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2016 was the year when the commodities
bear market ended. It capitulated in January
when crude oil fell below $30 a barrel and a
number of commodity-producing companies in
the energy and metals sectors were in a battle
for survival, selling off assets and desperately
restructuring their balance sheets.
As commodity prices fell below the cost of
production, these companies were losing
money at a rapid rate. If oil stayed below
$40, then 20% of global capacity would have
gone out of business. Similarly, major mining
companies Glencore and Anglo American were
forced to liquidate significant parts of their
overall businesses to reduce debt and to shore
up their balance sheets.
The market recognised that prices were
unsustainably low and there was a small
bounceback. As we enter January 2017,
prices are rising further. This is because,
although prices fell in 2015 and the beginning
of 2016, demand for commodities continued
to increase; not at an extremely strong rate
but fairly consistently. And so the requirement
for increased production over the medium
term remained.
The question for 2017 is
whether the market bounces
along the bottom or prices
increase significantly. My view
for 2017 is that we will have
significantly higher prices.
The Bloomberg Commodities Index rose
11.8% in 2016. That does not signal a bull
market. In my view, a commodity bull market
is when we experience a doubling or tripling of
commodity prices. In the bull market of 2000-
2008, the index tripled in value. That was a
full commodity bull market. 2016’s rise is just
bouncing along the bottom.
So, prices have risen, significantly in base
metals and in energy. In oil, OPEC countries
and a number of non-OPEC countries led by
Russia have agreed to take 1.8m barrels per
day of production off the market to reduce
excess inventories more quickly than they
would otherwise have been depleted.
Demand outstrips supply
The question for 2017 is whether the market
bounces along the bottom or prices increase
significantly. My view for 2017 is that we will
have significantly higher prices for a number
of reasons:
Firstly, the supply side is not in a position to
respond to significant demand growth. While
commodity producers have spent the last three
years dealing with very low prices, focusing on
balance sheet restructuring and saving cash,
they have not brought on new projects. Also,
in mining they have been ‘high grading’ (only
producing the highest grade ore) to just stay
cash-neutral or cash-positive.
Secondly, I expect there will be significant
demand growth. Emerging markets demand will
be greater than the market expects, especially
in Asia. China has been going through
economic restructuring for a number of years.
We believe that it is coming through that and
there will be stronger consumer-led demand
from China and all Asian emerging markets.
Thirdly, we think that in the developed and
emerging markets, consumers have enjoyed
low food and energy prices for two years, and
that has shored up their finances and now
they are also receiving higher wages. So, we
expect consumer demand for commodities
to increase. For example, for two years the oil
price has been around $50 rather than $110.
That halving in the price of oil was worth $2
trillion per year to the benefit of consumers,
at the expense of oil-producing companies
and countries.
Longer term we are bullish
about precious metals as
well. Gold is likely in the short
term to continue to be weak
while bond yields are rising.
Commodities, in general, are
negatively correlated with
bonds but gold at the moment
is behaving more like a low-yield
reserve currency and less like a
commodity.
Fourthly, governments of both developed and
emerging countries are signalling a shift in
focus from monetary policy to fiscal policy and
fiscal stimulus. They recognise that quantitative
easing has not materially helped consumers
and consider that fiscal stimulus is more likely
to do so. We expect to see the US, Europe
and Japan turning to fiscal stimulus, while
China continues to deploy it. That will
increase demand for commodities.
A widespread trend
The increase in demand is likely to be most
acute in base metals. Copper, zinc, nickel and
aluminium should benefit from a substantial
increase in consumer demand for metals.
We think the growth rate for oil demand will
continue to be strong in 2017. The return of
supply discipline will keep the oil price on an
upward trajectory. It is worth noting that there
is very little spare capacity globally. If the
OPEC agreement holds and 1.8 million
barrels are taken off the table globally, that accounts for almost all surplus inventory,
leaving the world vulnerable to a supply
disruption. We have concerns about this
given the security situation in the Middle East.
The new US administration is unlikely to want
to be the region’s peacekeeper. And while the
Russians have become more involved, it is
not clear whether this will contribute to stability
or not. It is likely that the boundaries drawn up
in the Sykes-Picot Agreement 100 years ago
will be redrawn.
Longer term we are bullish about precious
metals as well. Gold is likely in the short term
to continue to be weak while bond yields are
rising. Commodities, in general, are negatively
correlated with bonds but gold at the moment
is behaving more like a low-yield reserve
currency and less like a commodity. Gold will
be weak when bond yields are going up and
bond yields have some way to go. Once bond
yields plateau we would expect to see gold
strengthen again.
Turning to agricultural commodities, there have
been two years of abundant harvests as the
El Niño weather cycle’s stable weather pattern
has prevailed. But this has ended, so weather
is likely to be more variable in growing regions
and so crop yields are likely to fall. Our view
is that despite having two great years to
rebuild stocks, they are only adequate.
If the next Northern Hemisphere harvest is
compromised, we will see upward pressure
on agricultural prices.
Start of the bull market?
Across the commodity markets as a whole,
we expect 2017 to be another positive year.
Inventories are tightening. Commodity curves
are flattening, which supports prices and
returns for investors. Producers are likely to
have difficulty keeping up with demand over
the next couple of years.
We have had the end of the bear market, after
which there is normally a period of bouncing
along the bottom. While this historically has
persisted for two to five years, we think that a
focus on improving the lot of consumers could
bring this forward to 2017.
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