2011 Non-Predictions 1: Commodities

by: Macro Man

It's that time of year again when prices are about to start moving as everyone writes, reads and establishes their favorite trades for 2011, despite the information they are based on having been around for some time (which really highlights the flaws in the "perfect market hypothesis"). It's those pesky benchmarks again. If you are personally judged January 1st - December 31st then your behavior will treat those dates as important watersheds.

As is traditional, Team Macro Man (TMM) have to mark off MM’s "non-predictions" and draw up their own. The funny thing is that if you are like us you won't give a damn about marking last year's score sheet, and you will just want to read the predictions for next year. Just as you blank over in the preamble in your annual appraisal as all you want to know are your numbers... ("yeah yeah whatever, team player yawn, liked by mail room staff or not yawn...could do more to raise profile with Legal in Bratislava branch, yawn, self advancement motivational 360 degree zzzzz....Ccmon cmon cmon...just wake me up when we get to the numbers.") Nonetheless, the short and sweet is here:

  1. Oil (defined as second WTI future) will NOT rise as much as it did in 2009: Bang on. Even better if you closed out end of November and took a holiday.
  2. G10 FX carry will NOT repeat 2009's stellar performance: It was so bad they wrote a Bloomberg story about it. So, well done MM. AUD worked but there was a lot of choppiness and people being forced to cut risk at the wrong time.
  3. The Democrats will NOT lose control of either house of Congress: Wrong.
  4. True S&P 500 earnings will NOT reach the published consensus forecast level: Sadly a miss - earnings did come back quite well.
  5. China will NOT meaningfully adjust its exchange rate mechanism in H1: No luck here - the pisstaking lasted longer than the longs expected and tended to occur at the weirdest of times. Not correct but *very* few people made money out of this one way or the other this year.
  6. The Fed will NOT hike the Fed funds target rate this year: Bang on.
  7. There will NOT be a hung Parliament in the UK this year: MM's strength in rates did not translate to political forecasts this year.
  8. The MOF/BOJ will NOT intervene in USD/JPY: Well they did but let's be honest - it was a joke and lasted all of 15 minutes. I think this counts as a win. The rate differential closed up and the FX fell further.
  9. US 2-year yields will NOT reach their 2009 lows: Correct.
  10. The SPX will NOT close 2010 more than 20% away from 2009's closing price of 1115: Correct, though what a ride.

So 6/10 but 6/8 if you ignore MM's poor performance in political forecasting.

Now non-predictions for 2011:

The first thing we have noticed is that the first few days of January are usually a head fake and as soon as everyone gets their first major trades on for 2011, it starts to go pear shaped. So surely we should wait for everyone else to show their hand before playing ours and would it not make more sense to wait for 1st February to make our predictions?

But what are folks actually looking for in 2011 predictions? Either they fit with your own views, giving a bit more safety in numbers comfort, or are so far against what you are thinking that they can effectively be slated in the comments column and dismissed from your concern. The worst is if they sort of agree with what you are thinking but raise a doubt or two, not enough to make you cut your positions but just enough to niggle and annoy.

Commodities Non-Predictions

  1. Iron Ore Will Not Be Trading Higher on December 31st Than It Is on January 1st

Looking at the chart, iron ore is looking very toppy again. One thing TMM know about iron ore is that half the reason mining companies love it is that it has historically been a quasi-cartel and has phenomenal gross margins - once you’ve gone through the brain damage of building the railway to your particular patch of the West Australian desert you just have to survive long enough to pay down some debt before your EBITDA comes rolling in - just ask Andrew Forrest of Fortescue.

That being said, this has been the case for some time and the amount of capacity coming online at the moment is quite staggering - not only that but the biggest customer of note, China, is busily funding anyone who competes with what TMM think of as the “BBQ Bunch” - because frankly nothing else really unites the Australians (BHP Billiton (NYSE:BHP), Rio Tinto (NYSE:RIO), Fortescue Metals Group [ASX: FMG]) and Brazilian (Vale (NYSE:VALE)) except a love of grilled meat and hanging out by the beach. Look at the Simandou project, or any number of smaller projects that have obscenely low cash costs and one has to wonder how long this cartel is going to last.

This comes to the issue of timing which is as any investor knows easier said than done. However, in this regard the trade does line up - China is going through a tightening cycle and if you look at previous periods when China cut loan growth and raised rates it did nothing good for iron ore prices. Any slowdown in real estate in China is generally very bad for iron ore and unless India and Indonesia can pick up the slack immediately its hard to see any upside in this particular commodity.

  1. Rare Earth Metals Will Not Come Down to Earth Anytime Soon and Tungsten Won’t Either

It was arguably the smartest trade of 2009 to mid 2010 to just go out and “buy what China hasn’t got” - copper, metallurgical coal, iron ore - you name it, if China was a net importer it was a great trade from early 2009 to mid 2010. What TMM have noticed post mid July 2010 is that China has extended its FX piss-taking to commodities it does export and particularly rare earths. TMM previously discussed this here and true to form the smaller names in the space have outperformed substantially though the bubble rolls on in Lynas (OTCPK:LYSCF) and Molycorp (MCP) and correlation between all names in the space is picking up - anyone want to start an ETF?

(Click to enlarge)

Rather than engage in headline grabbing bollocks about how Lanthanum is going to infinity, TMM have given some thought to what’s next in this China strategic metals malarkey:

TMM has done some work on what China exports in metals and what’s strategic and has one answer as to what's next: Tungsten. Used primarily to harden steel for machine tools and the like it fits in with China’s end game (namely, putting competitors in downstream businesses and processing out of business) and is a market China has 80%+ of the output.

Sadly, much like rare earths, it does not trade on exchange though its substitutes do (Molybdenum and Cobalt - though Cobalt seems to be the most illiquid LME contract known to man). For those who you who trade metals and there are a few names and mines floating around which might be of interest including North American Tungsten [CVE: NTC], a Vietnamese conglomerate called Masan [HCN: MSN] that recently acquired a large deposit and a few other juniors. Majors are hard to find though listed names in China would likely fly if serious restrictions mooted in October went live.

Much like rare earths, in the long run technology can kill your end use demand for some of their applications (anyone want a Nickel Metal Hydride battery? NOPE). Tungsten can be substituted for Molybdenum and Vanadium though spikes in one tend to pull the others up slowly and it takes a while for substitution to kick in as can be seen below - notice one metal spikes, others rise and then the spike collapses abruptly, only this happens years not months later. This combo of sticky customers, limited substitutes, and China strategic resource hoarding makes it look like a good enough punt for 2011 to TMM.

(Click to enlarge)

  1. Copper is Not Coming Down Anytime Soon

Copper is now where TMM saw gold back around the $1100 mark - way above the cash cost curve with more than enough headroom to justify mining any and all deposits, but with no clear letup to the things that drive it. Given our dabbling on the short side of gold was at best a breakeven proposition, we are not stepping in front of the bus here.

Until some very big deposits come online (Ivanhoe’s (IVN) Oyu Tolgoi, the Unobtainium mine on Pandora Bougainville Copper Gold mine owned by Bougainville Copper (OTC:BOCOF), etc.) there is not much good news on the supply side to speak of. On the demand side, appliance demand in emerging markets and Chinese capex are not particularly helping.

One particularly worrying development is that China’s State Reserve Board has allegedly been releasing reserves, which means that they are taking one hell of punt: if they can’t slow down their economy enough or get enough mines online by the time they are done dumping product there is going to be one hell of a squeeze. Recent reports of China scrapping its property tax (more tomorrow) does not make TMM think the cycle has peaked just yet in this metal.

TMM are looking for indirect ways to play this game now that physical is a crowded consensus trade, albeit a good one. One way is play metal recyclers who are having a field day like Sims (SMS), but at 33x trailing its getting pretty demanding valuation wise. A basket of mid cap miners might be a better bet, especially given those geniuses of M&A, Rio Tinto, have been bitten by M&A fever again.

One things is for sure - if there is any chance of a China blowup or double dip copper has a very long way down to the bottom of the mine shaft, so watch China credit growth as always. In the meantime, sometimes the best trade is the obvious one - physical, and get your friendly equities analyst to find a cheap miner.

  1. WTI Not Going to Be Under $100 for Long

TMM have to be honest in saying that they’ve always been somewhat apprehensive about gold as a store of value but we have never needed much convincing on oil. Demand is short term inelastic, and it and its various products make up a lot of CPI indices in the developing world. And while countries have not been brought to their knees on devaluation by a gold shortage since the early ‘30s, there are plenty of examples of places that have been brutalized by oil going to far, too fast. Just ask Vietnam (2007), Indonesia (2004-2005, arguably 2007) and any other number of developing countries.

The long term bull case for oil is nothing new and given the major interruption during the financial crisis to oil exploration and development we face yet another year of net depletion of reserves with $100/bbl "new deposit" costs as demand in China and EM climbs with no end in sight. The awful truth about cars is that once people own them they tend to use them. Vehicle miles in the US did not drop all that much considering that about 5% more of the workforce stopped having to drive to work. They are not picking up much either but that's more than can be said for industrial output, employment, etc. In the meantime, car demand goes up elsewhere.

Looking at projections for auto sales in RoW for the next few years and the fact that there is ~0 penetration of electric of hybrid vehicles in those markets it is hard not to be bullish oil. According to numbers we’ve been getting (Ze Germans), oil sands projects that use to require $80 to break even are now thanks to USD/CAD amongst other things more of a $100 proposition. When we wrote about BP (NYSE:BP) back in July it may have been the sale of the century but calls on WTI or longs in oil sands centric companies like Encana (NYSE:ECA) or the still-walking-wounded-post-dilution Petrobras (NYSE:PZE) still look good to us.

>> Continue to 2011 Non-Predictions: Equities

Disclosure: None