The last few years have been thick with crises and conflict situations in the Middle East: Syria, Libya, Egypt and Iran, while Europe and the US have dished out their own market-moving contributions in the form of the Greek debt crisis, US debt ceiling negotiations and quantitative easing. All of the above will move commodities markets (mostly oil and gold) in the short term, typically up to 10% and occasionally, and then very short term, up to 20%.
Société Générale Investment Bank analysts have dissected the factors that influence the price of 22 commodities and found that a crisis will increase the degree to which the fundamentals of supply and demand will influence markets.
In a normal situation, that is, a market not driven by geopolitical or important financial news or fundamentals (such as barrels of oil produced versus oil consumed by cars; or ounces of gold mined versus ounces of jewellery bought) will play the biggest role in price variations. Before the collapse of Lehman Brothers supply and demand accounted for about 80% of the price variation for commodities and the rest was made up from macroeconomic data, currency strength and market liquidity.
The financial crisis disrupted this pattern and after Lehman the average percentage of the price move explained by underlying fundamentals fell to 71%. However, as the global economic outlook is beginning to improve fundamentals are starting to play a bigger role again. “Our analysis shows a clear regime change this summer in terms of what is driving commodities,” claims Michael Haigh, SGIB analyst in New York. Fundamentals now account for 83%, the highest level in the last seven years. News like that from the Middle East will tip the balance even further in favour of fundamentals, not only because there is an actual disruption in supply of oil but also because there is a threat of future disruptions.
“A couple of serious supply constraints in recent years confirm what we are seeing as a result of the Syrian crisis and uncertainty—the explanatory power of fundamentals because of geopolitics, for example, picks up when there is supply uncertainty,” says Haigh.
Before the chemical attacks in Syria in late August 2013, fundamentals explained 55% of Brent crude’s price movements but by late August, at which stage the Syrian conflict threatened to take on international proportions, fundamentals drove a highly significant 95% of the price. There was a similar pick-up for Brent crude during the Arab Spring in 2011 and for the grains markets in 2012 when the drought in the US was in full flow.
For instance, for gold, the role of supply and demand on average constitutes 81% of the price variability but can spike as high as 95%, according to SGIB. For Brent crude oil fundamentals make up on average 65% of the price and for copper 69%. For aluminium and silver this number is around 80% while for soft commodities such as coffee and cocoa, or grains and livestock, fundamentals account for over 90% of the price.
Other influencers are the dollar exchange rate, macroeconomics and market liquidity. The on-going normalisation of the global financial system after the 2008 meltdown suggests that the dominant role of fundamentals will stay in place for the foreseeable future. “If so, commodities should trade mainly on their respective fundamentals, allowing for significant dispersion between individual commodities and between commodities and other asset classes,” adds Haigh.
Gold & black gold
When it comes to oil the fundamentals are driven beyond anything else by national interest.
The two top producers, Saudi Arabia and Russia, each producing around 13% of the global oil supply, have their national budgets linked to the price of oil and both are for similar reasons happy to have the oil price trade between $110 and $150 a barrel. Russia’s budget depends heavily on the country’s exports of gas and oil and as long as the country is careful with its domestic spending the budget breaks even when oil prices are around $100/bbl.
In Saudi Arabia the cost of oil production is not far from $20 a barrel, yet because of heavy domestic spending the country as the lead producer of OPEC polices the price of oil so that it is never far from $110/bbl. If oil prices start falling Saudi Arabia (and potentially the rest of OPEC) can cut production by one million barrels a day in a relatively short period of time. Equally, if prices start to rise too fast, the country can release another one million barrels into the global market.
In addition, both the US and Europe hold large strategic oil reserves which would be released in the case of either a significant shortage or prices rising so high that they hurt the macro economy in those countries. “One natural stabiliser for global oil markets is strategic petroleum reserves. Low commercial inventories could prompt a coordinated release of these government stocks just as we saw in the aftermath of the Libya crisis in 2011. At 1.6bn barrels (of OECD crude oil reserves excluding the US) this safety valve remains ample,” says Francisco Blanch, commodities strategist at Bank of America Merrill Lynch.
In addition the Arab Spring has resulted in the Saudi government pumping billions of pounds into social projects and welfare in order to prevent domestic unrest, “which means that it is now no longer happy with oil prices at $100/bbl or below but at $110/bbl, says Haigh. With political decision makers battle ready when it comes to oil, there is not much scope for prices to move below $100/bbl. That doesn’t mean that prices will not continue to gyrate in reaction to crises like Syria but it does mean that those moves are not likely to be long lived.
Bank of America Merrill Lynch’s Blanch estimates that oil could rally to $120/bbl, not just in reaction to Syria but also because of workers’ protests and port closures in Libya, pipeline attacks in Iraq and oil theft and pipe vandalism in Nigeria. If the Syrian conflict spread into the rest of the region, Turkey and Iraq, then prices could even spike to $150/bbl.
“However, you would only see such a large spike in prices if there was a major escalation of conflict. Otherwise it is much more likely that the price will move up some $10/bbl and that for a short period,” says SGIB analyst Jesper Dannesboe.
When it comes to gold, financial crises will play a much bigger role than geopolitics because demand is spread across the globe in very different ways. For instance demand in the US stems to a large extent from ETF investors, in Europe key buying is roughly evenly distributed between ETF investors and bar and coin buyers, while in India and China jewellery is the main reason to buy gold.
David Lamb, managing director, Jewellery, at the World Gold Council says that although demand for physical gold rose sharply in the second quarter of this year, particularly demand for jewellery, bars and coins, “overall uptake of gold was down 12% on the year.”
Signs of economic recovery in the US followed by a sparkling rally in equities and bonds meant that ETF investors were no longer looking for safe-haven assets and have been pulling out of gold.
According to the latest quarterly report by the World Gold Council jewellery demand, bar and coin demand and ETF purchases accounted for inflows of $26m, $23m and an outflow of $18m, respectively, in the last quarter. Interestingly, at 110,000kg (3,536,582 troy ounces), US gold production was 8% lower in the first half of 2013, compared to the first half of last year, according to a US Geological Survey (USGS) report. Nevada mines produced less gold during the first half of this year compared to the second half of 2012 “as a result of lower grades and recoveries in Mill 5 and Mill 6 and lower grade at the Twin Creeks autoclaves,” said the USGS. “Some of the losses were offset by new production at the Emigrant Mine and higher throughput at the Phoenix Mine.”
Since the conflict in Syria started making the headlines gold prices have risen 20% to just over $1,400 an ounce, but the bigger factor has been the Federal Reserve and its plans about quantitative easing and bond buying which has meant that ETF speculators, already negative about gold, are continuing to pull out of the yellow metal.
What then outside of a conflict situation can investors use as a reliable indicator in the sea of information about supply and demand? For oil, this would be weekly inventory data such as the change of inventory levels reported by the US Department of Energy. Analysts will typically look at the year-on-year change to remove seasonal influences, such as spikes in demand during the summer holiday season when more people travel and petrol consumption goes up. A rise in inventory level will point to either oversupply or lack of demand and either way will result in a decline in prices.
Similarly in base metals a reliable indicator is the level of stocks held in London Metal Exchange warehouses or cancelled warrants—stocks which are due to leave warehouses in the near future. Although this number does not explain how much copper or aluminium is produced or consumed globally at any given time it is a very good indicator if there is spare material in the system.
This should provide a good enough idea of where the base-line price for commodities should be and allow for adjusting for a crisis situation. At present all eyes are on Syria, but the crisis in the pipeline is likely to be cause by weakening of emerging markets currencies. If, for instance, the Indian rupee weakens significantly it would stifle the buying of not only gold and oil but of a whole host of metals and raw materials. The only question is will Europe and the US have enough time to recover by then to counteract a drop in demand.