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What's Behind the Decline in Commodity Prices?

By  +Follow December 5, 2013 7:56AM
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On Thursday, Deutsche Bank (DB) hitched a ride on the bandwagon of investment banks fleeing the commodities space when it announced drastic cuts to operations in energy, dry bulk, agriculture, and base metals trading over the next two years.

The lender is not the only one fleeing from commodities, as the announcement comes on the heels of similar ones from other large investment banks like JP Morgan (JPM) , Barclay’s (BCS) , Goldman Sachs (GS) , UBS (UBS) , and Morgan Stanley (MS) , all of whom have apparently been scared off by a tightening regulatory environment (one that, it must be admitted, is at least in part of their own making); and even more so by the last three years of overall declining prices.

After a full decade of substantiall price gains commodities have slumped, and in 2013 the asset class as a whole is expected to underperform equities for the third consecutive year. The effects of this situation can be seen in a number of ways, but a look at the year-to-date performance of the S&P GSCI and Dow Jones UBS commodity indices is a good introduction, as both have traded lower in 2013 with respective losses of 2.6 and 10.6 percent. Furthermore, 10 of the GSCI’s components will end the year lower, compared to half that amount in 2012.

In any event, it looks as though the investment banks are following their own advice, as each one has come up with a variety of different forecasts for prices over the next few years that range from troubling to devastating. Putting aside, for the moment, that the largest international financial institutions may have more personal reasons for cutting back or even discontinuing trading in energy, metals, and agricultural products, their overall bearish outlook seems to be more or less justified by a convergence of three major factors.

 

Base Metals & Emerging Market Growth

China is the first of these. Since the early 1990’s, China has set the standard for eye-popping economic growth rates. The country has managed to lift millions of citizens out of poverty over the last couple of decades, and massive investments in infrastructure and development have made it the world’s number one importer of energy, and base metals like iron ore and copper.

Aside from the interruption of the financial crisis, the global economy had become quite comfortable with yearly GDP growth in the double digits.

This growth has been on the decline since its re-peak in 2010, falling to below 8 percent this year. For mining companies like BHP Billiton (BHP) and Rio Tinto (RIO) , this reduction to a still rather impressive GDP growth rate could mean that China will be buying less of their iron ore and copper. Since the turn of the millenium, however, stockpiles of these metals were often not large enough to keep up with demand, which kept prices high. If Chinese growth slows down even more, it could mean serious trouble for base metals in 2014.

 

Quantitative Easing & The Great Taper

Another factor that has been contributing to commodity price movement this year is the Federal Reserve’s massive fiscal stimulus program, or rather, fears that the Fed will soon begin gradually reducing its $85 billion monthly in treasury spending. If the Fed begins the dreaded “taper” by the end of March 2014, as many expect it to, the biggest victims will undoubtedly be gold, and to a lesser but still significant extent, silver.

Gold prices have spent the greater part of the year tanking, as is well known, largely because the yellow metal is being seen less and less as the “safe-haven” investment, and this has left it in. The implementation of QE itself did not contradict the metal’s 12-year bull market, at least until 2013 when the bull market for equities really ramped up. With many assuming that treasury spending would be around for a long, long time, there was less perceived need to hedge against risk.

Now, however, tapering is more or less expected by early next year. But a rebound in gold prices is by no means a given. Indeed, one of the Fed’s conditions for beginning the draw-down of stimulus spending is for inflation and the unemployment rate to meet specific targets.

 

Oversupply- Soft Commodities & Energy

The growing backstock of base metals like iron ore and copper is the result of a more mature and reasonable growth rate from major emerging markets like China, but there is also a glut in soft/agricultural commodities, and grain prices have been hit almost as hard as precious metals; corn prices have been cut almost in half. As of October, sugar supply exceeded demand by nearly 5 million tons, soybean production is rapidly approaching all-time highs, and record crops in major producing countries like Brazil and Vietnam are hurting coffee.

In fact, it seems that the only crop currently having a banner year is cocoa, increasingly consumed by developping economies, and in shortage due to the ravages of bad weather in major producing regions. In the US, retail chocolate prices are up about 7 percent over the last month, a clear sign that the higher costs are being passed down to the consumer.

The supply-demand balance in oil and gas stockpiles is also tilting in favor of oversupply, largely the result of substantial and unprecedented increases in US shale production. The difference here is that we may not see prices go down, at least not just yet. While the US and, increasingly, other nations develop unconventional resources putting more product out on the open market, a number of volatile political situations throughout Africa and Western Asia have been hitting major producers (ie- Libya, Nigeria, Sudan, and, potentially, Iraq), providing a temporary balance.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions.


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By  +Follow December 5, 2013 7:56AM
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