Weekly Commodities Update : Commodity Pessimists Feel the Squeeze as Futures Rally

The dramatic rally in riskier assets continued last week with stocks and commodities rallying hard while bonds sold off. Improved U.S. economic data has given traders enough confidence to believe that a recession is now more or less out of the question. The 23 October EU summit is expected to yield a substantial announcement and European politicians therefore have got less than a week to hammer out a sustainable strategy to finally get the European debt crisis under control.

So far the market has been prepared to believe that a solution is coming and stock markets have responded in a dramatic fashion while the dollar has dropped out of favour, at least for now. The main downside risk now lies with another round of extreme risk aversion, which could spark broad-based liquidation, as in September.

The Reuters Jeffries CRB index is four percent higher over the past week and in just two weeks the index has rallied 8.5 percent from the early October low. Some of the rally can be explained by the dollar - which has slumped by 4 percent during the same time. The agriculture sector which, surprisingly, had seen long exposure being reduced dramatically over the last couple of months, rose the most as traders returned to rebuild long exposure, especially in corn, soybeans and rice.

Speculative positions reduced despite rally
Another reason for the strong rally in commodities over the past week has been due to hedge funds and large investors rebuilding long positions. Recent data (to 11 October) from the CFTC shows that exposure to commodities fell to the lowest level since September 2009. The data was compiled at a stage where the rally was into its second week, showing that speculators had continued to offload positions and most likely would have spent the remainder of the week rebuilding exposure thereby adding to the upside pressure.

Brent crude approaching critical level
The ongoing speculation about a solution to the European debt situation and improved U.S. economic data continued to drive oil markets last week. With the dreaded fear of recession having moved to the backseat investors has been piling back into the black gold.

Brent crude outperformed U.S. WTI crude on a combination of continued tightness in the European markets together with news from Dow Jones UBS that its commodity rebalancing at the beginning of 2012 will support Brent crude. The DJ-UBS is estimated to have around 80 billion dollars of funds tracking the commodity index and they announced that the weighting of WTI will be reduced from 14.7 to 9.7 percent while Brent crude will be added for the first time with a weighting of 5.3 percent. The adjustments to its positions will take place between the fifth and the ninth working day of January and could result in the Brent WTI spread widening back out to its recent record given that many other fund managers will adapt the same strategy.

Technically Brent crude will find tough resistance ahead of 115 dollars per barrel as it seems to have moved ahead of levels that current economic activity can justify. 

Gold slow recovery continues
Investors continued to regain some of the confidence that was lost after the biggest slump in three years. Their return to gold was highlighted in the last week's CFTC data which showed that long exposure to gold was increased for the second week in a row. After having been a clear choice for months its relation to risk has confused many over the last month as gold has moved in line with other riskier assets.

Its strength will be tested soon as we approach resistance around 1,700 dollars per ounce. Gold priced in Euros has traded flat over the past two weeks indicating that much of the new found strength has been down to dollar weakness and on that basis further progress could slow down as the Euro approaches strong resistance at 1.3950 versus the dollar.

Crops rally from oversold situation
Crops like corn, soybeans and rice, were the main performers last week as exports kicked back to life, especially to China, while the United States Department of Agriculture in a report forecast a smaller-than-expected 2011/12 production for corn and soybeans. The price of wheat continues to suffer amid ample supply both in the U.S. and the world. The dramatic fall in prices have led U.S. farmers to hold back some of their production hoping that reduced supply eventually will trigger higher prices.

The latest data from the CFTC showed that investors continued to dump agriculture commodities despite the ongoing recovery, something that will add to the momentum if and once a rally takes hold.

Dollar and Weak Growth Prospects Dent Commodities

Stock and commodity markets continue to focus on the impact of weak global growth conditions and the EU debt crisis. The dollar moved back to its strongest levels in months benefitting from the Swiss currency peg, worries ahead of the 9/11 ten year anniversary and an European Central Bank more concerned about weak growth than inflation.

Swiss currency floor
Foreign exchange markets lit up this week with news that the Swiss National Bank all but made good on persistent rumours that it would peg the Swiss Franc to the Euro in order to halt the dramatic appreciation of the currency which had begun to hurt the Swiss economy. The line is now drawn at 1.20 versus the Euro at which level the SNB will buy Euros at whatever quantity required to hold the CHF.

..and the potential dollar/commodity impact
 

This move could strengthen the dollar with the SNB likely wanting to buy other currencies than Euros, of which it currently holds 55 percent, in order to maintain a diversified mix of currencies in its reserves. With the dollar being the most liquid of the pack it could now have found a friendly central bank. Asian Central Banks have been selling dollars against Euros for months. All eyes will be on EUR/USD as a break of key levels would open the way for a substantial move higher. It will be interesting to follow from a commodity perspective as a stronger dollar removes some support for the asset class.

The Reuters Jefferies CRB index lost one percent over the week with most commodities bar a few being in the red.  

Oil focus on supply disruptions, Obama job plan and hurricane Nate
Crude oil markets quickly found support this week after another sell off. The recovery was driven by a bounce in equity markets and hopes that President Obama’s job creation plan could stimulate growth. But more importantly near-term is the tightness in the spot market with the loss of Libyan oil continuing. We also have outages in Nigeria, Syria and the North Sea adding up to lower-than-expected production which so far has helped offset reduced demand caused by the economic slowdown. Further, producers in the Gulf of Mexico have had to evacuate workers once again ahead of Tropical Storm Nate which is expected to become the third hurricane this season. Cushing not spilling over
 

During the week the spread between WTI and Brent crude reached a new record high of 27 dollars with most of the above supply issues impacting Brent more than WTI. One of the major reasons for this dislocation has been the belief that increasing storage levels at Cushing, the delivery hub for NYMEX WTI crude, would put downside pressure on prices. The chart below shows, however, that storage levels have been falling since May and currently stands at levels last seen in November 2010 - at which time the spread was trading below one dollar.  

What is the correct price of Oil?
One must conclude that the current spread is more related to the supply issues currently affecting Brent crude. This can also be seen by the Brent oil curve moving into a very steep backwardation with spot price trading more than two dollars higher than Brent for delivery in 3 months time. Should the bottlenecks begin to disappear we can expect prices to adjust lower within the established $118 to $108 range. The price of WTI is arguably cheep on the basis that Cushing is not overflowing, but until we see a pick-up in economic activity investors’ negative views will be expressed through WTI crude.

Gold sold off and found buyers again
Gold reached a new nominal record at $1,921 a barrel but, again, the immediate response was a $100+ sell off highlighting the increased level of volatility seen recently. The drop below $1,800, however, triggered new buying, especially out of the Far East, and a quick bounce followed. This two way battle will continue over the coming weeks but the overall direction still points higher towards 1,970 and potentially the magical 2,000 level. Hedge funds and ETF investors have continued to reduce long exposure over the last four weeks and it could be a sign of rally fatigue but, as mentioned above, the demand on setbacks looks solid for now.

Over the last five years gold has tended to correct aggressively each time it moved further than 20 percent away from its 200 day moving average. This could be the reason why gold has been struggling to hold onto gains above 1,900 recently indicating that further upside progress will be slower than during the previous couple of months. 

UN FAO food price index stable in August
The monthly Food Price Index from the Food and Agriculture Organization of the United Nations averaged 231 points in August and was nearly unchanged from July, but 26 percent higher than a year ago. The index of 55 food commodities hit an all time high of 238 points back in February on the back of steep price rises in sugar. Over the last few months prices have stabilised but world food prices are expected to remain elevated this year as stockpiles will be running low after a difficult growing season. The cereal index which includes wheat, corn and rice, rose 2.2 percent in August, primarily on the back of the rise in international prices of rice and corn. The FAO said: “A policy change in Thailand, the world’s largest rice exporter, which is set to increase the purchasing price from farmers to above market levels, served to further support this increase. Corn prices also rose sharply in August, reflecting further deterioration in this year’s crop prospects in the United States”
 

The price of U.S. rough rice has risen by one third over the last two months, still some 26 percent below the peak in 2008 which caused food riots across Asia. Meanwhile corn prices remain elevated with a highly anticipated U.S. crop report on Monday expected to confirm worries that the crop size and quality of the upcoming harvest have suffered due to a hot and dry summer.

 

Gold at new record on debt woes on both sides of the Atlantic

Commodities have recovered strongly during the last couple of weeks after the June washout where speculative positions were reduced across the board. All the major commodity indexes are back in black having recorded solid gains over the last two weeks with increases seen across most sectors. 

Just like other asset classes the commodity space is keeping a close eye on developments on either side of the Atlantic. The European debt crisis is still full on with politicians and central bankers fighting hard to avoid contagion towards other countries like Italy which came under significant speculative attacks early in the week. In the U.S. the government is struggling to pass a law that will raise the debt ceiling with failure carrying the risk of downgrades and default. In the middle of this the Euro and the dollar is fighting it out with no clear winner emerging as of yet. 

Oil holding up as spare capacity is running low

Half of the 60 million barrels of crude that the International Energy Agency was going to release from its strategic reserves has now reached the market and if the intention was to bring prices down it has so far been a failure. The price of Brent crude at 116 is almost unchanged from the levels before the release with bottlenecks still existing due to lost Libyan high quality oil. WTI is lower but as Brent is the benchmark for oil transaction it’s really the one that counts.

Forward prices have stayed relatively firm as the main worry is still one of reduced spare capacity as increased demand from emerging economies in the months and years ahead continues to put strains on producers to keep up. In a report this week the IEA projected that oil consumption in 2012 could grow by 1.47 million barrels per day to 91 million bpd. It also said that the economic impact of higher oil prices could reduce the forecast. 

The price of Brent crude has been averaging 111.40 so far this year which is 39 percent higher than during 2010. This increase combined with higher food prices has impacted struggling households across the western world leading to reduced economic activity with the risk of additional rises reducing activity even further.

With the Libyan crisis still unresolved it remains to be seen whether the IEA will release more oil once the initial 60 million barrels has reached the market. The decision will be made 30 days after the initial announcement, which will be by Friday next week, so some speculation about this will help drive the market in the days ahead.

Brent crude for September delivery is currently trading in a 114 to 120 dollar range with focus also firmly on the economic developments either side of the Atlantic. Should President Obama and the Republicans reach a debt ceiling agreement market focus could switch back to the European debt crisis and thereby support the dollar removing some support for oil.

Debt worries supports gold and silver

Gold made a new record high this week in several currencies as it benefitted from macro-economic news on both sides of the Atlantic. The worsening debt situation in Europe, the possibility of another round of monetary stimulus in the U.S. combined with a possible credit rating downgrade have all been playing into the hands of gold bulls.

 During the last few months the gold space has become less crowded with investors having pulled money out of gold. This is now helping gold back to record territory with investors coming back despite it being a time of year with traditionally low physical demand.

On the back of a nine-day winning streak I would expect some near-term consolidation with 1,550 USD providing support and 1,600 the resistance. As long as the macro environment stays friendly towards gold there is no reason why the year long rally cannot continue. Should we manage to break above 1,600 it could set off towards the upper end of the trading channel, currently around 1,680.

Silver also benefitted from the gold rally as it sits well below the highs reached in April. It has outperformed gold by some margin this week but is currently stuck in a six dollar range with 40 USD providing some resistance.

Grain prices higher on strong fundamentals

The significant sell off in grain markets during late June and early July came to an abrupt end with fundamentals such as hot temperatures and increased exports driving prices higher. The sell off was extended by speculators pulling out of the market in a hurry, causing a dramatic drop in long positions held by Hedge Funds and large investors. Since the peak in early February they have scaled back futures positions from above one million lots down to 400,000, the lowest level in a year. 

With such a dramatic reduction in speculative interest the markets have been in a much better position to react to fundamental news and this has caused the rise in corn, and especially wheat, during the past week. The weather forecast for the next couple of weeks across the U.S. corn and wheat belts indicates very hot and dry conditions which could hurt yields and exacerbate a tight supply outlook.

Rice surges back to 2008 levels

Rough rice traded in Chicago has rallied more than 13 percent during the last month on the back of reduced U.S. crops combined with uncertainties about the intentions of the new Thai government with regard to its rice policy. Thailand, the world’s largest exporter, could implement a minimum price to its farmers which would trigger higher export prices and thereby higher world prices. Meanwhile, in the U.S. crop projections for this season have been reduced to 6 million tonnes from 7.55 million tonnes last year as dry weather in Texas and floods elsewhere have cut production.

Sugar pauses after breathtaking rally

The price of sugar has stabilised around the 30 dollars per pound mark, after having rallied 47 percent from the May low. The market has been struggling to deal with expectations of the first fall in Brazil’s sugar production in a decade. Bad weather has hurt the sugar cane crop leading to expectations for a 2.2 million tonne drop in sugar output to 32.4 million tonnes. This should keep supplies tight during Q3 which is also reflected in the forward prices. The United States Department of Agriculture this week released data indicating a lower stock level than preferred which could trigger more imports over the coming months. The price however may now be vulnerable to a pull back as most of the supporting news seems to have been priced in.

Natural gas continues to go nowhere

The important 4 dollar level was tested again last week before a sharp bounce pulled it back towards mid range. The market is caught between expectations for a rapid growth of inventories this summer and the prospects for above average temperatures across two-thirds of the U.S., which could trigger higher consumption. Adding to this we are beginning to approach the hurricane season which also tends to keep the market supported during the duration. You can follow potential hurricane developments on www.nhc.noaa.gov .

Cotton back to earth

The price of cotton dropped further this week as weather concerns in the U.S. were offset by generally favourably global growing conditions which should help a rebound in global production from the depressed levels of the 2010/11 season.

An extreme drought in Texas which is responsible for one third of U.S. production, has caused farmers to abandon the crop and currently some 30 percent of  total U.S. planted acreage risks being dropped leaving the U.S. production some 8 percent below last year.

Production from China and India, two main producers, is expected to more than offset lost U.S. output with favourable weather lifting yields at a time where consumption from the two nations has been slowing as high prices have led to an increased use of synthetic fibres.