dutchinvestor.research.why commodity prices may be headed for new highs

7/27/2019 Dutchinvestor.research.why Commodity Prices May Be Headed for New Highs

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DutchInvestor.com [WHY COMMODITY PRICES MAY BE HEADED FOR NEW HIGHS]

By BNY Mellon Asset Management 1

Why commodity prices may be headed for new highs

By BNY Mellon Asset Management

Introduction

The dramatic run-up in commodities prices and their subsequent collapse over the last few yearshave attracted attention from the media and investors. We believe there are important structuralsupply elements that could push prices beyond recent highs. Contrary to common misconceptions,we believe the US dollar does not need to weaken for commodity prices to move higher andspeculative investors do not determine price direction. If present trends continue, we could see oilprices north of $165 a barrel before 2013. It is the basic structural supply forces and an inability tomeet demand that will drive commodity prices higher and not the more sensationalistic possibilitieson which the press commentators like to focus.

Demand Elasticity and Commodity Corrections

With such a precipitous drop in commodity prices from mid-2008 through early-2009, whenindexes tracking commodity prices fell by more than 50%, it is hard to understand how marketfundamentals could have led to such a peak and, conversely, to such a collapse. The answer lies withthe concept of demand elasticity. In an earlier paper, we discussed the parabolic ascent ofcommodity prices and cautioned that this dynamic could unravel in an equally dramatic fashion ascommodity availability reaches what is known in commodities trading as a pinch point.

Quite simply, historically, as the available inventory of a commodity reaches a particularly low level,a scarcity value arises such that buyers are willing to pay a significantly increased price to secureanother unit of that commodity. The extent of that higher price will be determined by the elasticity


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of demand for that commodity. For instance, if a manufacturer is considering a large order ofwashing machines and realizes that the entire order will be worthless unless he is able to secure anadditional 100 pounds of copper, he may be willing to pay prices twice current levels to ensuredelivery of that copper.

As highlighted in Exhibit 1, a typically linear function of lower availability and higher pricesbecomes parabolic as scarcity becomes a concern and prices rally sharply. Our concern in 2008 wasthat with some slack in demand and a subsequent increase in the availability of commodities, thepricing function would reverse, and the fall in commodity prices would be equally extreme. Asturmoil in the economy emerged throughout 2008, that scenario is exactly what we saw: commodityprices fell sharply in the second half of that year.

Demand Recovery to Exert Renewed Pressure on Limited SupplyWhen commodity prices fell by more than two-thirds in 2008, many skeptics of the commodity cyclefelt vindicated, but their victory lap was cut short as prices rebounded with vigor in 2009. While the

timing was difficult to foresee, the recovery was not.

Commodity prices ultimately recovered as markets recognized that the recent fall in commodityprices was related to demand, not additional supply. As such, when demand for commoditiesrecovers we are more than likely to experience renewed, if not sharper, concerns about availability.We outgrew our supply system in 2006, and if demand reaches those levels again, we may seecommodities making new price highs.

Pundits have correctly pointed out that commodity prices have recovered far in advance of anyrecovery in demand. However, the resurrection of commodity prices in 2009 was about theexpectation of a recovery. Because the demand recovery has not been as sharp as the commodityprice recovery, commodity prices have begun to stall near current levels. For commodity prices to

break out of their current range, we believe we need to see signs of demand returning andcommodity consumption depleting inventory levels. As much as 2009 was about an expectation of arecovery, 2010 will be about the evidence of a recovery.

Understanding Commodity Cycle Length and Amplitude

Forecasting commodity prices with precision is an exceedingly difficult and somewhat futile task.The best we can hope for is to forecast directionality (rising versus falling prices) and attempt toanticipate catalysts that will lead to a continuation of commodity price trends or their impendingreversals. Supply and demand curves are usually the most appropriate place to start. Demand is apowerful, yet fickle, variable in the equation leading to significant volatility within the broadercommodity cycle. Demand will determine how high prices can go, as a function of the elasticity

discussed above. However, supply will determine the length of the cycle.

Another theme from our earlier publication was the difference in the length of supply and demandcycles, with the supply cycle ultimately determining the fate of the broader commodity cycle.Commodity prices depend on the ability of supply to meet demand, and while demand levels canfluctuate rapidly, supply levels generally do not. Given the amount of capital it requires to produce anew supply of commodities as well as geographical and geological challenges, projects can typicallytake a decade from concept to completion. Add a couple of years for commodity prices to increase tolevels sufficient to attract investment, and commodity cycles can exceed 15 years from trough topeak. See Exhibit 2 for historic commodity price cycles; where demand drives short cycle volatility(as represented by the jagged grey line) and supplies the longer term trend (as indicated by the redand blue arrows).

As it takes supply a long time to respond to increased demand, close analysis of the supply side isvital to understanding the length of the broader commodity cycle. The parabolic move in commodity


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prices from 2004 to 2008 suggested that demand had outstripped supply and thus new investmentin supply was needed. The important question is how much supply was added during the lastcommodity price run, and when we can expect the tidal wave of new supply that will mark the end

of the current commodity cycle.

As mentioned, it typically takes up to 15 years or more before meaningful supply can be added.Prior to the recent correction in commodity prices, we had expected 2011-2012 to be theapproximate year that meaningful new supply would be added to commodity markets. This wasbased on the number of new projects and capacity expansions announced by companies as theircash flows grew with higher commodity prices.

However, the recent economic recession has significantly pushed out that timetable. The rapid fall incommodity prices forced companies to reevaluate their investment projects, with many companiesdelaying or outright cancelling projects to preserve cash flows. We did not expect all of the projects

to go live as some of them were far too aggressive in terms of economics and timing, but the shiftwas far more dramatic than we had expected. In fact, the Financial crisis has further complicatedmatters as many companies are unable to secure financing as easily as they had planned. Exhibit 3highlights the evolution of supply expectations.

How Long Will the Cycle Last and How High Could Prices Go?

With all of these challenges to adding new supply, we have now pushed the tidal wave of newsupply to the 2013-2015 time frame. When that new supply enters the market, we believe the long-term trend of increasing commodity prices will reverse. Projects coming online with new supplymay provide more than enough commodities as they will have been designed for growth and theability to meet future demand. This additional supply will also likely come with improvedtechnology and production efficiencies which may lower the cost to produce those commodities.

Lower costs mean lower prices, especially when demand softens at weak points in the businesscycle. Until then, however, we anticipate new highs in commodity prices, driven mostly by the lagsin supply capacity.


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So does the reversal of the US dollars weakness mean the demise of the commodity price rise? No.While 2009 experienced a strong negative correlation between commodity prices and the US dollar,we expect that correlation to deteriorate during 2010. In the absence of traditional supply anddemand data points, the US dollar may have a larger impact on commodity prices, but as evidence ofa demand recovery emerges, the impact of the US dollar on commodity prices may fade. In fact, theUS dollar and commodities only experience a negative correlation half the time, as shown in Exhibit5.

As for the effect of speculators, it is true that growth has been explosive in commodity funds, ETFs,and other various financial instruments associated with commodities, but their impact on prices is

associated with increased volatility. Speculators can exaggerate the moves in commodity prices, butthey cannot determine their direction for an extended period of time.

Speculators can create positions within commodity paper markets that can have a significantimpact on commodity prices, but eventually commercial players need to transact at those prices setby the speculators in the physical market. If consumers of those commodities do not emerge topurchase physical amounts, prices will eventually collapse. The largest natural gas exchange-tradedfund (ETF) was a great example of this dynamic as a structurally oversupplied natural gas marketfound price support from an explosion of speculative buyers. Every time a new buyer of the ETFemerged, the fund was forced to issue new shares and purchase natural gas through the futuresmarket. Eventually, the ETF ran into problems issuing new shares as the fund was having difficulty

rolling its positions through the futures markets. Once the fund stopped issuing new shares of theETF, the price of natural gas collapsed. Exhibit 6 compares shares issued by the ETF versus domesticnatural gas prices, where most of the speculative activity takes place, versus UK prices, which are


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subject to far less speculator influence. As natural gas markets struggled over this time, the ETFshare issuance was only briefly able to support the US gas market.

Conclusion

Among the many factors that drive commodity prices, we believe demand elasticity, speculators andthe US dollar are all shorter-term catalysts. These factors can create significant volatility and shouldbe monitored. Speculators may exaggerate price moves, demand elasticity will limit how high pricescan go and dollar correlations will drive prices only in the absence of stronger influences. However,supply will ultimately determine the secular fate of commodity price trends. That is why, regardlessof the recent plummeting and limited recovery in commodity prices, we believe the fundamentalsecular issues around supply constraints could push commodity prices far beyond their recent highs

as demand recovers. The long lead times required for adding additional supply capacity means wecould see a renewed run in commodity prices well through 2013 or beyond.


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Contact:

Jonathan LubranT: +44 20-7163.4300

[email protected]

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