Commodity prices are volatile, but the worst may be over as global growth, and therefore demand, for commodities is improving. If prices stabilise from here, or rise, emerging market commodity producers are likely to benefit.
Commodity sector analysts anticipate price increases ranging from 5 per cent to 30 per cent over the next 12 months, depending on the commodity category. The general market expectation is that global demand for commodities should increase in line with global economic growth.
China accounts for a very large share of global commodity demand, including up to half of all demand for industrial metals.
Although investors are worried about the prospects for China’s economy, we think these concerns should ease once the economy starts responding to the stimulus measures of the government and central bank.
For now, there are some signs of success: confidence in service sector businesses is high and housing market transactions improved. Imports of metals appear to have bottomed out, as has demand for crude oil. Conversely, the manufacturing sector in China seems to be struggling and exports are weak. Overall growth in China may firm in Q4 2015/Q1 next year as more policy steps are taken to boost growth. Beijing has a number of tools to boost growth: FX reserves and sovereign wealth fund assets (34 per cent and 7 per cent of GDP) are high and can be run down, public sector debt is manageable (55 per cent GDP), permitting some fiscal easing, and inflation is low, which means monetary policy can also be eased. Once there are more signs of success, commodity prices should start to rise.
The sharp drop in Chinese equities is a small risk to Chinese GDP growth as prices are still up on the year and equity holdings are only a small – 10 per cent to 15 per cent – and shrinking share of Chinese household assets.
In the oil market, downside risks seem to be more limited than they are for industrial metals. One reason for this is that crude oil production could be quickly reduced if prices were to fall sharply. North American shale producers can rapidly cut back on production, even if Saudi Arabia chooses not to do so. It is the short lifespan – around 12 months – of many North American wells that enables this nimbleness in production. They have an average full-cycle cost of around US$50 to US$55 (£32.70 to £35.97) a barrel of WTI (West Texas Intermediate), and below these levels, producers would have a strong incentive to reduce production.
Another support for the oil price is its diverse sources of demand. China, for example, only accounts for 11 per cent of the global demand for crude, while the US and Europe together account for about 35 per cent. So a pick-up in global economic activity outside of China will certainly contribute to sustain oil prices at, or slightly above current levels.
We think that going into 2016, global demand and supply of oil will become more balanced and prices can be less volatile. The US is key to this adjustment and the drop in drill rig counts (-55 per cent since December 2014) and inventories (-7 per cent since April 2015) suggests that production there is topping out, albeit with a lag.
Metals producers, on the other hand, cannot be described as ‘nimble’ because of the long lead time of their past investments and their low marginal costs. Moreover, steel (and so iron ore) and copper are highly dependent on the Chinese construction sector. A repositioning of the Chinese economy away from exports and housing investment towards goods and services consumption would not provide a huge uplift to demand for these materials, so price rises are likely to be at best moderate.
Analysts seem more optimistic about other areas of the metals complex – aluminium, zinc, lead, nickel, palladium and platinum. The likely improvement in global activity, particularly in the manufacturing sector, and the potential for stronger capital expenditure in Europe (and potentially the US) are supporting demand for these commodities. Gold, on the other hand, is likely to be under pressure from a stronger US dollar. Gold acted as a safe haven for investors when the dollar was under pressure from quantitative easing in the US, but this source of demand for gold looks to be behind us.
Which emerging market countries and bond issuers are likely to benefit in this scenario?
Not all emerging issuers will be affected to the same extent by the stabilisation in commodities prices.
For energy producers, we believe that countries with strong balance sheets should benefit most from the stabilisation of oil prices. Among those, for which energy accounts for more than 50 per cent of exports, I am more comfortable with countries whose debt-to-GDP ratios remain at or below 30 per cent and whose budget deficits are constrained. Kuwait, Azerbaijan, Kazakhstan, Russia and Colombia are among these countries. Indonesia, for which oil accounts for more than 30 per cent of its total exports, should also benefit.
On the other hand, Venezuela, where costs of production remain high, and Iraq, whose production is completely disrupted, are two weak sovereign issuers that are unlikely to see any improvement in the near term at current oil prices.
For ore and metals, it is important to consider which commodity is the main source of revenue in each country.
Copper is the primary source of metals exports for Zambia and Chile, while Mongolia also exports copper as well as iron ore. This means that these three countries thus remain in large part dependent on a rebound in the Chinese construction and housing sectors.
The energy and metals sectors account for around 30 per cent of the emerging market corporate and quasi-sovereign bond universe. Based on these views of future commodities prices, I am positive about the oil and gas sector, but more cautious towards metals and mining.
Koon Chow is senior macro and FX strategist, emerging markets fixed income team, of Union Bancaire Privée.
Key points
The worst volatility in commodity prices may be over.
China accounts for a very large share of global commodities.
China only accounts for 11 per cent of the global demand for crude oil.
