Wednesday, July 09, 2008

Declining Commodity Prices?

Are we seeing a new trend in declining commodity prices? Could declining commodity prices be a major theme for the markets in the third quarter? Crude-oil futures are dropping rapidly amid a strengthening dollar and some easing of concern that Iran is edging closer to an imminent military confrontation with the West. Gold futures dropped as well, tumbling more than US$12 to around US$921 an ounce in recent Comex trading. Commodities will be one of the forces shaping markets in the third quarter. Broader commodity strength has been driven by economic demand and international growth, particularly from emerging markets. Why the sudden shift away to a downtrend? It appears that major investors are now coming to terms with the fact that the majority of international economies are forecasting lower GDP growth over the next two years, which will dampen demand for commodities somewhat.

If we add to the mix that stock index shorts in the US are at a record high, then we are in for a quick rebound in the US on any "good news". While down trending commodity prices is a good thing for stocks, we still have to contend with slowing global economy and more importantly higher inflation and higher interest rate environment. The key would be to stop the spiraling higher inflation and higher interest rate cycle. Hence a softer oil price range would be welcomed but not sufficient to boost stock sentiment. We need oil to break below US$120 to trade in the US$100-$118 range for the inflationary expectations to recede. Only then will we see a decent uptick for global equities. Below are some relevant views on USD and commodity prices:
  • Fortis: In the last dollar bull market (1995-2002), metal prices measured in a
    basket of other leading western currencies actually tended to increase
  • BNP: In long term, a 1% depreciation of USD leads to >1% increase in oil and gold prices. In short term, a 1% depreciation leads to a 1.17% rise in gold prices and a 0.89% rise in crude oil prices. For non-fuel commodities, the USD impact is significant but smaller over the short and long run. The impact of the real exchange rate is stronger in the long run than the nominal exchange rate
  • Goldman Sachs: Correlation b/w WTI crude and various USD crosses has risen over the last few years - to 95% for EUR/USD. However, volatility of oil prices > volatility of major currencies. Causality runs in direction of oil prices to currencies: High oil prices hurt USD b/c 1) US is more energy intensive than key trading partners, 2) Fed focus on core inflation (which excludes oil) widens EUR/USD interest rate differential, 3) Eurozone accounts for a larger portion of oil exporting countries' imports than the US does
  • Commonwealth Bank: Currency-commodity correlation is inconsistent over time but recent price rallies in base metals and oil have been amplified by weak USD. Commodities rally on perception of commodities (real assets) as hedges against inflation, which is partly caused by dollar weakening on Fed easing and recession fears. Rally also due to valuation - commodities priced in USD look cheaper in currencies appreciating vs USD
  • Allianz: Close oil-dollar correlation will not necessarily last for long. Global slowdown can ease oil prices even if dollar remains soft
  • JPMorgan: Oil disproportionately sensitive to dollar - oil prices in Oct up 22% since mid-July while broad, trade-weighted dollar fell just 4%
  • Econocator: USD and oil price level negatively correlated since 2002 but their returns are not correlated
  • MS: Oil exporter demand for USD assets and US goods is dwindling while demand for non-US goods and assets rising. Dollar weakness supports export-driven, de facto $-pegging economies - rapid growth of which drives up oil demand
p/s photos: Araya Hargate

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