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An Overview on Global Commodities, Mike Coleman, Director, RCMA Group

Transcript from Opalesque Singapore November Roundtable 2016

Mike’s biography could be found at: http://www.rcma.com/leadership-mike
4 Jan 2017

Mike Coleman: Regarding the commodity markets, the interesting thing here is that from a broader investor’s point of view, they are not correlated with the interest rate cycle particularly, and the bond and equity markets. So commodity markets are on the demand side primarily about GDP and industrial production growth for most commodities, and on the supply side, certainly for the agricultural and soft commodities, it’s a lot to do with weather.

So broadly speaking, you can divide commodities into agricultural and soft commodities, which are really more affected by the supply side and Industrial commodities, including petroleum, that are much more demand focused. Because of the weather impact and relatively short crop cycles, the supply of sugar or coffee, wheat or corn can vary as much as 20% or 25% year on year, whereas demand for food stuff is principally about population growth, how many mouths need feeding, and an element of disposable income.

People’s diets change as they get richer, they consume more calories, but it’s not a linear extension. While in the developed world we generally eat more calories than are good for us, we can’t eat double the calories we are currently consuming. So, for every population and economy, calorie consumption grows quickly with GDP and then flattens out, and then probably begins to decline again as we all get rich and health conscious.

But, agricultural or soft commodity markets are really about the weather. And from that side of view we are living through a very interesting period, because after broadly speaking, a benign global climate environment really from the mid-1970s through until the mid-2000s, over the last ten years we have moved into a much more volatile weather environment. We have had La Niña – El Niño flips several times in the last six years. Currently we have just flipped from an El Niño to a La Niña. We are experiencing a much higher incidence again of both weather disruption and weather positive impacts, depending on where the rain is falling and where it isn’t falling, and where it’s getting hot or not getting so hot.

That has delivered a constant stream of interesting opportunities in the agricultural and soft commodities. Currently the sugar and coffee markets are suffering from the impacts of last year’s drought, and so you have very strong bull markets going on in both and we think coffee especially has some way to run.

The grain markets in contrast have had a couple of years of very beneficial weather patterns in the US Corn Belt and the main growing areas in Brazil and Argentina, and so, you have massive global stocks of corns, soya beans, wheat. But those markets are already pricing that, and things can change quite quickly as we move into the South American growing season for next year. In sum, the agricultural and soft commodity markets are always presenting a range of weather-induced volatility that drives price action.

On the industrial demand focused commodities things tend to be much more structural around the industrial consumption cycle. Broadly speaking, we had a structural bull demand market for industrial raw materials around the industrialization and build out of China really from 2002 until about the middle of 2012, with an interruption for the global financial crisis. Mid-2012 until January 2016, we have had a very structural bear market, which has been all about the slowing of the Chinese growth engine, intersecting with the increase in long lead time production growth. Things like opening a new copper mine or to drilling a new oil well can take several years to bring into production. I will talk about US shale in a moment; a rubber plantation takes seven years, for instance.

And in 2012 we saw the interaction of all this investment into iron ore mines, copper mines, rubber plantations hitting a slowing China demand curve. When the world flips from structural deficits into structural oversupply or vice-versa, the long lead times around increasing production means that you have a dramatic change in the price regime. When the flip is to deficit and you can’t change supply very quickly, then the price has to go to a level to destroy demand or to substitute demand, and that’s what we saw happen in 2007, 2008, and again in 2010 and 2011.

When you flip to oversupply you have classic leverage impact and you then collapse to the marginal cost of production of the existing supply base. So if we take crude oil as the example that people know best, the market was pricing a $100 to a $110 a barrel because that was the price needed to dampen down global consumption, to encourage production in difficult high cost projects such as the pre-salt deep water fields off Brazil and encouraging developments in drilling and recovery techniques most dramatically around fracking and US shale oil. The speed with which the USA reversed 25 years of onshore production decline was astounding.

Shale production has a different dynamic to traditional oil production. You can bring it into production much more quickly; you can close it down more quickly. It adds a lot more variability both ways to the supply of petroleum.

Oil at $100-$110 is a price where the world needs to ration petroleum, but now in a world that has got too much petroleum the question is how much of the production do you need to shut off, and what’s the marginal cost of shutting that off? We found out that somewhere between $30 and $40 a barrel that causes enough damage to the margins at the US shale industry that you begin to reduce supply growth. That’s why the oil price dropped to $30 or $40 a barrel.

So broadly speaking, looking forward it’s difficult to get structurally bullish on industrial raw materials. You can’t get structurally bullish on those commodities until you can start seeing global GDP growth at 5% and industrial production growth at 5% to 6%. Without China, who is going to give you that type of demand growth? Potentially India, maybe, but not yet, not this year, and not next year.

Therefore, in the industrial demand-focused commodities, I think we are in the process of defining a bottom. I think we found the bottom in the China growth or deflation scare at the beginning of this year. Prices went really deep into the cost curve. The most visible example of the pain was in the US shale industry where they couldn’t refinance the debts and so on. Or let’s look at rubber where the price got down to $1,200 a ton from at one point almost $6,000/mt in early 2011. At $1,200 a tonne, nobody in Malaysia or Thailand can make a decent living tapping rubber. Only Indonesian small holders can make a living tapping rubber, and so production at the higher end of the cost curve is heavily impacted.

So I think we can say the bottom is in, absent a China collapse, should the Chinese economy blow up on debt concerns. Again, it seems like the Chinese government by piling debt on debt, and by reversing course, has done enough to stabilize the Chinese economy, but that’s coming at the cost potentially of something much more horrible. One day that model must fail. They can’t manage that well for that long when in fact those imbalances are getting bigger, not smaller. But for the time being, enough is being done to sort of put that floor in. So I think for things like petroleum we are defining the bottom range.

There is an analogy non-commodity people may find in the Japanese equity markets through the 1990s and 2000s. You can still get big percentage rallies but they can’t extend into a medium-term trend. So in the case of crude oil, yes, if OPEC manages to get a little bit of action together, then maybe you lift the floor from $30 to $50, but it’s very difficult to take it much above $70 because all that US shale comes chipping back on again as the price moves up through the $50s, and so probably you’re in this sine wave where seasonality or money flow and sentiment shifts and the market can go on a bit of a rally, but it can’t hold and it will come back.

You see the same thing in iron ore that has become all excited because China is turning on the infrastructure taps again. So it got up to $60 a tonne. At $60 a tonne, high cost producers like Sierra Leone are coming back, and everybody in Australia turns on the taps as well. A few months from now we’ll probably see iron ore inventories and again. This, in my view, is going to be the story in the industrial demand focus commodities-a sideways rolling sines curve until we get a global economy that starts growing strongly again.

The bad news on that is I started my career in 1982 which happened to be when commodity markets had just sold off from their early 1980 highs, and it took 20 years before we got two consecutive years of GDP growth above 5% strung together again.

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