Commodity supply cutbacks in focus


2015 has been characterised as a year of belt-tightening for miners, farmers and energy extraction companies in certain parts of the world

The notable exception has been the Organization of the Petroleum Exporting Countries (OPEC), which changed strategy last November to produce as much oil as it can to gain market share. Elsewhere in the oil space, severe cuts to upstream investment should see supply tighten in due course.
Less progress in supply cuts have been made in aluminium and certain other base metals that see their supply heavily driven by China’s production decisions. While China started the year committed to economic reform that would see markets play a more decisive role in decision making, a number of mishaps (notably the country’s stalled attempts at injecting market dynamics into the equity market) has made progress in this regard disappointing.
US dollar appreciation is likely to cap commodity price gains in the final quarter of this year, although any disappointing data in the US could paradoxically be commodity price positive if rate rise expectations are pushed out further.

Gold: 2013, take-two?
Over the past quarter it has become more apparent that gold’s role as a monetary asset has out-trumped its role as a safe haven asset. Greece’s near-miss with default did not drive any significant interest in the metal, yet when the Federal Reserve failed to raise rates in September, we saw US dollar depreciation and the gold price rallied.
In our view the Fed is likely to hike rates in December and there is naturally going to be a negative weight on the metal’s price in US dollar terms. Although the Fed has prepared the market for eventual rate increases, we would not be surprised to see downward price movements as we saw during the “taper-tantrums” in 2013.
In euro and yen terms, the metal is faring much better.
Expectations of continued policy easing by the European Central Bank and Bank of Japan are likely to favour gold as an alternative hard asset to the euro and yen.
Gold has outperformed major equity indices in both in the US and euro area euro (S&P500, Russell2000, DAX, Stoxx50) in local currency terms year to date. The underperformance of cyclical assets is likely to bring gold’s defensive qualities to the fore.
Physical demand for gold from China and India had been weak in H1 2015, but there are signs the tide is turning. Withdrawals from the Shanghai Gold Exchange hit a record high in the January to August period, indicating demand for the metal has strengthened. We observed a similar surge in gold withdrawals from the Shanghai Gold Exchange in 2013 which led to gold consumption hitting an all-time high that year. Also echoing trends in 2013, Swiss exports of the metal to Hong Kong and China have surged in recent months and China’s net imports of gold from Hong Kong have doubled from a year ago in July. At the same time the gold futures curve is in backwardation. That presents a theoretical conundrum – why should a nonperishable asset trade at a lower price on spot than in the future if it can so easily be lent? Some argue that the price difference is not being arbitraged out, because the metal remains in tight supply for immediate delivery (i.e. in appropriate LBMA or COMEX Good delivery form). Once again this echoes what we saw in 2013.
With the Chinese central bank now producing statistics on its gold holdings more frequently (monthly since June instead of one in 9 years), we can see a steady accumulation by the People’s Bank of China, which is adding to demand.
Unfortunately, China’s surge in demand in 2013, did little to lift prices. This déjà vu moment could have more eerie similarities to 2013.
Gold demand in India usually hits a seasonal high in October.
However, poor weather conditions bought on by the El Niño could curb rural spending this season. Rupee depreciation may also make the metal seem more expensive to Indians.

Silver: supply deficit looms
Despite reports of coin mints running out of silver coins, there does not appear to be a general shortage of the metal. Although the US, Canadian and Australian mints seem to be facing manufacturing bottle-necks.
Only 25% of silver production comes from primary silver mines, with the remaining extracted as a by-product of gold, lead, zinc and copper. Silver supplies are therefore often difficult to control as the decision to mine is often driven by the mining decision of other metals.
With a general cutback in mining activity across many metals, silver supply looked like it was tightening at the beginning of the year. We expect that the metal will be in a supply deficit in 2015. However, recent data from the World Metals Bureau indicates that mine supply is gathering pace once again.
Supply from scrap sources, historically over 20% of global supply, declined for the third successive year in 2014. Scrap supply may remain tight due to weak prices and could account for less than 15% in 2015.
Retail investment in India looks like an area of relative strength. According to Metal Focus data, year-to-date imports of silver bullion have amounted to 4,900tonnes, a 50% increase on the same period last year.
Silver maintains a tight correlation with gold. So despite the increase in demand for the metals from emerging markets like China and India for both metals, the global price may be more dictated by their role as a monetary asset.

Platinum: Plummets after emission scandal
The Volkswagen emissions scandal revealed on 18 September caused a sharp divergence in sentiment resulting in platinum’s premium over palladium trading at its lowest level in 13 years.
Despite an improvement in the demand outlook for platinum from jewellery and investment, negative sentiment for Platinum continues to weigh on prices. While fears of a consumer shift in preference for gasoline cars, buoyed by robust US auto sales have helped palladium reverse its downward trend.
The software defeat device used in Volkswagen’s diesel engines cheated on the results of NOx (nitrogen oxides) testing, violating the US clean air act. Versions of the Volkswagen’s diesel engines fitted with the Lean NOx trap (LNT) and urea based selective catalytic reduction (SCR) system emitted up to 35 and 20 times the EPAs required limit, respectively.
Models fitted with the SCR system require a top off of a urea solution on gases exiting the diesel oxidation catalyst. The software on Volkswagen cars sensed when the test mode was active and released urea into the emission gas to neutralize harmful nitrogen dioxide emissions. Despite having no role to play in the after treatment of NOx emissions platinum suffered the brunt of the scandal. It’s worth noting that a recall of cars by Volkswagen will also have no direct bearing on the demand for platinum, since the NOx after-treatment is not impacted by the PGM based oxidation catalyst. Exacerbated fears of a consumer shift in preference for gasoline vs diesel cars have weighed on the demand outlook for platinum known to derive 44% of its use in pollution abatement technology in both diesel and gasoline cars. While the case for fuel efficiency remains strong for diesel engines it’s hard to determine how long Volkswagen’s deception will curtail demand. The trend of rising European auto sales is diverging from the downward trajectory of platinum prices.
Plunging platinum prices have led a sharp rally in the gold to platinum ratio and could help switch investor preference for cheaper platinum jewellery. The onset of the festival season in India coupled with rising platinum imports from China (up 16% year on year) bodes well for Q4 demand outlook. Platinum backed exchange traded funds continue to add to their holdings expanding 4% this year.
On the supply side, improvement in operational and safety performance helped South African platinum mine production rise 21% since the first quarter as reported by the World Platinum Investment Council (WPIC). Scrap supply declined in the second quarter by 5% as falling prices reduced the auto catalyst collection rates. Despite a 9% rise predicted in total supply, WPIC have revised the 2015 forecast for the platinum market deficit to 445koz from 190koz on the back of higher investment demand.
Rising costs of production amidst falling prices have forced the world’s largest miners of platinum to slash jobs and idle mines in an attempt to reduce capex. Lonmin, the world’s third largest platinum producer will cut annual platinum production by 100,000 ounces putting 6000 jobs at risk. While Anglo American platinum sold its three platinum mines in Rustenburg to Sibanye Gold. And its parent Anglo American plans to cut a third of the global workforce over the next few years.
We believe platinum prices have been unduly impacted by the emissions scandal and weakness in platinum prices will continue in the short term as negative sentiment pervades fundamentals. However rising auto sales in US and Europe, the onset of the festival season in India and China and moderate speculative investment appetite bode well for platinum’s long term demand outlook.

Palladium: Fuelling up on diesel woes
Palladium known for generating 70% of its use in gasoline auto catalysts, that have a high penetration in US and Chinese auto markets, surged to a 3month high $709. Fears of a shift in investor preference to gasoline powered engines coupled with the best US auto sales in more than a decade helped improve the demand outlook for palladium.
In addition President Li Keqiang’s announcement on 22 September to accelerate construction of electric-car charging facilities in China boosted palladium prices. While in reality Palladium has no role to play in electric cars, the government’s commitment to clean energy was bolstered, aiding the pollution abating metal.
The rise in Chinese imports of 14% in August closely tracked by rising auto sales of 12% created a favorable environment for palladium’s demand.

Oil: in pursuit of balance
Oil prices have resumed their decline after brief rallies between March and June and between August and September. The oil supply glut warrants further price weakness to help the market gain balance.
The process appears to be working. Demand for crude is set to increase according to the International Energy Agency, which edged up its demand forecasts once again last month, bringing 2015 demand to a five-year high.
Low oil prices are driving project deferrals and will cut investment across the industry. A recent study by Wood Mackenzie shows that 20 billion barrel oil equivalent (boe) of final investment decisions in upstream energy will be deferred as a result of the rout in prices this year. That equates to a US$200bn hole in the industry’s investment pipeline. Over 50% of those cuts come from deep water projects and nearly 30% from Canadian oil sands. The lead-times for these projects are long. Once deferred these projects will not come back onstream quickly.
US oil rigs in operation have also started to fall again, helping to tighten supplies from the US. According to the IEA, US tight oil supply could fall by 400k b/d next year (from 4.3 m b/d to 3.9m b/d), factoring in rig closures and depletion rates. A key feature of the US tight oil market is the continued need for investment to maintain the current pace of production. Output per US tight oil well has historically fallen by more than 70% in the first year of operation, highlighting the need for rigs to be moved frequently.
Russian and North Sea oil production is also likely to decline, taking non-OPEC supply down to 57.7m b/d at the end of 2016 from 58.1 m b/d at the end of 2015 according to the IEA.
OPEC crude supply actually fell in August, led by losses in Saudi Arabia, Iraq and Angola. We don’t think that OPEC is going to change course on its strategy to rebuild market share and therefore the group’s production is unlikely to fall significantly, but the last month’s data highlights that it is difficult even for OPEC to continue to produce at such volumes.
We believe that it will take some time for strengthening demand and slowing supply to bring the market into balance. A lot rests on whether OPEC continues to increase production.
However, as the process gathers pace, we could see Brent crude reach US$60/bbl in the second half of 2016.
We believe that the era of US$100/bbl oil is well and truly over.
Oil may reach US$80/bbl when the markets regain balance in 2017.
However, there are risks of temporary spikes. As non-OPEC production continues to decline, the “call” on OPEC will increase. OPEC spare capacity remains low by historic standards. The ability of the group to respond to production shocks is likely to be compromised and so shocks could more easily translate into price increases, as they have done in historic periods of low capacity.
that supply disruption risks are non-negligible. Disruptions are currently significantly higher than they were in 2011-2012, with long-standing outages in Libya and Iran (OPEC) and Syria and Yemen (non-OPEC). In 2015, outages in the Neutral Zone at the Khafji and Wafra fields between Saudi Arabia and Kuwait have also detracted from supply. Further disruptions could put strain on a system that is operating at close to capacity.
The impact of shocks are likely to be short-lived because US tight oil can be very responsive to price changes. It can take as little as a month to switch on horizontal rigs in tight oil formations in the US and many lie idle at the moment.

Natural Gas: warm winter woes
Natural gas inventories rose by 10% last month as the end of the seasonally high demand period gave way to the fuel injection season. By the end of October the EIA expects inventories to increase to the third highest October-end levels on record.
Meteorologists expect the El Niño to provide a warmer winter in northern parts of the US, which will likely reduce heating degree days. Although southern parts of the US are likely to be colder than normal, the impact on heating demand is likely to be more pronounced in the north. Natural gas prices are likely to fall.

Have prices reached their bottom?
Industrial metals over the past quarter have been mainly driven by concern over China economic slowdown and rising volatility on the global stock market. Following the rout on China stock exchanges in late August, a Chinese hard landing scenario has become much more real in investors’ mind.
However, positive signs have lately emerged from a technical viewpoint which, if confirmed, could brighten the outlook for Q4.
With the exception of tin, industrial metals recorded negative returns of 10% on average over the past quarter, as global manufacturing data disappointed. China Manufacturing PMI came out weaker than expected for July and fell below the 50 mark for August and September, indicating that the sector has been contracting. The US ISM, although above the 50 mark, also disappointed, adding to the general pessimism that has been affecting the industrial metals market for months.
As global stock markets were recovering from the Chinese turmoil late August, metal prices rebounded from their multiyear lows as well, ending the quarter in a positive note.
Although signs of fundamental support have yet to materialise for most metals, market sentiment has recently started to reverse for aluminium, copper and tin, suggesting that prices could have reached their bottoms in Q3. We believe that prices will recover in Q4 as global production cuts across industrial metals accelerate.

Aluminium: Surging output weighs on price
Aluminium declined by 5% in Q3 as concerns over elevated Chinese output kept prices low. After surging 35% in Q1, output from China has stabilised in Q2/Q3 according to the World Bureau of Metal Statistics (WBMS). However, China production rise was in response to a leap in domestic consumption which rose to an all-time high in March 2015.
Although China is a net exporter of the metal, exports dropped 23% in H1 2015 and 27% compared to June 2014, suggesting that concern regarding oversupply was somewhat overblown.
The global aluminium market is in deficit, confirming that the market is tightening.
At the London Metal Exchange, net non-commercial positions in aluminium futures have shown signs of recovery in Q3 as money managers reduced their short positions for the metal, suggesting that sentiment may continue to experience a favourable shift in Q4. Tighter market conditions combined with positive sentiment could lift aluminium prices.

Copper: weak prices lead to supply cut
An uncertain global economic outlook has prompted volatile copper trading, initially dragging the price of copper down to its six-year low at the end August. The metal subsequently rebounded 9%, crossing US$5,400/MT on the back of supply concerns after a severe earthquake in Chile. Copper closed the quarter at US$5176/MT, down 10%.
Weak copper prices have however started to affect global supply as two of the largest commodity producers announced revised figures for 2015 and 2016. Glencore revised down its output target for 2015 by 500k tonnes while Freeport said it will reduce capital spending to US$4bn in 2016 compared with US$5.6bn initially planned. Chile, the world’s second largest producer of refined metal after China, saw its production down 6.4% y-o-y to July according to the WBMS. Codelco, the world’s largest copper miner, also expects output from Chilean mines to fall 33% in the next 25 years as ore grade is declining in Chile.
Meanwhile, sentiment towards the metal is also reversing. Net long positions into copper futures listed on the LME and COMEX recently surged as money managers dropped their short positions. Although net positions remain more than 40% below their peak in May, this shift in sentiment should eventually lend support to copper price in the near term.
Of the 364k tonnes of surplus forecast by the International Copper Study Group (ICSG) for 2015 in April, only 19k tonnes (5.2%) have materialised so far. China copper net imports surged 11% y-o-y to July as domestic consumption jumped 7.1%, indicating that China demand for the metal has been strong. We maintain our view that copper will end this year in a deficit on strong global demand and further production cuts.
We expect the price of copper to lead industrial metals recovery in Q4.

Lead: Waiting for a catalyst
Down by 5% in Q3, the global lead market appears to be relatively balanced this year according to the latest numbers from the International Lead and Zinc Study Group (ILZSG).
The metal posted a small 1,000 tons surplus in July 2015.
China is the world’s largest producer and consumer of refined lead, followed by the US. While manufacturing weakness has weighed on prices across the industrial metals complex, we expect negative sentiment to be overdone. Accordingly a turnaround in sentiment could help support prices.

Nickel: Elevated stockpiles keep prices low
According to data from the WBMS, the global market in H1 2015 recorded a deficit for the first time since 2006 while the Chinese market has been in deficit since 2000. China accounts for 36% of the world production and 60% of the world consumption and is on track for its largest deficit in 2015. As a result, China has been importing nickel during H1 2015, getting close to its record in July 2009.
However, large stockpiles kept the price of nickel low in Q3.
While inventories at the LME have declined by 4% since the peak at 470k tonnes in June, stock-to-use for July still stands at around 800, indicating that any shortfall of supply can be covered by inventories for at least 2 years.
We however believe that global demand for nickel will continue to ramp up, above all from China, trimming inventories further. We maintain our bullish view on nickel and expect the metal to be one of the best performers of the complex in Q4.

Tin: Price gains on low Indonesian exports
Tin was the best performer among industrial metals in Q3,
gaining 13% as Indonesia, the largest exporters of tin, is on track for its lowest annual exports on record.
The decision of Indonesia to introduce new rules for shipments of tin in May has caused delays in delivering export approvals under the new rules sending tin exports for July to 6.3mn tonnes, down 24% compared to previous month and 17% y-o-y.
The news came shortly after the metal reached its historical low early July, providing a boost to the price of tin.
At the Indonesia Tin Conference and Exhibition (ICDX) in mid-September, the Association of Indonesian Tin Exporters(AETI) stressed the importance to support the price of the metal as between 50% and 70% of Indonesian tin resources are not minable at prices around US$15,000/MT according to the president of the association. After reaching US$14,000/MT in late August, tin rose 12% since. We believe global supply will continue to tighten and lend support to the metal in Q4.

Zinc: Inventories build-up weighs on price
Zinc is the worst performer of the quarter, down 16%, as inventories at the LME warehouses saw 38% rise since mid-August, underscoring the abundant supply situation market.
According to the ILZSG latest numbers, the world zinc market recorded a surplus of 172k tonnes during H1 2015, following two years of deficit, with the largest monthly surplus being in February.
A recovery of other industrial metals would lift the price of zinc. However continued rising inventories are likely to cap upside gain in the near term.

Extreme El Niño
The 2015 El Niño is already the strongest since 1997-98 by some measures, and could become the most severe since records began in 1950. In our last quarterly outlook, we described some of the implications of an intensifying El Niño event. Meteorologists can confirm that we are in a strong event, lifting some of our conditional statements on its implications. However, El Niños rarely occur in isolation, with several other weather patterns competing, complicating actual outcomes. Extreme El Niños are also very rare, with only three others on record (1972-73, 1982-83, 1997-98), limiting our empirical knowledge on the topic. Notwithstanding these limitations, we believe that the weather event will be positive for corn, cocoa and sugar prices and negative for soy and coffee.
The El Niño is likely to last into 2016, peaking in winter 2015 and therefore will affect a number of global crops in production.
The El Niño had arrived too late to affect the US winter wheat harvest that has just completed. The US crop remained strong, but fell short of the 2012/13 high. Larger crops in the European Union, Russia and Ukraine have helped boost global production to a record high for 2015/16.
Australian climate is highly influenced by temperature patterns in the Indian Ocean. Sea surface temperatures in the southern Indian Ocean had hit the highest on record for the southern hemisphere winter. El Niño is usually associated with belowaverage southern hemisphere winter–spring rainfall over eastern Australia, and a warm Indian Ocean typically reinforces this pattern over central and southeast Australia.
However, this pattern has been offset in central and some southern areas by the record warm Indian Ocean. Warmth in the Indian Ocean is likely to continue. Wheat growing in eastern pasts of Australia is likely to suffer, while wheat growth in Western Australia will likely prosper, with both effects broadly offsetting each other on price. El Niño intensification could out-trump the Indian Ocean effects in due course, but with a significant portion of the reproductive growth period over, there is likely to be little upside to prices in this season.

Corn is likely to be in its first supply deficit since 2010, with reduced planting driving the tightness. The El Niño is likely to exacerbate the situation as unfavorable weather conditions in the US could hurt the crop. European Union corn growing has been adversely affected by hot dry weather, with the USDA reducing its estimate for the size of the EU crop for this season by close to 7% last month.

With the Brazilian and Argentine harvests over, focus is now on the US where the harvest will begin. US production typically increases in El Niño years with a combination of increased precipitation and warmth aiding yields. With that boost to yields we are likely to see record global production, after a very strong output from Brazil earlier this year. While demand is also expected to increase, it will not keep pace with supply, likely leading to the fourth consecutive year of supply surplus.

The El Niño is likely to exacerbate the dryness in West Africa and hamper the cocoa crop this year. Ghanaian yields have been poor this year. The Ivory Coast paradoxically has suffered from too much rain during its flowering process in July, and now excess dryness brought on by the El Niño will be ill-timed as the crop enters its main harvest period. Although cocoa prices have already rallied this year, we could see the further upside to price.

The El Niño has suppressed the Indian monsoon, driving rainfall 12% below normal levels. India, the second largest producer of sugar, relies on monsoon rainfall for 70% of its annual precipitation. Some of the key sugar-producing regions of India have seen their rainfall fall 20 to 59% below normal.
The Indian Sugar Mills Association has revised its production estimate for this year down to 27 million tonnes (-3.6% from its July forecast).
Brazil, the largest producer of sugar, is experiencing excess rain which is slowing its harvest. São Paulo has harvested 8% less cane so far this year (harvest should end in November) and sugar production in the region is currently 14% below last year’s levels. Should the rain not abate, cane in the ground could start to spoil, hurting this year’s crop.
China has been reducing its own planting of cane amid weak prices in recent years and will need to import a record 5.5 million tonnes in the 2015/16 marketing year which has just started (up 70,000 from last year). The USDA has already upgraded the 2014/15 import estimate by a million tonnes to 4.8 million tonnes. China is now the largest importer of sugar and the USDA’s forecast of Chinese consumption growth of 1.7% this year will see its share of global consumption grow.
Although there is no danger of running out of physical sugar, with five prior years of surplus global production to work through, a smaller crop this year is likely to lead to a supply deficit. The International Sugar Organization raised its deficit forecast to 2.487 million tonnes in August from 2.3 million in May.

Arabica coffee has seen significant volatility this year amid speculation about the size of this year’s Brazilian harvest and volatility in the Brazilian Real. Brazil accounts for 45% of global arabica production and last year’s drought threatened to damage this year’s crop. While rain has been unseasonal this year, it has been plentiful, helping to reverse some of the damage to coffee bushes last year. Speculation ceased at the end of September with Conab (State Agricultural Department) announcing that the arabica harvest was only 3.1% below last year’s, significantly better than many had expected.
Still weighing on coffee prices is the depreciating Brazilian Real. Economic woes and corruption scandals have depreciated the currency by 40% against the US Dollar in the past year. As coffee is traded in US Dollars, Brazilian farmers have been keen to sell into the international markets as they have been able to maintain a stable income in Brazilian Real terms despite the falling price of coffee.
The El Niño is helping to provide precipitation in key growing areas in Brazil during its flowering process, which should aid recovery of the crop yield in 2016. El Niño may reduce rainfall in Central America and Mexico (25% of global Arabica production). That could help supress the rust fungus that has been damaging the crop in the region for the past few years. As long as the dryness is not excessive, we could see crop production in the region improve. El Niño is also likely to increase dryness in Colombia (10% of global production) and hurt the crop there. According to the Federacion Nacional de Cafeteros de Colombia, 18% of the national crop is likely to be exposed to areas of reduced precipitation. However, on balance we believe El Niño is likely to benefit than damage more growing regions. And Colombian production has had a running start to the year, with January to August production up 13% compared to the same period last year.

Martin Arnold, Edith Southammakosane – Directors, ETF Securities Research – ETF Securities