A walk on the macro side

Commodities, basking in the midst of a strong five-year bull run last year, were among the darlings of the alternative asset world. This year, the ride has been bumpier as prices have come off the boil. Investors have had to adjust their expectations, adopt a longer term view and become more discerning. Although fluctuations are expected to continue, China's voracious appetite for resources and the tight supply/demand dynamics in many commodities, especially in base metals, will continue to power the asset class along.

According to Paul Horsnell, managing director and head of commodities research of Barclays Capital, commodity prices have been impacted by a variety of macro issues, such as problems in the US sub-prime mortgage market, weather patterns and questions over the commitment of institutional investors to the sector.

In addition, energy prices have been affected by supply side issues as well as geopolitical tensions, while base metals continue to be buoyed by soaring demand. Meanwhile, agricultural commodities are the beneficiaries of the biofuels trend, as well as emerging market countries becoming wealthier and hungrier for protein.

Although base metals and agricultural crops have garnered more attention over the past few months, energy continues to dominate the commodity scene. As of late May, overall average prices for oil dipped about 9% from last year's record average of around $66 (€49.4) a barrel. However, oil prices have wavered and it is difficult to predict the future direction due to geopolitical wild cards and the world's surprising resilience to expensive oil.

In 2006, for example, prices were depressed in the first half on the back of historically high inventory levels of crude but then they soared when fighting broke out between Israel and Hezbollah in the summer. The anticipation of the hurricane season in the Gulf of Mexico provided a lift but they dropped again in the autumn mainly due to an oversupply, the easing of geopolitical tensions and clement weather.

The same roller coaster scenario has been playing out this year. Seasonally warm weather and cuts in demand kept prices relatively low but in May they spiked on the back of concerns over Iran's nuclear programme, fears of war in Lebanon, unrest in Venezuela and violence in Nigeria. Markets become nervous after Iran dismissed calls to suspend its uranium enrichment programme on the eve of a vital meeting with the EU while protesters forced further disruption to oil production in Nigeria.

Shell said 150,000 barrels a day of oil production had been halted after protesters stormed the Bomu pipeline complex in Nigeria, a major artery feeding the Bonny crude export terminal. This followed Nigerian rebels blowing up three oil pipelines in the Niger Delta, forcing Eni, the Italian oil producer, to halt production of 150,000 barrels a day from its Brass export terminal.

Oil prices are expected to trade at the higher end as the summer approaches and demand rises as the US heads into its so called ‘driving season'. It is also unlikely that OPEC will reverse its policy and open its taps any further. The group insists that crude supplies are adequate and it is sticking to the decision it took last year to curb production by 1.7m barrels per day, or about 6%.

Looking ahead, analysts believe that oil prices will continue to oscillate for the remainder of 2007 and that the market will continue to remain in contango, reflecting worries about the security of future supplies rather than about oversupply. Contango, which impacts returns, is when the longer dated futures are more expensive than near term contracts. This means that investors have to pay more when monthly contracts expire and they buy new futures to renew their positions.

Historically, the opposite condition, backwardation, has prevailed in oil and allowed indexes to make returns, even in falling markets, by rolling positions from prompt contracts into later ones. This trend is now found in many of the base and agricultural commodities where the supply has not kept pace with growing demand. This is mainly due to China, and to lesser extent the UK, Russia, the newly minted EU entrants, the UAE and Saudi Arabia gobbling natural resources at a furious pace to stoke their infrastructure projects.

Although the China story may be sounding a trite cliché, analysts agree that it is still the most significant story in the commodities world. As Ian Henderson, fund manager of JP Morgan Natural Resource fund puts it: "There is no other country in the emerging world that has China's influence and impact. Other countries such as India, Mexico, South Africa and Taiwan are growing rapidly but individually they are small. China, on the other hand, represents, one fifth of the emerging world GDP which makes it bigger than India, Russia and Brazil put together."

The figures speak for themselves. According the latest statistics from the IMF, from 2002-05, China alone accounted for 48% of the increased demand for aluminium, 51% of copper, 110% of lead, 87% of nickel, 54% of steel, 86% of tin, and 113% of zinc. The country's presence in the energy markets is not as pronounced and it only imported about 30% of oil. The country's appetite is not expected to diminish over the next three years and this year alone saw Chinese copper imports jump nearly 50%.

Even the country's recent jittery stock market, and a slowdown in growth, will not dampen China's quest for base metals. The Chinese government may be forecasting 8-9% growth this year, down from 10.7% in 2006, but the country still has a long way to go before it catches up with its developed counterparts.This is especially true on the infrastructure front where the pressure is on to build skyscrapers, bridges, roads, cities, cars and factories to modernise as well as accommodate the huge swathes of its population moving from the country to the city. Official figures from the Chinese government predict that more than 300m farmers will migrate from rural to urban areas over the next 20 years and they will need places to live and work.

Franz Wenzel, a Paris-based senior investment strategist at AXA Investment Managers, says: "Although there has been volatility in the commodity markets, there needs to be a slowdown in China's growth to say 7-8% instead of the current 9% to have an impact on commodity prices. China will continue to be the manufacturing hub of the world. Turn over a product to read the label and it is likely to say ‘made in China'.

"I do not expect this trend to recede or retreat. The problem is that inventories in many base metals are and have been at record lows for the past two to three years. They have been recovering in the past six months but they are still at historic lows. China was the wake-up call and the supply side did not respond appropriately."

Although China is a dominant force, other regions are also making their mark on commodity prices. Jeffrey Currie, head of global commodities research at Goldman Sachs, notes: "The UK is engaging in one of the most ambitious infrastructure development programmes in the run-up to the 2012 Olympics, while there is a great deal of activity in the Middle East and Russia which is also creating demand for base metals."

In fact, according to figures from the International Iron and Steel Institute, demand for steel in the Middle East is expected to rise 8.4% in 2008 to 43.6m tons, above expectations for a world growth average of 6.1%. This can mainly be attributed to the UAE as well as Saudi Arabia cranking up their construction budgets. For example, buoyed by its oil revenues the UAE is spending an estimated $200bn on a variety of residential, commercial and infrastructure projects.

Meanwhile, construction workers in Dubai have not seemingly paused for breath and the emirate currently accounts for about 30% of the world's cranes. About 50 skyscrapers are currently being built, and six of them are slated to be in the so called ‘supertowers' bracket, which means they will stand over 100 floors. The showpiece is expected to be the Burj Dubai, a $1bn, 161-story tower which will be the world's tallest man-made structure.

Michael Power, strategist at Investec, a UK-based fund management group, comments: "The consumption of raw materials in the Middle East is considerable with several infrastructure projects being undertaken. Dubai is second to Shanghai in terms of looking like a building site, plus eight of the 20 tallest buildings being built today are in the Gulf region. In this respect, Doha is rapidly becoming the new Dubai."

Not surprisingly, against the background of volatile prices, investors are advised to proceed with caution and to monitor closely the economic factors underlying individual commodities.

As Power says: "It is dangerous game to take the short-term view unless you have good luck or fantastic judgement. It is important to stand back and gain perspective on how the supply and demand fundamentals impact the price on a particular commodity."

Currie also notes that investors should pay close attention to the convergence plays within different commodity sectors and how that impacts prices and volatility. "We are beginning to see supply substitutions in different commodity sectors, such as crude oil which is used to make plastic pipes, competing with copper made pipes. This is not great from an investor perspective because it increases supply, reduces backwardation and subsequently the returns."