Sifting commodities will produce pay dirt

Howard Winn
23 March 2010

The United States consumes 10 litres of crude oil per person per day while China consumes one litre. Put this way it is easier to see why a small shift in demand in the US will propel oil prices from the current level of around US$80 back up to US$90 to US$100 a barrel this year, according to Dominic Schnider, the head of commodity research at UBS Wealth Management.

“We don’t need a recovery in the US for oil prices to rise – we just need it to stabilise,” he says.

This together with the continued strong demand from emerging markets, particularly China, will be enough to take crude oil to a higher range and why he thinks oil is a good investment up to US$100.

“You have to remember that what took crude oil prices to US$150 was emerging market demand, and what brought it back down again to the US$30 level was the fall in consumption by the OECD economies.”

While commodity investors benefited last year from the widespread rise in commodity prices as they moved up from extreme depressed levels as a result of the financial crisis, this year investors need to look at the individual drivers of particular commodities.

Financial markets got off to an unpromising start dipping sharply in late January as investor confidence was undermined successively by the Obama administration’s announcement that it intended to introduce a special tax on banks as well as the possibility of limiting their investment activity, while in Europe Greece’s debt burden caused tremors in financial markets, and China’s tightening monetary conditions sent negative reverberations around the world.

These economic concerns have collectively acted as a brake on markets but have not halted the trend which Schnider sees as one of recovering demand, at least for this year. But like many other observers he believes this year’s recovery is not based on solid fundamentals but is dependent on the various government stimulus packages.

“This will be an issue at the end of the year when the US will have to decide whether or not to go for another stimulus package, and we realise that things are not that great in the developed world and need more money to stimulate the economy. This will be a turning point for commodities,” says Schnider.

He says that the purchasing managers’ index indicates that at least in the short run economic activity should begin to expand, not only in China, where it is obviously already occurring, but also in the developed world.

With expansion comes restocking which he thinks will continue for at least another six months. In the present environment where growth is tepid in developed economies, Schnider advises investing in commodities that are highly exposed to emerging markets and which also have on the supply side, a quasi-monopolistic structure such as Opec.

Another attractive situation is the case of iron ore where two countries dominate the supply side. Coal and copper is similarly supplied by a few dominant countries.

Schnider is cautious over aluminium which he says has a huge overhang with record inventory levels in London Metal Exchange warehouses around the world. While much of this is thought to be tied up in financial deals it is still uncertain how much is available to the market.

Energy is attractive because of its implications for emerging markets. In addition to oil, coal is attractive with emerging markets accounting for 70 per cent of global consumption and China alone accounting for 40 per cent.

China was a net exporter of coal until 2007. Last year, it imported 130 million tonnes – triple 2008 levels – while exporting 22.4 million tonnes which was about half of 2008 exports. It consumes more than two billion tonnes annually.

China’s demand for coal imports has increased as the government enforces its aim of closing down small coal mines which are often unsafe while it attempts to consolidate the industry into fewer large groups. At the same time it has had to import better quality coal for its newer steel mils. These factors coupled with growing demand mean that China will continue to support high global coal prices which Schnider believes could move 20 to 25 per cent higher over the next 18 months.

China’s growth is also supporting base metal prices which should move higher in the first half of 2010, according to Schnider. He favours copper which is currently trading at around US$7,300 a tonne with a target price of US$8,300. He thinks the price of lead and nickel will struggle due to ample supply.

Although gold has been in the doldrums lately, Schnider remains a fan. He says that a lot of people ask him if gold is cheap. He points out that when gold was at US$800 an ounce it would buy almost 25 barrels of oil. These days an ounce of gold would buy around half that amount – so he does not think it is particularly cheap or expensive.

He sees a number of reasons why gold should account for at least 10 per cent of a portfolio. With the US printing money at the current level he says there is a risk of inflation. Gold has been hurt by the dollar’s recent strength but Schnider says this is more to do with the weakness of the euro rather than fundamental strength in the dollar, and expects the dollar to weaken. Gold remains a useful hedge against US dollar weakness.

Another driver for gold is that central banks, which in previous years used to provide 250-400 tonnes a year of gold to the market, have stopped selling. Average supply between 2003-2008 was 425 tonnes a year.

“Those banks that have gold are not selling and those who don’t have it want to buy it. The drying up of bank selling alone has a big impact on the market.” Schnider says the change in attitude of the banks “has changed the game”.

“European banks are stuffed with paper assets and are glad to have real assets,” he says.

Investors bought 1,200 tonnes last year but Schnider expects this to fall this year to 600-770 tonnes. But this decline is expected to be offset by an increase in jewellery sales. The market could be undersupplied this year.

He expects gold prices to move up gradually. “I don’t expect it to move up 30 to 40 per cent, not unless the dollar plunges by a huge amount and inflation shoots up by 8 per cent – but I don’t expect this.”


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