Investing

What's Ahead for Commodities


The most recent surge in commodities has been tied to the weakening U.S. dollar, which makes dollar-denominated commodities more affordable, and improved economic conditions, which reignites concerns about rising inflation. Oil prices jumped more than 10% in little more than a week, getting another lift on Aug. 21 as the dollar lost some ground to the euro on strong economic reports out of France and Germany.

But determining whether to bet on commodities now calls for some careful disentangling of conflicting economic signals.

China has been the most important driver of global commodities demand over the past 10 years. Some analysts worry that China will rein in the massive economic stimulus it has deployed to counter the worldwide recession to prevent an economic bubble from developing. The government has cracked down on mortgage lending standards and now plans to tighten capital requirements for banks, which could reduce other types of lending.

Meanwhile, improving auto sales in the U.S., thanks to the success of the cash-for-clunkers program, and further strength in the housing market suggest the economy is getting ready to expand, which would boost demand for oil and other commodities.

The Dollar's Influence on Oil's Outlook Phil Flynn, an energy analyst at PFGBEST, a nonclearing U.S. futures commission merchant in Chicago, attributes the runup in oil prices from the lows of $30-$40 per barrel earlier this year to government stimulus programs in China and elsewhere. He believes China's stimulus program caused it to import "a record amount of oil" in the last couple of months, with some of the oil going unused amid a decline in industrial production. He expects China to remove some of its stimulus and, once that happens, he predicts oil prices will fall due to oversupply, at least in the short term.

However, some analysts believe sentiment toward the dollar will have more influence on crude oil prices than China. Unhappy about the ballooning of the Federal Reserve's balance sheet and the amount of debt the U.S. has borrowed, many people are betting against the dollar and expressing those bets in the crude oil market, says Paul Smith, chief risk officer at Mobius Risk Group in Houston.

"A lot of people have bought crude on expectations that the dollar will crater," Smith says. But with so many investors betting against the dollar, it will be hard for new capital to come into the market to drive the dollar down further, he says. "That paints a bear picture for commodities in general for the short term." Further positive economic news out of the U.S. or any hint that the Fed might consider hiking interest rates would cause a short-covering rally in the dollar, he predicts.

If the dollar stabilizes, the oil market will be forced to focus on supply and demand again, says Flynn at PFGBEST. U.S. energy inventory numbers are much higher than they were a year ago—up 15.2% for crude, 3.8% for gasoline, and 22.6% for distillates such as home heating oil. Demand, on the other hand, has fallen substantially from last year, down 0.1% for gasoline, 9.1% for distillates, and 13.5% for jet fuel. Flynn expects to see oil prices back below $50 a barrel by the first quarter of 2010.

China's Infrastructure Projects While China pushes for better-quality mortgage and other kinds of loans, the country will keep boosting its economy in other ways, according to Frank Holmes, commodities fund manager at U.S. Global Investors (GROW). He sees the government continuing to use its strategic dollar reserves to buy physical commodities such as oil and metals that it needs to support ongoing economic growth.

The nature of its infrastructure projects has changed from the massive dams and power stations of 10 years ago to electrical transmission lines into rural areas and high-speed trains, both of which require plenty of copper and other metals.

Copper prices have doubled to around $2.80 from $1.40 a pound at the start of this year, certainly on the prospect of an economic recovery, says Dave Meger, a metals analyst at PFGBEST. "Copper is a perfect example of a recovery-type commodity. It's used so widely across the board in the industrial sector."

Luther Lu, an analyst at Friedman Billings Ramsey (FBR) who covers coal, metals, and mining, anticipates a pullback in commodities but thinks certain products are more vulnerable than others. Copper prices should remain strong due to perceived scarcity and the likelihood that China is stockpiling some of it for new nuclear power plants and other aspects of its electrical infrastructure buildout program. Aluminum, by contrast, will pull back more because it's not in short supply and is in fact "infinitely recyclable, according to Alcoa (AA)," says Lu.

He's projecting an average price of $2.60 for copper in 2010 and an average price of 86¢ per pound for aluminum, vs. 89¢ currently.

Mine Strikes and the Metals Industry Investors in metals need to be more aware of the impact of strikes at major mines around the world, which can potentially deplete inventories very quickly, says Holmes at U.S. Global Investors. He attributes the spike in nickel prices until recently more on a lingering strike at Canada's largest mine than on Chinese stockpiling. A strike that may begin Aug. 24 at the Impala mine in South Africa, which accounts for about one-third of that country's platinum production, could drive platinum prices much higher, he says. South Africa produces roughly 70% of the world's platinum supply.

Platinum and palladium have mostly been tracking equity and oil prices for most of this year, and are reacting to improvement in the broader economy, says Tim Murray, general manager of precious metals marketing for Johnson Matthey North America (JMAT.L) in Wayne, Pa.

Most of the U.S. demand for these metals is tied to their use in cleaning auto emissions, and "we're now starting to see hopeful signs that perhaps the auto market has bottomed and is beginning to recover here," he says. That's somewhat bullish for platinum and palladium, but not necessarily a buy signal, even though it tends to offer support to prices, he adds.

Platinum is now selling for roughly $1,250 an ounce, down dramatically from its peak around $2,100 in June 2008, but a nice recovery from a low of around $800 in the fourth quarter of 2008. Chinese jewelry demand for platinum has been strong this year because of the lower prices, but the Chinese will probably buy less as the price rises. Another reason for caution in platinum: Long positions by traders on the New York Mercantile Exchange and the total physical platinum and palladium being bought and held in Zurich bank vaults by platinum exchange-traded funds are near all-time highs, which means platinum could be ripe for a sell-off, though not a big one, says Murray.

Agricultural Commodities Meanwhile, demand for agricultural commodities has strengthened despite the economic downturn, says Dan Basse, president of AgResource, an agriculture market research company in Chicago. He doesn't see a slowdown in lending in China affecting the longer-term dynamics of rising disposable income and higher caloric intake in that country.

Another weight on commodities, besides further economic weakness or dollar strength, is the sharply reduced amount of leverage being used compared with the six to seven years before the financial crisis. That's resulted in "tons of excess capacity for a lot of things [such as] gasoline and petrochemical refining," says Smith. "If it was leveraging credit that created that demand, that is not coming back easily."
Bogoslaw is a reporter for Bloomberg Businessweek's Finance channel.

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