monetary Agency (SAMA) from the previous day.
Considering the geo-political uncertainty surrounding the KSA, is the spread over US Treasuries sufficient? In the short term – two to five years – I think it is, but from a longer term perspective this should be regarded as a trading asset. If US bond yield return to a more normal level – they have averaged 6.5% since 1974 – the credit spread is likely to widen. Its current level is a function of the lack of alternative assets offering an acceptable yield, pushing investors towards markets with which many are unfamiliar. KSA bonds do have advantages over some other emerging markets, their currency is pegged to the US$ and their foreign exchange reserves remain substantial, nonetheless, they will also be sensitive to the price of oil.
For foreign investors ETFs are still the only way to access the Saudi stock market, unless you already have $5bln of AUM – then you are limited to 5% of any company and a number of the 170 listed stocks remain restricted. For those not deterred, the iShares MSCI Saudi Arabia Capped ETF (KSA) is an example of a way to gain access.
Given how much of the economy of KSA relies on oil revenues, it is not surprising that the TASI Index correlates with the price of oil. It makes the Saudi stock exchange a traders market with energy prices dominating direction. Several emerging stock markets have rallied dramatically this year, as the chart below illustrates, the TASI has not been among their number:-
Source: Saudi Stock Exchange, Trading Economics
Tightness in supply makes it likely that oil will find a higher trading range, but previous OPEC deals have been wrecked by cheating on quotas. Longer term, improvements in technology will reduce the cost of extraction, increase the amount of recoverable reserves and diminish our dependence on fossil fuels by improving energy efficiency and developing, affordable, renewable, alternative sources of energy. By all means trade the range but remember commodities have always had a negative real expected return in the long run.
Macro Letter – No 62 – 30-09-2016
China – Coal, Steel, Water and Demographics – Which way now?
This year several commodity markets saw significant price increases. I discussed this in Macro Letter – No 51 – 11-3-2016 – How do we square the decline in trade with the rebound in industrial commodities?
The price of Iron Ore, Aluminium and other industrial metals has rallied sharply over the last few weeks – WTI now seems to have followed suit. Most commentators regard this as a short covering rally.
Over the last six months the US economy has maintaining momentum, albeit at a disappointingly modest pace. Elsewhere the economic headwinds are blowing harder, with Europe and Japan still mired in a “slow-growth/no-growth” environment. Yet during the last few weeks the spot price of premium coking coal – one of the key inputs for steel production – has doubled to more than $200/tonne. Although this is from multi-year lows seen in 2015, coking coal is now the top performing commodity market year to date:-
Source: Steel Index, Amcharts.com
According to CME data, the futures curve for Australian Coking Coal is in steep backwardation out to December 2017 delivery. This suggests a short-term supply shortage rather than a generalised increase in demand. Mining.com – Stunning coking coal rally wreaks havoc in steel, iron ore explains what has been happening:-
The rise in the price of coking is upending the economics of the iron ore and steel markets with the Australian export benchmark price climbing 164% so far this year.
Metallurgical coal was exchanging hands at $206.40 on Monday according to data provided by Steel Index as it consolidates at higher levels following weeks of panic buying not seen since 2011, when floods in key export region in Queensland sent the price surging to $335 a tonne (albeit not for long).
The rally was triggered by Beijing’s decision to limit coal mines’ operating days to 276 or fewer a year from 330 before as it seeks to restructure the industry. Safety closures and weather related supply curbs in China and Australia only added fuel to the fire.
Source: TSI, Bloomberg, SGX
The price of Iron Ore has also risen by 31% to around $55/tonne, but, as the chart above makes clear, the ratio between the price of iron ore and coking coal is now at its lowest this century.
China’s coking coal output has fallen more than 10% due to the government edict to curtail domestic production. In response import volumes rose 45% in August alone. Goldman Sachs and Macquarie have both increased their price forecasts for 2017 and 2018.
The National Development and Reform Commission (NDRC) – the agency responsible for implementing production cuts – had achieved only 39% of the annual target for reducing coal capacity and 47% of the annual reduction in steel capacity as of the end of July. The Peterson – Institute – State of Play in the Chinese Steel Industry explains the reasons for this policy. Suffice to say, China’s domestic steel production tripled between 2005 and 2015 taking its share of global steel production from 31% to 50%. Under WTO rules it will have Market Economy Status from December 2016 – a wave of anti-dumping laws suits may well follow unless it curtails production.
Despite common knowledge of official policy, commentators have suggested that the recent production cut was intended to deliberately squeeze coal prices, allowing heavily indebted coal producers to repay loans to domestic Chinese banks. After two meetings between the China Iron and Steel Association and the NDRC, coal producers will now be allowed to produce an additional 50 tonne/day from October to alleviate shortages.
The steel industry was under margin pressure even before the rise in coal prices – the government has been forcing an industry wide consolidation. The high price of coal accelerates this “oligopolisation” of the sector. It is part of a broader reform and consolidation of State Owned Enterprises (SOEs). The Peterson Institute – China’s SOE Reform—The Wrong Path takes issue with this policy. It has its attractions in the short-term nonetheless – consolidation reduces competition within industries, the pricing power of these consolidated “oligopolies” should rise, enabling them to increase profitability and reduce their indebtedness. President Xi has called for “Stronger, bigger, better” state-owned enterprises. I fear for the squeezed private sector in this environment.
A more important structural reform was announced last month when the Supreme People’s Court ordered the establishment of more special divisions to handle liquidation and bankruptcy cases in intermediate courts. China has an undeveloped bankruptcy code – defaulting borrowers linger, acting as a drag on the economy. At the G20 summit President Xi said, “China has taken the most robust and solid measures in cutting excess capacity and we will honour our commitment with actions”. An efficient method of “zombie corporation liquidation” would expedite this process.
Another explanation for the government’s decision to reduce the number working days at coal mines is its commitment to reducing pollution. Brookings – The end of coal-fired growth in China looks at the bigger picture:-
China’s coal consumption grew from 1.36 billion tons per year in 2000 to 4.24 billion tons per year in 2013, an annual growth rate of 12 percent. As of 2015, the country accounts for approximately 50 percent of global demand for coal. In other words, China’s economic miracle was fueled primarily by coal.
…China’s coal consumption decreased by 2.9 percent in 2014 and 3.6 percent in 2015, and the economy has maintained a moderate speed of growth. This indicates that there is a decoupling of economic growth from the growth in coal consumption. China’s coal consumption might have in fact already peaked.
Over the past 35 years, coal powered the engine of China’s rapidly developing economy. Coal represented 75 percent of overall energy consumption. This number decreased to 64.4 percent in 2015—the lowest in China’s modern history—as the country’s energy intensity decreased by 65 percent relative to 35 years ago. In fact, though rarely noticed until the recent peak, this has been part of a fundamental shift in the Chinese economy’s relationship with coal.
The authors present three arguments to support their view that China’s reliance on coal is in structural decline. Firstly, a decrease in manufacturing and construction, which have seen over-investment during the last decade or more. Second, policies on climate change and air pollution—especially the Paris Agreement’s, signed this month, which calls for a 20% clean energy target by 2030. Read China-United States Exchange Foundation – After the Paris Climate Agreement, What’s Next? for more details. Finally, China’s adoption of technological innovation in energy, communications, and manufacturing.
In his G20 speech President Xi said “…green mountains and clear water are as good as mountains of gold and silver”. The problem of clean water is probably the single greatest resource challenge facing China today as this article from CEAC – China that once thrived on water, faces water problems today points out:-
The total amount of water resources in China is so huge as to reach 2325.85 billion cubic meters, which is the 4th largest in the world. However, Chinese population is so large that the per capita amount of water resources is only 1730.4 cubic meters. This is extremely small in the world. Moreover, water resources are distributed unevenly by the region. Generally speaking, water is scarce in northern parts of China, including the Northeast, the North, and the Northwest regions. Beijing is in the North region. On the other hand, water is abundant in the South Central, the South, and the Southwest regions. The problem is that water is growing scarcer, while its consumption is rising. Particularly, people in Northwest China suffer from chronic shortage of water.
…It is not the quantity of water that matters critically in China. The quality of water is deteriorating rapidly. According to “The Monthly Report of Ground Water” which was released by the Ministry of Water Resources of China this January, they conducted water quality observation researches of 2,103 wells in the Songliao plain of the Northeast region and the Jianghan plain in an inland area last year, and it turned out that 80% of ground water is too severely contaminated to drink. Ground water pollution is serious, particularly in the regions of water scarcity.
In the shorter-term there has been some increase in demand. Steel usage has risen in response to the mini-stimulus package implemented in April. It was aimed largely at railway and housing construction. Electricity demand picked up again in May +2.1% from April +1.9%, fuelling an increase in demand for thermal coal. Other leading indicators, also suggest that the slowdown in Chinese growth may have run its course. There has been an increase in railway freight volumes and pickup in copper output:-
Source: Market Realist, National Bureau of Statistics
Outside China the picture looks mixed. LME stocks of Copper and Zinc have recovered but Nickle and Aluminium stocks remain depleted. Global demand still appears to be subdued.
Chinese economy is unlikely to return to the double digit growth rates seen prior to the great recession, but, despite its indebtedness, the world’s largest command economy may be able to avoid an imminent banking crisis.
The Debt to GDP ratio continues to rise. A source of grave concern which is noted in the BIS Quarterly Review, September 2016. At the end of July total Chinese debt reached $28trln – greater than the government debt of the US and Japan combined. Corporate debt, which is fortunately denominated primarily in local currency, now stands at 171% of GDP whilst total debt stands at 255%. A favourite BIS measure is the Credit to GDP gap. A figure above 10 is a warning signal that an economy may be approaching a “Minsky Moment” – China scores 30.1, the highest of any large economy.
China has also continued to reduce its vast foreign exchange reserves, although at a more moderate pace than in 2014 and 2015. In July it reduced its holding of US Treasuries by $22bln – the largest one month decline in three years. It also released information about its gold holdings which, as many market participants had predicted, have risen substantially – it last reported this information in 2009. The US Bond sales may, therefore, have been to insure the stability of the RMB versus the US$ ahead of the G20 summit which was hosted by China this month.
Should we be concerned about a Chinese banking crisis? According to Michael Pettis – China Financial Markets – Does it matter if China cleans up its banks? banking solvency is not the issue, but the indebtedness of the economy is:-
The only “solution” to excessive debt within the economy is to allocate the costs of that debt, and not to transfer it from one entity to another.
The recapitalization of the banks is nice, in other words, but it is hardly necessary if we believe, and most of us do, that the banks are effectively guaranteed by the local governments and ultimately the central government, and that depositors have a limited ability to withdraw their deposits from the banking system. “Cleaning up the banks” is what you need to do when lending incentives are driven primarily by market considerations, because significant amounts of bad loans substantially change the way banks operate, and almost always to the detriment of the real economy.
…If we change our very conservative assumptions so that debt is equal to 280% of GDP, and is growing at 20% annually, and that debt-servicing capacity is growing at half the rate of GDP (3.0-3.5%, which I think is probably still too high), then for China to reach the point at which debt-servicing costs rise in line with debt-servicing capacity, Beijing’s reforms must deliver an improvement in productivity that either:
Causes each unit of new debt to generate 18 times as much GDP growth as it is doing now, or
Causes all assets backed by the total stock of debt (280% of GDP) to generate 50% more GDP growth than they do now.
Pettis remains pessimistic about China’s ability to grow its way out of debt. History is certainly on his side in this respect, however, policies such as the One Belt One Road Initiative, which aims to improve cross-border infrastructure in order to reduce transportation costs between China and its trading partners, still makes sense at this stage of China’s development. Comparisons have been made with the US Marshall Plan which helped to regenerate Europe after WWII but with an indicated aim of financing $4trln of new projects, its scale is much larger. Chatham House – Westward ho—the China dream and ‘one belt, one road’: Chinese foreign policy under Xi Jinping reviews the policy in detail, as does Peterson Institute – China’s Belt and Road Initiative.
Meanwhile, the great rebalancing towards domestic consumption continues, at what, in other countries, would be considered break-neck speed. This may, nonetheless, be too slow for China – the mini-stimulus package, in April, was a clear political capitulation. The Kansas City Federal Reserve – Consumer Spending in China: The Past and the Future looks at the success of rebalancing to date and the prospects going forward. They point out that Chinese consumption as a share of GDP declined between 1970 and 2000 largely as a result of demographic forces – low birth rate and aging population – together with urbanisation. Post 2000 rapid house price appreciation accelerated this trend. Since 2010 consumption has begun to rise from a low point of 37% of GDP, this coincides with the peak in household savings at 42% – it is now around 38.5%. The authors predict:-
In a benchmark scenario of relatively stable income growth and a further modest decline in the household saving rate, consumption growth in China remains at around 9 percent per year over the next five years, causing the share of Chinese consumption in GDP to increase by about 5 percentage points to 44 percent by 2020. This scenario has two implications. First, it suggests that strong consumption growth is sustainable in the near future, allowing China to continue transitioning toward a consumption-driven economy. Second, it suggests that strength in near-term Chinese consumption growth will partly rely on a further decline in the household saving rate. As the household saving rate cannot decline indefinitely, consumption growth may need to rely more heavily on household income to be sustainable in the long run.
Parallels have been made with Japan where the savings rate has declined from 40% to 19% of GDP since 1970. If China follows this pattern, savings as a percentage of income will continue to decline. The transition could be relatively smooth provided the residential property market does not collapse in the interim. The FRBKC article concludes:-
The declining saving rate in China reflects both a changing demographic structure—an expected increase in the young dependency ratio after multiple decades of decline—and a changing consumption pattern of young people, who face less pressure to save thanks to financial support from their parents and grandparents.
In the long run, transitioning to a consumption-driven economy may require some policy changes. Specifically, China may need to implement successful supply-side reforms—which are on the government’s agenda but haven’t yet been significantly pushed forward—to enable domestic production to meet rising domestic demand. Although the Chinese household saving rate is declining from a very high level, the downward trend cannot last forever. A truly consumption-driven economy must rely on strong household income growth, which is ultimately driven by improved technology and investment.
In the long run, demographic forces will affect China more than any other factor. According to the Ministry of Human Resources China’s working population hit a record 774.5mln in 2015, however, the UN estimate China will have 212mln fewer workers by 2050. The UN Demographic Profile is found on page 189.
Market impact and investment opportunities
Next week the RMB will be included in the SDR – the Peterson Institute – China’s Renminbi Is about to Break the Financial Glass Ceiling discusses this in more detail. There is widespread speculation that the PBoC will widen the RMB currency bands at any moment. In other respects the PBoC is in a more difficult position. The RMB has already weakened by 5% against the US$ this year. Cutting interest rates would probably cause the currency to weaken further, riling the US voters ahead of the election. They are not impotent, however, and injected a record RMB 310bln into the money market in August – part of an overt policy to support the official banking sector, diminishing the influence of shadow banks.
Domestic investors have favoured bonds over equities for the past couple of months, while the spread between corporate bonds and government bonds has narrowed. Chinese 10yr government bond yields have fallen around 50bp this year, but official policy, encouraging investors to purchase higher yielding bonds and reduce their exposure to leveraged wealth management products and other non-standard assets, is boosting demand for corporate issues.
Retail investors, who were badly burnt in the stock market collapse of 2015, remain obsessed with the property market despite massive over-supply. Equity broker margin balances remain low. Institutional portfolio managers have reduced exposure to stocks from 62% in July to 49% this month. In the post-crash environment IPO issuance has been subdued with only RMB 955bln of capital raised in the seven months to July. This compares to RMB 1.55trln in 2015. The final quarter may see better sentiment. Stocks may get a boost from local government spending in Q3 and Q4 – if only to insure their budgets are not reduced next year. The table below, from Star Capital, ranks forty of the world’s major stock markets. Using their metrics, China is second cheapest and has the lowest PE, Price to Cash flow and Price to Book:-
The Shanghai Composite Index (SHCOMP) is down 8.85% YTD and by 41.84% since its high in June 2015, however it is up 48.25% from June 2014. Russia’s RTS Index by contrast is up 72.81% from its December 2014 low but still 29.68% below its level of June 2014.
Looking outside China, several Australia-centric mining stocks have already risen on the back of the move in coking coal but it seems unlikely that the supply imbalance will prove protracted. Anglo American (AAL) is still looking to sell more of its Australian coal mines – they may well find Chinese buyers.
Outside of China, infrastructure investment across Asia Pacific is on the rise, which is supportive for industrial commodities in general. KPMG – 10 emerging trends in 2016, published in January, takes a very optimistic long term view:-
Ultimately, however, we believe that this may well be the tipping point that ushers in 50 years (or more) of prosperity as capital starts to match up with projects which, in turn, will drive economic growth in the developing world and shore up retirement savings in the mature markets.
Commodity markets tend to exhibit very individual characteristics, however, several industrial and agricultural commodities have formed a longer term base this year. Is this the beginning of the next commodity super-cycle? It’s too soon to call, but without a rise in global demand the prospects for substantial gains are likely to be limited – Indian GDP growth is slowing. The IMF WEO July update revised its India GDP forecast for 2016 to 7.4% from 7.5% – in 2015 it was 7.6%. Its China forecast was revised up 0.1% and its overall Emerging Market and Developing Economy forecast for 2016 and 2017 was unchanged at 4.1% and 4.6%, although, world economic growth was revised 0.1% lower.
China’s stock market remains cheap by many metrics, but the level of indebtedness is an impediment to economic growth. The property market, although over-supplied, continues to attract investment, but this is economically unproductive in the long run. Government policy is attempting to steer the economy towards higher domestic consumption and technologically driven, productivity enhancing, investments. Environmental issues are finally being addressed, yet the challenge of clean water remains substantial.
Near term, debt reduction – and it has yet to begin – will hamper growth, which will, in turn, reduce the attractiveness of Chinese stocks. Reform of the SOEs will involve consolidation into a smaller number of vast enterprises. Private enterprises will suffer. “Zombie” companies will start to be dealt with as bankruptcy procedures become standardised, but, as with all policy in China, a gradualist approach is likely to be implemented. Commodity markets may continue to rise due to supply side factors but I doubt that Chinese demand will rebound even to the level of 2013/2014, let alone the early part of the century.
Macro Letter – No 51 – 11-3-2016
How do we square the decline in trade with the rebound in industrial commodities?
The price of Iron Ore, Aluminium and other industrial metals has rallied sharply over the last few weeks – WTI now seems to have followed suit. Most commentators regard this as a short covering rally. World trade continues to slow as the chart of Manufacturing and Services PMI below reveals:-
Source: Bloomberg, JP Morgan
Chinese February trade data adds to the picture of a slowdown. Exports declined 25.4% YoY, while imports fell 13.8%. Analysts had forecast a 12.5% drop exports, and 10.0% in imports. The trade surplus fell to $32.59bln – against expectations of $50.15bln. This exceptionally sharp decline may be the result of the date of the Chinese New Year but the trend is disquieting.
At last weekends National People’s Congress the 2016 GDP growth forecast was revised downwards to 6.5 – 7%. This followed the release of Q4 2015 GDP at 6.8% and the PBoC’s decision to cut the reserve requirement ratio by 0.5% in order to insure ample liquidity – for large banks the ratio is now 17%.
These charts from the Wall Street Journal put things in a global perspective:-
Source: WSJ, WTO
Further evidence comes from this week’s Monday briefing from Deloitte – Carry on Consuming:-
Manufacturing activity is shrinking in the US and China, the world’s two largest economies. Output is still rising in the euro area, but at the slowest pace in a year. Britain’s manufacturing sector is back in recession.
Part of the problem is lacklustre global demand for manufactured products, particularly in emerging market economies. This has contributed to a slowdown in trade, one of the pre-crisis drivers of global growth. The value of global goods exports last year fell by 13.8% in dollar terms, the first contraction since 2009.
…And yet for me the big conclusion from last week’s meeting in Beijing was that, despite the storm clouds, the world economy should keep growing this year. None of my colleagues, in the US, China, India, Europe, Japan or Australia, anticipate a sharp slowdown in GDP growth in their region this year. All expect consumer spending, the dominant element in GDP everywhere, to hold up.
The performance of many emerging markets has been particularly dire of late, as so many, in order to balance government budgets and meet debt servicing obligations, are reliant on a high price for their commodities.
In an LSE Lecture, given at the beginning of February, Jaime Caruana – General Manager of the BIS – Credit, commodities and currencies – made a number of observations about commodity prices, emerging market debt and the rise of the US$:-
The global economy now finds itself at the centre of three major economic developments. The first is disappointing growth and downward revisions of projections, especially in emerging economies; the second is the large shifts in exchange rates, again especially for emerging market currencies against the US dollar; and the third is the sharp fall in commodity prices, hitting a number of commodity-exporting countries particularly hard, but at the same time providing a positive dividend to other economies.
…Total debt in the global economy, including public debt, has increased significantly since the crisis (end of 2007). True, private debt has been reduced in some countries, namely Ireland, Spain, the United Kingdom, the United States and others. However, public debt has increased significantly in advanced economies, and private debt has increased in emerging economies and some advanced economies less affected by the 2008 financial crisis.
Source: BIS, IMF, World Bank
…Increased leverage would be less of a concern if debt is used to finance productive and profitable investments. However, the profitability of EME non-financial companies has fallen. Traditionally, EME firms have been more profitable than their advanced economy peers, but this is no longer the case…
Source: BIS, Datastream, S&P, Capital IQ
…Based on the most recent reading for the third quarter of 2015, global liquidity conditions may have begun to tighten for emerging economies. A key yardstick is the US dollar-denominated debt of non-bank borrowers outside the United States. It stood at $9.8 trillion in September 2015, unchanged from the previous reading in June, and the dollar borrowing by non-banks in the emerging economies stood at $3.3 trillion, again unchanged from June (Graph 3). This is the first time since 2009 that the latter has stopped increasing.
One important aspect of this additional borrowing in dollars is the strong association between the strength of the dollar and dollar-denominated borrowing by EME borrowers.
…As a rule of thumb, a 1% depreciation of the US dollar is associated with a 0.6 percentage point increase in the quarterly growth rate of US dollar-denominated cross-border lending outside the United States.
…Unlike in previous EME crises in the 1980s and 1990s that had the attributes of a sharp “sudden stop” in lending to EME sovereigns or a run on the banking system, the borrowing in dollars in recent years has been undertaken by private sector non-bank borrowers – mainly non-financial firms. Even if a firm operates in a country whose central bank holds large foreign exchange reserves, there is the question of how the dollars are transferred from the central bank to the firm itself. Unless there is some mechanism that transfers resources from the foreign exchange reserves to the firms themselves, the firms with dollar debts will need to curtail operations and reduce leverage, leading to a direct hit on overall economic growth.
Mr Caruana’s concerns seem at odds with the sudden upturn in a number of industrial commodities, commodity related equities and resource-centric currencies. The rebound started with Aluminium and spread to Copper:-
Collapsing warehouse stocks tell a part of the story:-
The move has been even more pronounced in Zinc:-
A similar pattern has begun to occur in Iron Ore, which bottomed at the end of December; I regret, the five year Swap Futures chart below doesn’t capture the dramatic rise from $52 to $62 seen in the spot price on Monday:-
This move occurred in the face of data from the World Steel Association – January 2016 crude steel production showing a 7.1% decline globally.
Energy prices have remained subdued, with crude oil making fresh lows in February, but even here the sentiment may have changed:-
Although Coal and Natural Gas have yet to catch a significant bid:-
Source: Trading Economics, ICE
A nascent rally is also evident amongst the precious metals complex, here are Palladium and Platinum for good measure:-
As to whether the real economy is beginning to recover I would not put too much weight on the recent rebound in the Baltic Dry Index, it tends to be, at best, lagging indicator:-
The inelastic nature of prices in many commodity markets and the shipping sector in particular, make it extremely dangerous to imply that a small “flight of swallows makes a summer”.
Conclusion and investment opportunities
Whilst have I written about specific aspects of commodity markets, it has been some while since I last focused on commodities in a general sense. In February of last year I wrote – Where is the oil price heading in 2015? In which I looked at the oil futures contango – despite a decline of almost a third in the spot price of WTI (from $45 to $30 per bbl) the contango has not increased as shown by a comparison of the one year futures spreads (March 15-16 vs March 16-17):-
Source: CME, SpreadCharts.com
Producer pain also shows up in US energy production data. Crude oil rig count peaked at 1,609 rigs in October 2014 reaching a low of 439 in February. The Kansas City Federal Reserve – The Reallocation of Energy-Sector Workers after Oil Price Booms and Busts is a timely research response to the 140,000 mining jobs lost during 2015.
Oil production peaked at 9.6mln bpd in April 2015 and is estimated to be down by more than 400,000 bpd. The EIA – Short-Term Energy Outlook forecasts production will decrease to 8.7mln bpd in 2016 and to 8.2mln bpd in 2017.
In December 2014 in How the collapse in energy prices will affect US Growth and Inflation and what that means for stocks I wrote: –
The decline in the oil price, if it holds, should have a long-term benign effect on US growth and inflation. In the shorter term, however, the rebalancing of the economy away from the energy sector may take its toll, not just on the energy sector, but also on financial services – both the banks, which have lent the energy companies money, and the investors, who have purchased energy related debt. This will breed contagion with other speculative investment markets – lower quality bonds, small cap growth stocks and leveraged derivative investments of many colours.
Looking even farther back to my second Macro Letter in December 2013 – Commodity super-cycles in a fiat currency world I concluded:-
Looking ahead to 2014 I can see little reason, thus far, to be broadly long commodities – as mentioned at the beginning I encourage all investors to view each market on its own particular merits. However, just like 2013, I am waiting for bearish sentiment to turn. To misquote St Augustine’s teenage prayer “Give me commodities Lord, but not yet!”
With anaemic growth and slowing global trade, I believe the current rebound in commodity prices will be relatively short-lived. Chart patterns suggest room for further upside in the next couple of months, possibly aided by seasonal factors, but, with a mounting burden of debt hanging over the global economy – especially those parts which are expected to deliver stronger structural growth – I do not anticipate the beginning of the next commodity upturn for a while.