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Editorial Comment from the October 2006 issue of the HRA Journal
It’s been a bad month for traders in the metals and energy sectors. Although there has been little “horrible” news on the economic front its clear the US economy is putting on the brakes. What is still open to question by many is if the slowdown will be of the smooth glide or brick wall variety.
Although we’ve been more bearish than most on the US economy in the past, we find ourselves in the relatively bullish camp this time around. Yes, we expect a continued slowdown; we called for one for months based on housing topping out. A slowdown yes, but not a recession.
Though we reserve the right to change our minds based on incoming data that is still our belief. Because of that we were clearly not bearish enough on commodity prices and the impact they would have on share prices short term.
The way the market has been trading the past few weeks clearly indicates many think the landing for the US economy will be hard indeed. Thinking that, they are selling out the positions that have been the most profitable this cycle, namely resources.
The second editorial section deals with our reasons for thinking the growth surge in Asia et al will continue, but that’s the longer term story. It was started as commodity prices started coming off in earnest. It’s not intended as a display of market myopia on our part. We’re well aware of what’s going on out there; we own this stuff too. But we think it’s important to remember the secular trend hasn’t changed, as ugly as the current market may look.
OIL—THE PROXIMAL CAUSE
The hardest hit area, thanks to warm weather, no hurricanes and building inventories, has been energy. This is a bad news good news story of sorts.
Many have taken weakness in the oil price as a signal of general economic weakness and sold not only oil but precious and base metals as well. This in turn has led to a strengthening of opinion that the commodity “bubble” is over. We don’t think it’s a bubble, or over.
The good news part of the energy equation is that a fall of this magnitude should provide a huge boost to US consumers. This comes none too soon as the effect of stalling real estate prices is clearly being felt. A $20 drop in oil prices adds about half a billion a day to US discretionary spending since money not left at the gas pump can be left at Wal-Mart instead.
The added weight to the selling came from weaker housing and manufacturing numbers in the US. Traders are beginning to think the US may really be going off the cliff, economically speaking. The trend may still worsen but most of the recent numbers have pointed to some stabilization. We expect housing may get worse still but much of the bad news is in the market in terms of dropping construction starts. There might also be more bad news from the US auto sector which is, to be polite, floundering. Here again, falling oil prices and a suspiciously large drop in gas prices might help. If pump prices drop enough Detroit might be able to move some of those lumbering SUVs off the lots.
The chart below shows just how strong a driver oil has been for the gold price. It’s a 90 day performance chart for oil (blue), gold (red) and the US Dollar Index (green). As you can see, in the past two months in particular, gold has been dancing to oil’s tune. Though there has been some Dollar movement it’s clearly oil calling the shots.
We think gold will decouple from oil soon. Although the correlation is strong between oil and gold at the moment it’s very much a moving target. If a similar chart was run back through the past few years you’d find many periods where there was little or no correlation or even apparent inverse correlation. Until gold decouples convincingly from oil however, look to the crude price as a guide to the yellow metals direction.
Gold has been dropping because falling oil spoils the inflation story. It’s also profit taking by some of the same funds who are backing out of oil. We would also definitely not discount the possibility of other funds being margined out of gold or other commodities a la Amaranth.
There has been talk in some circles that gold’s new support base in this cycle is the 300 day moving average price, rather then the 200 day moving average used by most analysts. If that is true, gold is still above this support level, though not by much. If we get a bounce from the 300 day level it should happen soon. Otherwise we look to the $540-550 level as support. It’s important to remember that most traders in the forward markets are technical traders first and foremost. If they decide a certain level is the one to test then the market has a way of getting there.
THEY AREN’T THE WORLD
For base metals, the story is similar. Its fear of a US slowdown reducing metals demand that has brought the shorts out in force. In the short run, sentiment reigns supreme so non ferrous metals will have some tough sledding for a while too.
A turn around in base metals will require one of two things; compelling evidence that the US Economy will at least muddle through or evidence that supply is not, in fact, overwhelming demand. We think that is isn’t but only time and physical buyers continuing to put a floor under prices will convince traders.
We’ve said many times that we think the medium and long term fate of metals prices will not be determined in the US. It simply is not the center of the universe that so many analysts seem to keep insisting it is. Yes, it is the world’s largest economy and a big metals user but, at the margin, demand comes from elsewhere.
It is rapidly growing economies that use commodities much more intensively that will determine demand levels going forward. Short of the sort of deep US slowdown we don’t expect, there should be enough continued demand from other areas to make up for weakening numbers in the US.
The US economy will continue to matter for a long time but it will matter less. Based on recent trends in the world economy we have trouble seeing all other economies as “deer caught in headlights” whenever the US weakens.
So far, growth numbers in China and India have not faltered and there has been strengthening in both Japan and Germany. Admittedly, both Japan and Germany are still growing at less than three percent but that is still a big improvement over the sub one percent levels they displayed a year ago.
Only time will tell if we are right, but our premise for some time has been that, this cycle, the assumption can no longer be made that all economies will just follow the US around. In the past, it’s been true that when the US economy got the sniffles the rest of the world got pneumonia but maybe not this time.
China is diversifying trade more rapidly than US analysts credit and India’s economy is less integrated still with the world economy. Japan, the world’s second largest economy, went through a depression in the 1990’s but North Americans and Europeans barely noticed. We don’t think we’ll get off that easy if the US has a true recession but a bout of slow growth may impact the world far less than most believe. Remember too that a real slowdown in the US would have a silver (and golden) lining. It would all but guarantee a series of Fed rate cuts that would undermine the Dollar and send precious metals back up.
Most recent commentary we’ve seen assumes big drops in metals prices over the next 6 months. Negative sentiment could do some of the job but in order for prices to go down and stay down supply has to catch up with demand and stay ahead of it. The current bearishness has brought out plenty of analysts who insist lower forward prices imply metal prices have to fall. Many of the same analysts have been quoted making comments like “proven deposits of copper are good for a hundred years!” Statements like that are meaningless. Prices are not about stocks, they’re about flows. In other words, it’s not what’s in the ground that important so much as what can be produced every year and at what price.
A large percentage of all known metal deposits are not feasible for technical, political or logistical reasons and even those that are won’t mine themselves. The timelines for developing mines haven’t changed. It’s worth noting again that consensus estimates about the speed that metals supplies would increase at have been consistently overoptimistic.
We stress again that sentiment will rule the day short term and its negative now but some statistics might give you some comfort about longer term prospects.
The latest figures for supply demand (to the end of July) for major metals are as follows:
Nickel: 51,000 t deficit Lead: 79,000 t deficit Zinc: 148,000 t deficit Copper: 65,000 t surplus
Stocks of all these metals are very low, even copper. As we expected it was the first to come into balance. It is important to note that these calculations to not take changes in private stocks into account. China is widely believed to have drawn down its strategic copper inventory by several hundred thousand tonnes. So even for copper the surplus may be illusionary.
Metals will come into balance at some point but the numbers above hardly make the case that it’s a bubble or that a freefall in prices should be expected.
Before we move on we’d like to draw your attention to the graph below. It shows spot prices for copper over the past three years. Added to the graph is a series of red diamonds that represent the 27 month price for copper brought forward to their expiry date. In other words, you could have bought 27 month copper futures expiring on the dates shown by the diamonds at the price levels indicated. As you can see, the forward contracts were not exactly great predictors of future prices.
We’ve seen a number of recent comments that have used lower forward prices as “proof” that markets would come off severely. In fact, a dropping forward curve is mainly evidence of strong demand in the spot market. Perhaps traders will remember that one day soon. Ω
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