Commodities - what a difference a year makes

27 Feb 2017

By Shadforth Financial Group

It’s been a long time since mid-2011, the last time commodity prices rallied like we saw in 2016. Since prices peaked in 2011 most commodity prices dropped until the end of 2015. Declining commodity prices were caused by weaker demand from China and plentiful supply as new capacity entered the market.

Ultimately, iron ore — Australia’s largest commodity export — slumped from US $187 per tonne in early 2011 to just US $40. And it wasn’t just iron ore.

In early 2016, oil was experiencing 16 year lows as OPEC members maintained a high output of oil in their battle for market share with newer shale oil producers. Some OPEC members were happy to cope with low prices if it permanently damaged their shale oil competitors.

In 2016 it was a very different story. Iron ore prices rallied nearly 100 per cent and coking coal – the coal predominantly used for making steel — surged 189 per cent over the year. Zinc was another strong performer — up 75 per cent over the year.

The RBA produces a monthly Commodity Price Index which measures the latest prices for commodities and then weights them according to how important they are for Australia’s exports. The chart below shows how the commodity price index rebounded strongly during 2016.

Price index of Australia's commodity exports

So what changed?

Commodity prices began to rally in 2016 as excess supply worked through the system. This was supported by Chinese government stimulus spending that led to greater demand. Between 2011 and 2016 supply was also reduced because many smaller producers were squeezed out of the market as their cost of production often exceeded the price they could receive. Ultimately, this helped to rebalance supply and demand and companies with greater financial resources, such as Rio Tinto and BHP Billiton were well-placed for the rebound.

The battle against shale oil

On 30 November 2016, OPEC surprised investors by announcing an agreement to reduce their collective output of oil by 1.2 million barrels per day from 33.7 million barrels per day down to 32.5 million barrels per day. This boosted oil prices and added to gains made earlier during 2016. Oil prices rose moderately during 2016 and this likely triggered an increase in the number of shale oil rigs in the United States. In fact, between June 2016 and December 2016, the rig count rose from 316 to 525. While this is a substantial increase it is still considerably lower than the high of 1609 rigs reached in October 2014.

Commodities and the share market

In the Australian share market, commodity producing companies are placed in a sector called materials. This is because most commodities, with the exception of fossil fuels and most agricultural products, are used as the materials to produce other items. In the Australian share market, the materials sector is the second largest, after financials. The materials sector was a top performer in 2016, generating a return of 39 per cent. The chart below shows the weight of each sector in the top 200 shares and its performance during 2016. As can be seen, the materials sector performed strongly compared to other sectors, especially in comparison to financials.

How will Trump’s policies affect commodities?

Donald Trump’s business-friendly agenda and campaign promises of large infrastructure spending has supported the 2016 commodity rally into 2017. If President Trump  is able to deliver his campaign promises, it would likely benefit Australian commodity producers as demand for iron ore, copper and aluminium increases. The main uncertainty is whether Congress will pass the plans of President Trump or whether they will demand the plans are scaled back or rejected.

The potential impact of Trump’s proposed policies on the value of the US dollar is another factor to monitor. If new trade barriers between the US and Mexico and between the US and China are created this could lead the US dollar lower.

Trump’s proposed business tax cuts and corporate  profits repatriation policies could boost US business profits and conversely increase the value of the US dollar. How this tug-of-war plays out remains to be seen. In the short term, we can be fairly confident that the US dollar will be volatile.

What is the outlook for commodities in 2017?

We expect earnings upgrades from commodity shares because commodity prices for immediate delivery, known as spot prices, are currently well above analyst expectations. Focusing on resources such as iron ore and coal, we expect prices to remain firm but the potential price upside is limited because of the supply capability of mining companies combined with below average demand owing to slower global growth. The management teams of mining companies appear very confident in the outlook and this increases the probability of more mergers and acquisitions. Given the environment, it may be wise to stick to the so-called tier-one asset owners, who are well-capitalised low cost producers.

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