Brent crude is up almost 3.5% to $58.20 per barrel this morning after Saudi Arabia started bombing targets in neighbouring Yemen. Yemen contributes less than 0.2% of global oil supply but it is located on Bab el-Mandeb, the fourth-biggest shipping choke point in the world through which around 3.5 million barrels a day of oil and petroleum passes. Closing the strait would stop tankers from the Persian Gulf from reaching the Suez Canal, diverting them around the southern tip of Africa, adding to transit time and cost. If this worst case scenario did happen the impact would most clearly be felt on the oil market, but the route is a major transit route for the worlds container traffic and so any disruption would also be a drag on world trade and economic growth.
“With only months left before the mid-year peak in sales of commodity-intensive goods, time is running out for China to support commodity prices in 2015…Instead of delivering its reliable first-quarter seasonal expansion in trade, China’s metal processing industry remains dormant.”
Amid this downbeat assessment Morgan Stanley has slashed its forecasts for base metals in 2015 and 2016. The bank reduced its 2015 estimate for nickel by 23% to $14,815 per metric tonne and copper by 16% to $5,945 per tonne. Although the bank also cut its 2016 outlook too, both nickel and copper prices are still higher than 2015 at $16,094 a tonne and $6,283 a tonne respectively.
China, which last year reported the slowest economic growth in more than two decades, is being buffeted by the twin headwinds of a property slump and excess industrial capacity. Meanwhile a preliminary Purchasing Managers’ Index from HSBC/Markit fell to an 11-month low of 49.2 in March. With Premier Li Keqiang setting the lowest GDP growth target in more than 15 years, growth in base metal demand from China is likely to remain “dormant” over the next few years.
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Whether it is a farmer deciding what crop to plant for the next harvest, a manufacturer deciding whether now is the best time to purchase the commodities it needs, or an investor taking a position in coffee futures in anticipation of a drought in Brazil, all these decisions consists of dealing with the future.
And as it’s difficult to make predictions, especially about the future dealing with risk is essential.
Commodity market risk comes in many forms and can mean different things to different people.
The main risk is price. Whether you buy, sell or trade commodities the risk foremost in most minds is that the price moves against your position resulting in a loss.
Second, there is a supply risk if the commodities don’t arrive on time and to the condition expected. This may mean price is a secondary thought, especially if the perceived or actual risk of a disruption to supply is high.
Third, career risk (or not having skin in the game) is another factor. A manager may not care much about gains, especially those in which they won’t share in, but may be afraid of losses that could cost him or her their job.
Fourth, a lack of liquidity or cash flow could mean that an investor or physical trader can’t take a position or pay for a hedge that they might otherwise make. This means opportunities are missed and / or risk, that could have been insured against is not meaning risk could actually increase.
Finally, there is a reputational risk. Ensuring the supply of commodities is from a sustainable source (i.e. environmentally or socially) is essential to avoid the risk of bad publicity but also the risk that factors outside your control disrupts supplies.
Price volatility is often used as a measure of risk, a catchall for everything from the risk of supply disruptions to inventories being damaged to there being an unexpected surge in demand.
Long periods of low volatility (much like the last few years) can lead market participants to believe that risk is low. This can inadvertently lead to behaviour that actually increases risk, perhaps by taking on too much leverage in expectation that prices will stay within a tight band or never fall below a certain level.
But as ever it is impossible to boil anything down to one metric and risk and commodity price volatility is no different. Risk exists only in the future and it’s impossible to know for sure what it will hold.
Go back a few years, investors and commodity buyers were fearful that the commodity super cycle was in full flow and prices would continue to rise. Now, the same people may be concerned about missing the bottom but also being wary about catching a falling knife. Here our attitudes to and calculation of risk become blurred by emotion and psychology.
Properly understanding and controlling for risk can be summarised by two quotes. The first “Risk means more things can happen than will happen” and second “Pigs get fat, hogs get slaughtered”.
Or always think in terms of risk and return (or loss) and never get too greedy.
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