Commodities: Investment Demand Soars as Physical Demand Eases

Rising stockpiles and declining physical premiums are being ignored and investment communities, as a long-term appeal for commodities, continue to find favour. Investment demand for base metals, energy and precious metals reached new highs with open interest registering fresh records. While it gets difficult for physical traders to sell at current elevated prices, investors continue to accumulate long positions. Once again, commodity prices have large investment premiums attached to them, un-explainable by fundamentals. Let’s examine the investment demand for commodities in detail.

Investment demand soars

In the last 5 years, three themes have helped establish commodities as distinctly identifiable investment class: Portfolio diversification, inflation hedge and infrastructure needs in BRIC economies. Post credit crisis, these themes have emerged even stronger.

Despite factoring a 60% rise from the lows this year, US equities have returned 0% in the last 10 years and have been gradually losing appeal as a long-term investment avenue. Portfolio diversification in mortgage, corporate bonds and related OTC products have brought a shocking experience to investors. With almost zero interest % rates in three major economies (US, UK and Japan), returns from government bonds or treasuries can’t help bridging severe asset-liability mismatch that pension funds face in western economies. Funds are therefore seeking alternative avenues; commodities appeal to them as a place to diversify more than ever.

A pledge to keep interest rates low for “an extended period” is supportive to struggling economies, but could cause asset bubbles in years to come. History suggests that central banks err on the side of caution; they are pro-active in cutting rates and slow in retracing. From George Soros to Warren Buffett, all seem convinced that recent “reflationary” initiatives by central banks could drive us to 1970s style high inflation. Holding a physical asset over a paper asset bodes well in such times.

A growing middle class population, rising standard of living and large infrastructural needs underline sustainable demand for commodities in BRIC economies. The long-term growth potential of these economies are unquestionable and now that Indian and Chinese economies have shown their resilience to global slowdown by leading the recovery yet again, investors get convinced of the hypothesis.

Notwithstanding the bullish long-term story, one can’t ignore near-term issues. Despite record re-stocking by China, ILZS and ICS forecast surplus metal supply in 2009 and most of 2010. Chinese re-stocking is feared to be ending by mining majors, while large housing projects or sustainable auto demand in the west look evasive. A 50% rise in the Australian Dollar and a 35% rise in the Brazilian Real this year have crushed operating margins in domestic industries while Chinese exporters fear a rising yuan will hurt a budding recovery - the cruel side of dollar weakness. Stockpiles in exchange for most of the metals have risen to a multi-year high while a lot of material seems to hold off exchanges. High prices are helping idled factories to restart at a time when incremental demand seem to be slowing. We fear that investors are right in long-term direction, but are ahead of time by a wide margin. Current “investment premium” in commodities are too high to hold.

The last week

Rising exchange stocks and falling daily volatility were featured in base metals this week. Except Nickel, most base metals consolidated off highs and got driven by intra-day dollar movements. Any significant buying or selling interest remains evasive. Nickel continued to slip and held just above the psychologically important 16000 mark. Crude came under pressure from a rising inventory and traded the low of 76.27 - not too far from $75, which it broke-out in early Oct09 after a few attempts. Gold registered a small rise this week, but looks to be slowing. Domestic Steel Rebar and Wire Rod prices recovered 3-4% in China, but overall, the mood remains low-key on prices. SHFE stocks showed another noticeable rise in Zinc (7857mt); Copper and Aluminium changes were insignificant. Copper LME Stocks have passed above 400k, which was last seen in Apr09 when prices were hovering at $4350, 35% lower.

Chinese production and import-export data for metals showed slowing imports and y-o-y rise in production rates holding well. Chinese m-o-m Copper and Aluminium production growth rate slowed but stayed positive, 1% and 4% respectively. Chinese IP and Retails Sales remained robust while new loans halved m-o-m. Y-o-y comparison in most of the economic numbers will have a significant influence of base-effect due to the steep downturn last year at this time; numbers should therefore be read carefully.

US and EU economic data disppointed, showing early signs of exhaustion. The German Zew Index slipped to a 4 month low despite rising exports. EU industrial production rose above expectations while US consumer confidence fell unexpectedly. We shall keep a close eye on the trend of economic data from the west.

Physical market

Physical premiums for all base metals, except aluminium, remained range-bound and close to the lows of the year. Demand for aluminium in Korea was seen easing but remained good in the rest of Asia; Singapore premiums were hovering around $90. With a rise in Zinc stocks in SHFE, zinc premiums in Asia eased by $8-10.

Market mood

Technically, base metal price ranges are narrowing in a triangle and are nearing a break-out. Given technical patterns of Copper, Zinc and Lead, we expect the break-out to be on the upside but fear that it could be a false break-out, inviting profit takers. We think that toward year's end the forces of profit-taking are stronger than those of dip-buying and therefore selling on strength should be the near-term strategy.

We are watching the Euro, which failed to stay above 1.50 after a few attempts last week, quite closely. The US Dollar index is mirroring the same trend and has made a double-bottom while staying well in the down-trend. A change in course should be attempted only after a convincing break-out of the trend.

Analysing the historical trends in COT positions in Copper in Comex, we feel that Copper is making a topping pattern and is vulnerable to negative shocks in the medium term. However, we don’t deny that it could remain off-highs for a few more weeks. A fall below $75 on a weekly close basis could invite fresh short positions in Crude as a technical break-out gets rejected. We would accumulate short positions on Gold for a 1-2 week horizon.

Disclosure: None

Comments

[Gary A:]

The carry trade is fueling this. And the desire for Wall Street to gain access to Chinese consumers and credit card madness could be a fuel for this. Maybe the Chinese will say no, if they are smart: seekingalpha.com/insta...

Nov 17 02:13 PM