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Written by: Geoff Blanning
14/01/2016
Schroders' head of commodities Geoff Blanning says after five years of declines the commodity bear market is long in the tooth and expects bullish surprises to trigger strong recovery rallies in 2016 and beyond.

Commodity investors suffered in 2015 as major headwinds continued, primarily the strengthening dollar and the weakening Chinese economy. In the energy market, the new Saudi-led OPEC market share policy drove oil prices much lower than many expected, while weather played an unusually important role too, reducing demand for both oil and gas in the US and Europe and supporting near-record production of grains and oilseeds worldwide.

These are the three key catalysts for bullish surprises:

  1. Geopolitics: It is a matter of time before disruption to commodity trade flows occurs again – most likely energy or food-related in the Middle East and/or Russia.
  2. US dollar: Further dollar gains seem inappropriate, especially when observing the Federal Reserve’s tortuous interest-rate deliberations. When the dollar turns, commodities could surge.
  3. Supply/demand balances: There could be a return to supply/demand balance across a range of commodities. Distress amongst miners and energy producers accelerated in Q4 and the adjustment to supply will likely be extended. US natural gas is a prime example.

Energy: risks in the short-term but great potential for price appreciation

With oil priced at $31/barrel, it is more likely than ever that US production will fall steeply in 2016. Assuming global demand continues to grow at a modest rate, it is logical to forecast a solid price recovery as the year progresses.

The problem for oil remains in the short-term. The recent disastrous OPEC meeting, which confirmed a production “free-for-all”, gives rise to the possibility of higher OPEC output in Q1 2016. But an eventual strong recovery towards $60 (i.e. +70%) appears inevitable once supply gains have peaked out.

There is a clear shortage of gas developing in the medium-term (1-2 years) and we project a severely undersupplied market by the end of 2016, offering gains of 30-40% on a 12-month view. EU gas could also benefit from renewed Russia-Ukraine tensions.

Base metals: outlook dominated by China

Base metals stabilised recently, however, a constructive view will not be justified until we can be confident Chinese demand has bottomed, or supply cuts are deep enough to engineer deficits and inventory drawdowns.  Potential downside remains highest in copper; largest upside potential is in nickel.

In China we face a backdrop of a still-high investment/GDP ratio, high housing inventory and limited deleveraging. As the central government makes aggressive efforts to reduce overcapacity in 2016, the reduction of credit to loss-making productive capacity will become an important offset to weaker demand. Indeed, announced closures in the zinc and copper industries, combined with closure of high-cost, small-scale supply is leading to a tightening in underlying concentrate markets.

Precious metals: gold could benefit from weakening of the dollar

In gold, a key question is whether the market’s focus will shift in 2016 from its recent obsession with US interest rates and the dollar to a focus on demand and supply.

Although this is likely to be delayed, a greater focus on US real rates is probable; recovering inflation will keep real rates suppressed, supporting gold. Gold could gain anytime there is increased pressure on major equity indices, stress in high-yield markets or a further ratcheting up of China’s financial crisis.

Platinum fundamentals remain neutral. A very weak rand (moving from 11.5 to over 15 to the dollar in 2015) has delayed supply adjustments in South Africa (70% of global platinum mine supply). Investor sentiment was seriously impacted by the VW scandal, however the impact is likely to be less than initially feared.

Agriculture – turnaround year for major agricultural commodities

The negative fundamentals for the grains and oilseeds markets (i.e. large global crops and inventories, export competition, slowing Chinese demand, freight disadvantage for US products and the strong US dollar) are continuing, but are now largely factored into prices.

The fundamentals for vegetable oils are turning bullish owing to lower palm oil yields and growing Indian imports. We expect palm oil to continue to be the outperformer in the oilseeds subsector, followed by European rapeseed and Canadian canola.

The coffee market should continue to trade sideways barring any changes in the prevailing weather in Latin America or in other major growing countries. Fundamentals for sugar, which rose 20% in Q4 2015, are turning supportive for prices and there are expectations of a global deficit in 15/16, the first in six seasons.

An increasing number of animals, growth in their average weight and low US exports shaped the negative picture for meats in 2015. Given the fall in Chinese meat production, a sudden increase in imports of pork and poultry is likely in 2016 and could well be bullish, especially if the dollar weakens.

Geoff Blanning is head of commodities at Schroders

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