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Prospects of commodities positive in the long term

Further cost-cutting measures by firms will run down inventories to minimum levels. (EB FILE)

By Sunil Kumar Singh

What do contrarian investment advisor Marc Faber, billionaire George Soros and super investor Jim Rogers have in common? Well, all of them are bullish on either one or more classes of commodities.

Prices of many commodities, especially metals, energy and bullion have been on an upward trend despite the global financial downturn.

On the Dubai Gold and Commodities Exchange (DGCE), the total trade volume jumped 300 per cent year-on-year to reach 153,747 contracts last month.

Commodities in general are currently being influenced by outside macro-economic factors and not necessarily by supply and demand fundamentals.

These factors include currency movements, monetary tightening in Asia plus potential interest rate increase in the United States, movement in equity markets and a general increase in risk aversion.

This has caused a partial sell-off in risky assets along with gold, according to a report by Rothschild Private Banking and Trust, released last week.

The contagion effect is also resulting in minor outflows from the main gold Exchange-Traded Funds (ETFs). However, recent short covering and new physical buying in India and the Middle East has helped gold maintain its current value, it said.

Overall, Rothschild remains upbeat on the long-term outlook for commodities. However, there are a number of headwinds for commodities in the short term, including a stronger US dollar and mixed economic data, the report said.

Another report by Bank of America-Merrill Lynch titled 'Mena Quarterly' released last week, said the global recovery is favouring cyclical commodities.

"We believe there is growing probability that oil prices will rise above $100/bbl as we head into 2011 on a combination of loose monetary policy and dollar depreciation on a trade-weighted basis," the report said.

However, it added that a tightening in physical oil supply and demand fundamentals could play a significant role in propping prices up.

Crude oil inventories have now drawn significantly across all major regions in the world, highlighting a relatively balanced picture for oil worldwide. Petroleum products, particularly distillate, inventories remain a concern but increased demand, also due to the current cold increase in the US, will help reduce the overhang.

Given the stronger-than-expected cyclical rebound, we expect WTI and Brent crude oil price to average $85/bbl for 2010, it said.

The global economy is starting to bounce back from the sharpest recession in the post Second World War period and almost every country has started to show signs of improvement.

Final demand is recovering, the global inventory cycle is turning up and the implosion in global trade that pulled down the global economy is reversing. While the recovery might be choppy, business cycle effects, re-stocking and fiscal spending make us significantly more bullish on the recovery relative to consensus. In our view, this will lend support to a strong rebound in global oil demand, it added.

Bric story

Analysts said one of the strongest cases of commodities becoming an increasingly attractive investment proposition is that it will continue to attract strong demand from emerging markets that will, in turn, spur commodity prices.

According to combined statistics from International Energy Agency, World Bureau of Metals and the US Department of Agriculture, the market share of emerging markets and developing economies in commodity consumption has drastically jumped over a period of 20 years. The crude oil consumption in emerging markets, for instance, has jumped from 43.1 per cent in 1993 to 51.8 per cent in 2008, aluminium has risen from 32.4 per cent in 1993 to 59.2 per cent in 2008, and copper from 35.2 per cent to 61.7 per cent during the same period.

The demand and prices of commodities are expected to increase further.

According to a recent report by the IMF research, looking ahead into 2010, prices of many commodities are likely to increase further. The demand side should generally be the main source of upward pressure, as global activity is widely expected to expand at a faster pace.

With inventories remaining above average for many commodities and substantial spare capacity in many commodity sectors, the upward pressure is likely to remain moderate for some time, unless much stronger-than-expected global growth or other surprises lead to a rapid drawdown of these buffers, it says.

"The demand for commodities is going to continue, and I'm relatively positive on commodities on a long-term perspective because of their strong demand from Bric countries," said George Lo, Chief Investment Officer, Lloyds International Private Banking.

Another strength of commodities is that they turn out to be good hedge against the debasement of the US dollar, he said.

According to the report by Bank of America-Merrill Lynch, extremely loose monetary policy around the world has been supporting physical oil demand and driving tactical asset allocation into oil.

A likely move by China's central bank to tighten monetary policy via foreign exchange appreciation will also be bullish for commodities.

Of course, WTI and Brent crude oil prices are not just driven by physical supply and demand factors.

"We estimate that the sharp depreciation of the dollar has contributed to about one third of the rise in global crude oil prices in 2009," the report added. As prices of commodities rise, analysts believe it is also the time investments in commodities have started to come back into vogue.

Long-term profits

According to JP Morgan, there are three key reasons to invest in commodities now.

First, the long-term structural factors remain supportive. Secondly, the signs of recovery in 2010 across markets are emerging, and thirdly, investing across the three main commodity sectors of energy, base metals and precious metals result in a highly diversified opportunity.

But how should an investor go about investing in commodities?

What strategy should an investor adopt – should he go for buying commodity mutual funds, or commodity stocks or direct into commodity futures trading?

"We encourage retail investors to consider commodity funds as the first entry point of investment, because if they choose something like derivatives or ETFs linked to one commodity, such as gold or oil, there are risks of losing money when their prices go down. Commodity funds invest in diversified commodities and companies and are thus less risky.

"A typical retail customer should be looking to allocate in commodities on a three to five year time horizon," said Simon Littmoden, Vice-President, Business Development Mena, JP Morgan Asset Management.

"One way to trade in commodities is to trade underlying equities (such as buying shares of a gold company or a coal company, etc). The other way is to buy the actual commodity," said Neven Hendricks, COO, Deloitte corporate Finance. MR Raghu, Senior Vice-President-Research, Kuwait Financial Centre (Markaz) said: "The CRB commodity Index is holding flat for the year, while MSCI World is down by five per cent. Commodities are favoured because they tend to do well in both scenarios. If the economy recovers (which is widely hoped so), then it will reinvigorate demand and this is positive for commodities.

"However, if the global economy falters (some camp seriously bet on this), then dollar will weaken further and again this is plus for commodities.

Gold outlook

"Given the high level of uncertainty in the market, gold looks good both technically and fundamentally. Oil is worth watching alongside basic materials."

The outlook of gold also remains stable to positive.

According to Anan Fakhreddin, Managing Director, World Gold Council Middle East and Turkey, the outlook for gold remains positive globally.

The unique demand and supply drivers that support the global gold market continue to encourage sustained levels of demand from investors, consumers and central banks throughout the world, he said.

Although the total global identifiable gold investment in 2009 was up seven per cent relative to 2008, but it was down 50 per cent when compared to the extremely high levels seen during the final quarter of 2008, according to the World Gold Council's Gold Demand Trends that came out recently.

However, the demand for gold ETFs last year was 594.7 tonnes, up 85 per cent than a year earlier, equivalent to an inflow of $17.7 billion, said the report. Even if the prospects of commodities as an alternative investment option have strengthened, analysts caution that investors must do their homework before they leap into commodities trading, as there are various risks attached to investment in commodities.

Volatile ride

"We should never that commodities can be a very volatile ride. For example 2008 was a very difficult year for commodities, said Littmoden.

Some analysts also question continuation of gold's bull run this year and beyond. "In the recent past, ETFs have been the predominant buyers of gold. Gold-based ETFs have been purchasing the physical gold and the volume bought has grown to be so large that around five per cent of all gold reserves is held by ETFs, that's equivalent to 17 years of industrial demand.

"However, at some point these buyers would become sellers and when they become sellers the price of gold may go lower from what it is now," said Khurram Jafree, Director and Head of Investment Advisory, Mena, Barclays Wealth.

Bank Sarasin's outlook report for 2010 said as the pace of economic growth is expected to weaken in the second half of the year, the outlook for commodities is rather subdued.

"At the start of the year, however, commodity prices should experience a modest rise, although they could peak as early as the first quarter. While we anticipate a slight dip in metal prices in 2010, we expect the cost of energy commodities to stabilise," it said. We believe there are a number of factors preventing metals from repeating their strong performance of 2009. On the macroeconomic front, we expect the industrial upturn to lose momentum.

"Demand from industrialised countries is therefore unlikely to be much higher than the level of 2009. Developing countries such as India and China will be unable to compensate for the drop in consumption of industrialised nations," it said.

Strategic inventories

Furthermore, the stockpiling of strategic inventories in China should now be complete. This factor was probably a key reason for the sharp increase in the price of copper during 2009.

The ongoing restocking of commodities by end users, which led to a disproportionate surge in demand in the third quarter of 2009, should ease off again slightly at the beginning of 2010.

From the second quarter onwards, however, further cost-cutting measures by companies will run down inventories to minimum levels. Even the implementation of more infrastructure projects will not provide sustainable momentum to metal prices in our view, it said.

For the full year 2010 we expect the price of the major industrial metals to be lower on balance. As the economy starts to slow down, inflationary concerns and private demand will drop off during the course of 2010.

A stronger dollar as well as a relative slowdown in demand for ETFs will no longer offer such solid support, so that the gold price will finish roughly 10 per cent lower than the level it stood at in December 2009, it said.

However, Bank Sarasin expects prices of agricultural commodities to rise. We expect a more favourable trend in agricultural commodities.

General cost-saving measures and the credit crunch that persisted until the middle of 2009 resulted in very fragile demand as well as the reduced use of agrochemicals such as potassium, nitrogen and magnesium. In 2010, more agrochemicals will need to be used in order to maintain both the quantity and quality of the harvest.

Additionally, according to a report that came last month by CPM Group, a New York-based commodities market research, consulting, asset management, and investment-banking firm, commodities have gained enormous interest from a wide range of investors.

While many investors want to maintain their long positions, expecting still higher commodities prices in the months and years ahead, the fact is that commodities prices already are up over the past 12 months and had demonstrated their ability to plunge sharply in late 2008.


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