Posts tagged Commodities
Credit is due to the Yellen Fed for setting clear expectations and then delivering on them. Markets expected a 25 basis point increase in the target Fed funds rate, accompanied by an accommodative policy statement, and that is just what they got. “Monetary policy remains accommodative” was the key phrase in that statement, underscoring the reality that data trumps calendar when it comes to the size and timing of policy actions in 2016.
Nonetheless this is something of a brave new world, a definitive coda in the policy-driven economy of the past seven years. There are plenty of risks as well as opportunities in the year ahead. Here are five observations informing our thinking as we see out 2015.
#1 – Sell the Rumor, Buy the News
Counter-intuition was a theme in many asset markets in the immediate lead-up to and aftermath of the 12/16 announcement. Asset classes that typically fare poorly in rising rate environments, such as precious metals and high dividend stocks, were strong outperformers on the day. The dollar was mostly muted against other major currencies. Most likely, expectations were largely baked into prices well in advance of Wednesday and thus the news itself gave little reason for further action. If anything, the trading dynamic Wednesday afternoon was characterized by some holiday bargain shopping in recently oversold corners of the market.
#2 – Ignore the Short Term Noise
We expect to see higher than average volatility prevail through the remainder of the year, and we attribute this to little more than the residual noise following a major policy event. The S&P 500 opened Wednesday morning at 2043 and closed Thursday afternoon at 2041, with this net return of zero punctuated by an aggregate spread of three percent over the two day period. The two year Treasury yield is at a five year high, while the ten year still sits below its average over the same period. We do not see much in the way of meaningful trend signals coming from the market until this residual froth settles, and recommend riding out the volatility to the extent possible.
#3 – Inflation is the New Jobs
The big event on macro calendars for the past several years has been the jobs report – “where for one brief moment the interests of Main Street, Wall Street and Washington align” as the Wall Street Journal likes to say in its first Friday of the month live blog. We’re not sure that the mid-month Consumer Price Index report will earn its own following of econo-journalist fanboys and fangirls next year, but it should. Assuming that the prevailing employment trend doesn’t go into sharp reverse, we expect that prices will be the key variable influencing the size and timing of future Fed action. The FOMC policy statement released Wednesday made repeated mention of near-term and long-term inflationary readings and progress towards the 2 percent target. Although reasonably balanced, we give somewhat more weight to the possibility for a faster than expected pickup in prices (outside the volatile energy and food sectors). It may be time to dust off those TIPS for portfolio inclusion.
#4 – The Fed and the Spread
While the Fed has occupied the spotlight for much of 4Q15, the real action in 2016 may be less in future rate hikes than in risk spreads between Treasuries and other fixed income asset classes. It is always worth remembering that risk spreads have a direct effect on household financial decisions through mortgages, personal loans and the like. High yield spreads have taken a hit recently, in part due to another wave of commodity price slumps, but we would be more concerned about investment grade spreads as a wild card that could inflict collateral damage on other asset classes. The Office of Financial Research (OFR), an independent office of the Treasury Department whose annual Financial Stability Report should be required reading for anyone invested in global asset markets, calls out “elevated and rising credit risks in the US nonfinancial business sector” as a key area of potential weakness. US companies have benefitted greatly from historically cheap borrowing costs in the past five years, serving up dividends and buybacks and other things investors hold near and dear. Those good times may be nearing an end.
#5 – Commodities: More Pain, but Stable
Speaking of commodity price slumps, we have listened to a number of quarterly earnings calls from energy companies over the past couple months. In expressing their views on 2016 the dominant theme is an impersonation of Rocky 2’s Clubber Lang: “My prediction? Pain”. The supply-demand imbalances that have sent crude prices down to seven year lows this year will not work themselves out overnight. Nonetheless, the impact of US E&P downsizing should start to be felt and inventories should gradually recede from their recent record levels. Demand should improve as well, with China a likely buyer of more oil at lock-in price levels for its strategic petroleum reserves. While we do not see a return to fortune and favor for commodities in the near term, we also do not necessarily see commodity prices as a key risk story for 2016. In our most-likely scenario model we have modestly narrowed our crude price range to $40-55 from $40-60.
There are plenty more blips on our radar screen: emerging markets, corporate earnings, geopolitics and US elections – among others – are all in the mix, set to surprise, befuddle, delight or antagonize investors in the year to come. We will have plenty more to say about all of them. Happy holidays.
Those brave enough to wade into the markets on August 25, at the depths of the recent pullback in risk assets, have been amply rewarded. The S&P 500 is up 7.8 percent since then (as of the 10/8 close). But oil bulls have fared even better. Spot prices for the key Brent and West Texas Intermediate crude benchmarks have jumped by more than 25 percent since late August amid a growing sentiment that the collapse in energy prices has finally found a floor. Is this sentiment justified, or is this just a repeat of the false dawn we saw earlier this year? Consider the chart below, which plots the price trend for Brent spot crude over the last twelve months.
Impressive though this latest rally may be, prices actually rose faster and higher back in February. A strong jobs report jolted risk assets back to life after a volatile January. Brent crude jumped 29 percent between January 14 and February 19 as part of this broad-based rally. But the rally ran into headwinds around the $60/barrel level. The structural factors of oversupply and weaker demand have proven resilient, making it difficult to see a clear path for prices to regain the $100-plus level where they traded for almost the entire stretch of time from 2011 to midsummer 2014. Even the usual tailwind of summer demand failed to boost prices much past the mid-60s, and then the China story moved front and center to deflate animal spirits and push prices to new six year lows.
Supply Side: Cuts Ahead
US domestic energy companies have surprised observers, continuing to pump out volume in the face of sharply lower upstream price realizations. That may be changing. A report last month by the International Energy Agency predicted that US production will fall sharply in 2016 as the effects of the long price winter finally force decisions on project viability. Experts estimate that some $1.5 trillion of global energy investment is unlikely to be viable in the $50/barrel price area. Industry executives at this week’s Oil and Money conference in London cautioned that a supply contraction from projects switching off may lead to a sudden spike in prices down the road, as spare capacity disappears. Such a spike, though, does not appear imminent. Reduced supply will take time to work its way into the price equation; indeed, the latest figures last week pointed to yet another rise in US crude oil stocks.
The Return of Geopolitics
Another factor, which has been notable for most of this year by its absence, is geopolitics. Instability in the Middle East often leads to higher oil prices, but the volatile conflicts raging across the region this year have had little impact. That may be changing, though, with Russia’s military intervention adding a new dimension of complexity – and risk – to the situation in Syria. The so-called “moderate” Syrian rebel groups Moscow appears to be targeting in its air-to-ground operations have been the beneficiaries of support by the US and some of its key Gulf State (and oil producing) allies. There is continued concern in some policy corners about the potential for a proxy war. A “geopolitical premium” is arguably one of the factors at play in this week’s leg of the crude price rally.
The Demand Puzzle
Hanging over the question of how sustainable this latest energy price rally can be is demand – or, rather, the continued lack thereof. The International Monetary Fund has reduced its forecast for global growth in the wake of growing concerns over the size of China’s slowdown. Its current forecast for China’s real GDP in 2020 is 14 percent lower today than it was three years ago. China’s problems are having a visible effect around the world; for example, Brazil’s exports to China (now its largest trading partner, having supplanted the US) have fallen by 23 percent this year and factor heavily into Brazil’s negative growth environment. A vicious cycle of low growth in developed and emerging markets feeding off each other will be at the top of the list of concerns for international policymakers as they meet for the annual World Bank and IMF meeting in Lima, Peru this week.
The average price of Brent spot crude oil from January 2011 to June 2014 was $110. We do not see the current environment favoring a return to those levels within a 2015-2016 time frame. Investors game enough to put their short-term money at play could perhaps do well by a strategy of “buy at $40, sell at $60.” For those contemplating their annual asset class exposure rebalancing, we would continue to recommend staying modestly underweight oil and industrial commodities more generally. False dawns look rosy, until they fall back into night.
The collapse in oil prices was arguably the headline economic story of 2014. The malaise carried into January of this year, with prices of key benchmark crudes hitting six year lows last month. A sharp rebound in the first two weeks of this month has observers wondering if the slide is over, and, if so, what that may portend for the months ahead. One interesting development, which will be the focus of this post, is a significant widening of the spread between two of the most widely-referenced benchmarks: Brent crude and West Texas Intermediate crude. Why is this seemingly arcane byway of commodities markets of interest? In our opinion it sheds light on some key supply and demand factors at play that may influence economic and asset market trends as the year winds on.
We normally think of commodities as fungible – one person’s barrel of oil or bushel of wheat is the same as the next person’s. While that is true in the abstract, the reality is that the prices of many commodities are strongly influenced by differentiating factors. Crude oil is a case in point. There are many “flavors” of crude oil, measured chiefly by a range of densities (light to heavy) and sulfur content (sweet to sour). These determine how a given barrel of crude is used – for gasoline, jet fuel, home heating oil etc. The location of crude oil sources also matters. Brent crude, a light-sweet variety, comes from the North Sea between Great Britain and western Scandinavia. West Texas Intermediate is also a light-sweet variety, but as the name would suggest it is produced and traded in the U.S. mid-southwest. The chart below shows the price trends for both benchmarks over the past six months.
Brent and WTI crude are quite similar in terms of density and sulfur content, and so all else being equal one would expect them to trade at or close to the same price. All else is not equal, of course. As the above chart shows, Brent crude has traded at a premium to WTI for almost all of the past six months, and in fact the Brent premium has been a staple feature of the market for a much longer period. However, Brent prices plunged at a faster rate in the final throes of the price meltdown, reaching parity with WTI in the middle of last month. It was a brief parity. In the second half of January Brent oil stabilized while WTI continued to fall to new lows. The percentage spread between the two benchmarks is now more than twice its last six months’ average. A barrel of Brent crude is more than 6% dearer today than on January 1, while WTI crude is about flat year to date. What’s behind this divergence?
Texas Hold ‘Em
Both supply and demand are at play here, but the trend of U.S. oil prices is at heart a supply story. We are producing more oil, at a faster rate, than at any time since the early 1980s. Financial media chatter to the contrary, the pace does not appear to be slacking off despite the global plunge in prices. Last week both crude oil production and inventories reached record levels. And domestic oil production is a captive of home-grown demand; the export of U.S. crude to other markets is prohibited by current government policy. Whatever is left over in the storage tanks after U.S. orders have been filled stays in the tanks. Energy-hungry manufacturing economies in Asia and elsewhere get their stuff from other sources, including the North Sea.
A number of the major exploration & production (E&P) companies have announced plans to delay forthcoming U.S. drilling projects, and that may help provide more price support down the road. And there is a reasonable possibility that the export ban may weaken or be eliminated in the not too distant future, which would open new sources of demand. But the supply-demand imbalance shows few signs of going away any time soon. If indeed prices have found a structural floor, they may still face significant headwinds in getting anywhere close to the $100-plus levels where it has traded for most of the past five years. Which may not be a bad thing at all; “stable and low” may turn out to be a pretty nice recipe for consumers, businesses and stocks alike.
We normally think of commodities as a single asset class: an alternative investment exposure alongside equities and fixed income. An examination of commodities trends in 2014 to date should disabuse anyone of the idea that there is much in the way of close correlation between the major commodities sub-classes. Global macroeconomic trends, geopolitics, Mother Nature and quirky human behavioral economics all have an impact on commodities prices. In this piece we look at four representative exposures to the main commodities groupings of energy, industrial materials, precious metals and agriculture.
Crude Oil: The Economics of Geopolitics
“Geopolitics” is the term we use to describe socio-political flashpoints around the world, but more often than not the term could be substituted with “whatever is happening in the Middle East this week”. Unsurprisingly, the major action in crude oil trends so far this year has taken place in the last couple weeks, as violent civil unrest once again threatens the sustainability of a single government in Iraq. Prices for Brent crude, a key benchmark, shot up 8.5% from mid-April to mid-June (they have subsided somewhat since then). With the summer driving season in full swing we should not be surprised to see continued upward pressure on crude – and its downstream refined products – in the weeks ahead.
Copper: As Goes China…
Copper is widely used as a proxy for industrial metals, the fortunes of which very much track trends in the world’s major manufacturing centers. Today that means China more than anywhere else, and copper’s rather volatile trajectory in 2014 reflects investor perceptions of how well China is managing its dual objectives of economic growth and rebalancing its GDP mix to a more stable allocation between consumption and investment. At the beginning of the year those perceptions were negative, and a “China hard landing” turned into one of the driving motifs of the first twelve weeks or so of the year. Copper prices plunged 12.3% through mid-March, at which point data coming out of China were conflicting enough to indicate that a major negative event was not imminent. Prices have regained strength since then, and have recently regained position above key technical support levels, though still down year to date.
Corn: The Climate Change Commodity
Two years ago a scorching drought hit the Midwest, America’s breadbasket, and agricultural prices soared. Since then, extreme weather events have become a familiar part of the daily news refrain. 2014 started with one of the coldest, nastiest winters on record, and investors appeared to believe this signaled another rough year for crop harvests. Corn futures prices, one of the benchmark agricultural commodities, soared 20% from January to early May. Then, a bevy of crop reports indicated that this year’s harvests are actually likely to be some of the best in recent years. That has resulted in a dramatic plunge over the past six weeks, to where corn futures prices are now just below where they started the year. Climate change is a reality, but it would seem that betting against Mother Nature remains a fool’s errand.
Gold: The Risk-Off Mindset Continues
Precious metals occupy a strange place in the popular mindset. The storied role of gold throughout human economic history gives it a luster as something special: an asset towards which to run when things start to look grim. In 2011 gold prices soared as the Eurozone seemed on the edge of collapse and political dysfunction drove the U.S. to the brink of a debt default. But what the gold bugs never seem to comprehend is that gold is just another commodity, the price of which rises and falls like any other. Currently prices are about 30% below those highs reached in 2011. Gold is up about 7.2% in 2014; recently it has followed crude oil up as a hard-asset play amid uncertainty in the Middle East. But there’s no magic here. There is no floor to gold prices, there are no contractual obligations to repay principal to investors (as there are with fixed income instruments), and so it is hard to make a compelling case for gold being a safe haven.
So there we are: two key commodities sectors up (crude oil and gold) and two down (copper and corn) as the second half gets underway. As the tone of this paper should indicate, we tend to be skeptical of the value in predicting near-term commodities price trends. But we do pay attention to correlation relationships between commodities, equities and fixed income. These have been much higher in recent years than historical norms, but we see some evidence of potential mean reversion. That may afford an opportunity to bring commodities back into our asset allocation mix.