Fundamental Bullish Commodities Story Still Intact

Here’s a note from Andy Lees of UBS which tells me that, despite the commodities tumble, the fundamental story supporting a bullish commodities trade remains intact.

Chinese coal prices are now only 13% off their highs as energy shortages build up again. Whilst crops are still not at their peaks, the overall crops and fibres index is 42% above its 2008 high as per the chart below. Economists say it doesn’t matter because it is just a transfer of wealth from the commodity consumers to the commodity producers, but of course that is nonsense if it is being driven by a genuine supply constraint as is indeed the case. It is a tax by Mother Nature rather than by another country or producer.

In 2007 and 2008 commodity prices were able to reach new highs because households were allowed to borrow to maintain consumption. That ability has largely been eroded. Whilst the household has built up his savings ratio, it has been insufficient to offset government borrowing. Taken together, the US household plus the Federal government has borrowed USD196.7bn over the last 3 months, second only to Q1 2009 and as you can see that borrowing requirement is getting worse. The savings ratio is also just an average so will not give a true picture of the squeeze in discretionary income that a lot of people are suffering.

Clearly, the run-up in commodity prices has a very large component of speculation to it. The rout last week helps us keep this in mind. But the fundamental story supporting commodities comes from growth in emerging markets. Many Chinese provincial governments are going flat out to make exceedingly high growth targets.

"Back in January the head of China’s NDRC called on the provinces to be more realistic in their growth targets. Only 5 or 6 of its 30 provinces are targeting annual economic growth of 8% or 9% with the rest all aiming for growth in excess of 10%, with some wanting to double economic output over the next 5 years (14.8% pa)."

-Andy Lees, 9 May 2011

China is resource constrained. I have talked about the coal problem and the hydro problem in particular. But the resource constraints go right across the commodities sector. We see the same problems in India as well. Yesterday Andy caught us up on this.

Last week India’s Power Ministry warned that a growing coal shortage threatens the power industry “with a cascading impact on the country’s growth story” according to The Hindu Business Line. Over the next 5 years 62.68GW of new power capacity will be added requiring an additional 313m tonnes of coal against the 100m tonnes of new production that Coal India is saying will come on stream. 42GW or 67% of the new capacity will be stranded, equivalent to 24.2% of present capacity.

India’s coal imports will have to rise by 213m tonnes in addition to the 250m to 550m tonnes of incremental Chinese coal imports over that period – (it has said it will increase imports to between 400m & 700m tonnes from the present 150m tonnes). Indian coal has a low calorific value and the power stations are being built accordingly, which means they are not suitable for higher quality imported coal which has a much higher thermal efficiency. Historically India has blended fuel to compensate, but there are limitations to blending the coal which would go up from around 10% of the mix to around 35%, significantly affecting the efficiency and the lifespan of the boilers etc. Based off the period 2005 through 2009 and using the BP world energy statistics, it would appear that India’s energy elasticity is about 77% so if the Power Ministry is right that 42GW of the new capacity is left stranded then it will lower India’s growth potential from about 10% pa over the next 5 years to about 3% pa.

Much of the fundamental story remains intact, therefore – especially given the low or negative real yields we see across the EM space, which supports credit growth. This accommodative policy is apparent in Turkey, Brazil and Chile, and China – right across the EM space. China may add fuel to the commodity rally. Elsewhere, EM policy-makers are finally starting to ‘get it’.

Nevertheless, it is in the developed economies where we have to look for signs of demand destruction. Unless we see greater personal income growth in the US and Europe, demand destruction is going to happen. Before the drop in the commodities sector last week the International Energy Agency was pointing to the possibility that demand destruction was already occurring.

QE is ending in June. So that won’t be a factor in inflation expectations. The ‘goldilocks’ scenario would be moderating commodity prices, followed by moderating global growth, followed by an increase in growth as inflation expectations come down.

We will have to see where commodity prices go. But clearly, the Obama Administration, now in re-election mode, has a particular incentive to get regulators and exchanges to crack down on speculation in the sector by raising margin requirements. The fundamentals for the developed economies are weak. Austerity is pulling down demand right across Western Europe and I expect the same in the US.

So, you have strong growth in emerging markets offset by weaker growth in the developed economies. Who wins this battle? For now, EM is winning and that is bullish for commodities over the near-term.