CIBC World Markets Inc. Economic Insights—April 29, 2015 Commodities: Looking for the After-Party Nick Exarhos and Andrew Grantham The party’s over, and now we’re dealing with the hangover. A flood of new supply driven by the prior commodity cycle’s investment boom has hit the wall of waning demand in emerging markets, particularly China. And while lower supply will alleviate the pressure placed on some prices (for example, oil), a slow global growth environment going forward will ensure that any afterparty in commodity prices doesn’t live up to the hype of 2007 or even 2011. countries at this stage were still seeing strong population growth, whereas China’s is already slowing and due to ease further going forward (Chart 1, right). The result is that China’s 8% or so average growth in GDP per capita since the global downturn was well above that achieved in the US or France (both around 4.5%), and even South Korea (6.5%), when those economies were at the same stage of maturity. While recent stimulus measures should help manage a “soft landing”, the global economy needs to get used to a slower Chinese growth pace over the coming decade. Global Growth: Failing to Step on the Gas Ever since the end of the recession, forecasters have been waiting for global growth to accelerate. Yet it hasn’t happened, and we remain stuck in the 3½% or so range that we have been in since the early days of the recovery (Table 1). The fallout from the financial crisis meant that growth in many developed countries, in particular Europe, was slow to recover. That has impacted developing countries as well, with many still reliant on Western consumers to buy their exports. Commodities Still Have a Place in Portfolios A lower speed limit on global growth is already restraining prices for many commodities. But that doesn’t mean investors should shy away from that space. The decline in oil prices, for example, has been more a story of excess supply than flailing demand. Meanwhile, a continued recovery in the US housing market should see lumber prices perform well over the coming years. Out of the commodities we cover, oil and lumber are two of our favourite picks for the coming year (Table 2). In addition to greater potential upside in prices, they also provide greater diversification for investors than, for example, metals, which are often highly correlated with each other and the broad commodity space (Chart 2). While there are signs that 2015 will be a better year for the Eurozone and the US, that’s largely because both are among the highest net beneficiaries of lower oil prices. Plenty of spare capacity remains in Europe, allowing it to grow above its long-run “potential” in 2016 as well. But that’s not the case stateside, where we see growth easing to a 2.4% pace next year. For China, somewhat slower growth should be expected given its development stage. Looking historically at when other countries were at a similar level of GDP per capita, the 7% growth rate target Chinese authorities have set for this year doesn’t appear all that elevated (Chart 1, left). There’s one big difference, however. Most other Chart 1 China Slightly Ahead in Growth Rates (L), But Without Demographics to Back it Up (R) 10 Avg. Real GDP Growth (% Yr/Yr) 8 3.6 US 2.2 2.4 2.9 2.4 EZ -0.4 0.9 1.7 2.0 China 7.7 * at Purchasing Power Parity 7.4 6.8 6.6 US 1934-53 France 1950-69 Korea 1984-2003 China 2007-26 (F) 95 85 t+18 3.4 t+15 3.3 t+12 3.3 t+9 World* 105 0 Korea 1984-2003 2016F France 1950-69 2015F US 1934-53 2014E China 2007-2014 2013A t+6 2 t Global Growth Not Joining the Party 115 t+3 4 Population Index Start Year = 100 125 6 Table 1 135 Source: OECD, IMF, CIBC 3 CIBC World Markets Inc. Economic Insights—April 29, 2015 Chart 3 Demand Effects Only Partly Responsible (L); US Rig Efficiency Topping Out (R) Drop in WTI Since Jun-14 0 US Rig Effeciency (Weighted Average) -20 0.3 0.0 2yr 5yr 10yr -40 -0.8 -50 % Est Demand Effect Nov-13 -0.5 -30 bbl/day Actual Decline Feb-15 0.5 -0.3 300 290 280 270 260 250 240 230 220 210 200 -10 0.8 Nov-14 1.0 Aug-14 1.3 May-14 Correlation to Overall Commodity Complex Feb-14 Chart 2 Source: Bloomberg, CIBC Source: Bloomberg, EIA, CIBC Oil Rout Driven Primarily by Supply wells offline. With the average shale break-even placed at around $70/bbl, rig counts in the US have halved from year-ago levels. The biggest story this year has been the dramatic decline in oil. Though crude hasn’t been alone in feeling the weight of slowing global demand, the principal component that explains the demand side driving cyclical commodities shows that the majority of oil’s decline has been driven off specific supply effects (Chart 3, left). The shale revolution has driven a near-twofold increase in US oil production over the past five years, with America now pumping over 9 mn bbl/day. And though productivity gains, driven in part by producers focusing on the highest yielding oil fields and by technological advances in the hydraulic fracturing process, have buffered the fall in absolute rig counts, improvements on that front appear to have reached their near-term limit. After seeing an upswing as prices initially tumbled in late-summer 2014, average US rig efficiency has flat-lined for the past few months (Chart 3, right). That rapid increase wasn’t matched by a commensurate rise in worldwide demand, which grew by slightly under 3.5% between 2011 and 2014. The dramatic fall in prices, however, has meant that American producers have had to slash investment plans and take more expensive Crude Imbalance to Narrow by H2 US supply will tail off in the coming quarters, and the International Energy Agency estimates that there should be roughly 2 mn bbl/day more in oil demand by the Table 2 Key Commodities Prices 27-Apr Oil (WTI) $/bbl Natural Gas (Henry) $/Mn Btu 2012 2013 2014 2015 (f) 2016 (f) 2017 (f) 57 94 98 93 57 68 75 2.48 2.75 3.73 4.35 2.95 3.50 3.75 Gold* $/troy oz 1202 1675 1202 1184 1100 1200 1150 Silver* $/troy oz 16.38 30.3 19.5 15.7 15.3 17.6 17.4 Iron Ore (62% Fe) $/mt 59 129 136 97 59 63 62 C opper $/lb 2.74 3.62 3.33 3.12 2.75 3.00 3.05 Aluminum $/lb 0.84 0.92 0.84 0.85 0.84 0.89 0.91 Nickel $/lb 5.98 7.97 6.82 7.68 7.95 8.26 9.20 Zinc $/lb 1.02 0.89 0.87 0.98 1.05 1.11 1.11 Lumber** $/'000 bd ft 255 287 345 338 285 335 350 Potash $/tonne 305 459 379 297 310 315 315 * end of period, Source: CIBC **1st CME Futures 4 CIBC World Markets Inc. Economic Insights—April 29, 2015 Chart 5 1.5 2500 0.5 2000 0.0 1500 1000 fcst -1.0 Jan Feb Mar Apr May Jan-15 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 YoY, % 2015 Average 2010-2014 May-14 Sep-13 -2 0 2 4 6 8 10 12 14 16 3000 1.0 $/mmbtu US Prod Growth (Inv., L) Henry Hub Price (R) Source: IEA, CIBC *Note: Assuming OPEC Supply agerages 30.3 mn bbl/d Source: Bloomberg, EIA, CIBC That’s occurring at the same time as Chinese demand, particularly for steel, slows dramatically, dragging prices meaningfully lower (Chart 6, right). Our iron ore forecast matches our expectations for cooler Chinese demand. fourth quarter of this year than there was in the first, balancing the global crude market (Chart 4). That rise in demand will be critical in seeing a sustained recovery in prices, as production will only be idled until we see prices ramp back up to producer break-evens. So there’s likely a longer-term ceiling on prices at around $75/bbl—a level that we forecast on average for 2017 following a slow and uneven recovery this year and next. Copper, and Other Metals, to Face Slower Days Copper faces many of the same demand headwinds plaguing iron, but does benefit from a more diverse set of uses. Furthermore, copper production hasn’t seen the same type of surge experienced by iron ore. Ore grades in Chile—the country responsible for a third of the world’s copper production—are on the decline, and other potential higher quality mine locations are in jurisdictions with greater country-specific risk. Natural Gas Upside Capped by Shale Abundance The shale revolution has gained infamy in crude markets, but the horizontal drilling techniques applied to oil extraction took root in the drilling of natural gas. Growth in landlocked US natural gas production has kept a lid on meaningful price appreciation, and recent outcomes could have been worse had it not been for cold weather saving the day for producers, bringing inventory levels slightly below their five-year average (Chart 5, left). Chart 6 Iron Ore Production Continues to Grow (L), While Marginal Consumer Slows (R) Global Iron Ore Production 3400 3200 3000 $/mt 160 140 16 120 12 100 8 2600 4 60 0 40 Feb-15 Aug-14 1800 Feb-14 2000 80 Feb-12 2200 The commodity super-cycle drove massive investments in expanding iron ore production. With companies hoping to capitalize on surging emerging market demand, global production has been on a steady climb (Chart 6, left). YoY, % 2800 2400 Iron Succumbs to Chinese Slowdown Mt 20 Aug-13 That’s certainly been a fillip to prices, though over the longer term, trading in natural gas has been at the mercy of production, where double-digit annual gains haven’t been abnormal (Chart 5, right). Continued strong production trends are reasons we think upside remains modest in Henry Hub prices, though a strong economy in the US should provide a solid base of demand. Feb-13 -0.5 Bcf Jan-13 3500 mn bbl/d May-12 US Natural Gas Storage Levels World Oil Market: Supply* minus Demand Aug-12 2.0 Sep-11 Oil Demand to Catch Up by Q3 Jan-11 Cold Winter Drives Reduction in Storage (L), But Price of US North Am. Nat Gas Driven by Production (R) Chart 4 Chinese Steel Prod (L) Iron Ore Price 62% Fe (R) Source: Bloomberg, US Geological Survey, CIBC 5 CIBC World Markets Inc. Economic Insights—April 29, 2015 Chart 7 Chart 8 Metals Driven by Global Industrial Production Output Gold Gaining Greenback Sensitivity 120 % Yr/Yr % Yr/Yr 80 40 Dec-14 0.0 25 20 15 -0.1 10 -0.2 5 0 -80 2000 2002 2004 2006 2008 2010 2012 2014 Feb-15 Mar-15 Apr-15 -0.3 0 -40 Jan-15 -5 -0.4 -10 -0.5 -15 -0.6 CRB Metals Index (L) CPB World Production Volume (R) -0.7 60-day Correlation: Dollar Index and Gold Source: CPB, CRB, CIBC Source: Bloomberg, CIBC end to 2014 and start to 2015 (Chart 9, left). A bottom has likely been signaled by a small increase in firsthalf contracted prices (Chart 9, right), though sluggish demand from Brazil and the US will cap potash’s upside. That should increase the cost of capital for mining projects going forward, creating a more constrained supply picture and seeing copper prices perform slightly better than iron ore. However, neither are likely to reach prior-cycle price peaks in the medium term, since cyclical metals still largely respond to the global industrial production cycle (Chart 7). Though we aren’t bulls on metals in general, supply restrictions, largely driven by the Indonesian export ban, have us favouring a nickel price appreciation. Lumber Prices Underpinned by US Housing The housing market should be a primary beneficiary of a healthier US economy, and a vastly improved labour market more specifically. Improved job prospects among younger demographics in the US should encourage those stuck living with relatives to branch off on their own. And while renting a condo and multiples construction will remain a larger part of the market than in past years, new single-family sales—the primary driver of American lumber demand—have been on a clear uptrend. With interest rate hikes likely coming at a slower pace than in past cycles, the US housing upturn shouldn’t be disrupted and as such we are bullish on lumber in the years ahead. Yellen Hikes to Cap Precious Metal Gains Despite whatever delays have been created by a lacklustre Q1, Fed hikes should be coming sooner rather than later. The US$ should be a prime beneficiary of that move off of zero, allowing the greenback to gain against most other major currencies, including that most ancient median of exchange, gold. And judging from recent correlations, gold has been gaining sensitivity to the greenback’s moves (Chart 8). There’s scope for the dollar to give ground further out, as policy elsewhere normalizes, but higher interest rates increase the opportunity cost of holding non-yielding assets like precious metals. That should limit gold’s upside further out, while weighing only slightly less on silver, given its more diverse set of industrial uses. Chart 9 Heathier Chinese Potash Imports Continue in ‘15 (L), a Reason to Believe in a Price Bottom (R) China Monthly Imports (Mt) 1.0 H1 China Contracted Potash Prices 500 0.8 Potash Prices Finding a Bottom 400 0.6 In fertilizer markets, there are some more encouraging signs regarding Chinese demand. The economic rotation toward the consumer has been a cause of poorer results for cyclical commodities. But a more protein-intensive diet amongst emerging market populations will be a strong source of potash demand going forward. Though the breaking of the producer cartel had smacked prices in recent years, Chinese import shipments saw a strong 300 0.4 200 0.2 100 2013 2014 Nov Sep Jul May Mar Jan 0.0 6 $/mt 0 2015 Source: Bloomberg, CIBC