Materials Risk

The calm before the storm?: A little known commodity market where all eyes are on the hurricane season

It’s just been Hurricane Preparedness Week in the US, and while that might not mean too much for anyone living outside of striking distance of the US Gulf coast or Eastern seaboard, it is important for commodity markets.

Oil (and to a lesser extent gas) of course get all the attention. A look at a seasonal oil price patterns shows frequent spikes during the hurricane season (June to November), and although the risk has subsided in recent years as shale extraction has become more dominant, the risk of a disruption to supply remains.

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Related article: The changing of the seasons

The other main commodity market affected by hurricane activity is orange juice. futures. Florida (the second largest orange producer after Brazil) has been in the eye of many storms that have significantly damaged its crop.

And so this is about the time of year that traders typically make seasonal long bets ahead of the hurricane season. Historically, July has typically been the second strongest month with prices on average up by 1.5% (rising ~60% of the time) as market participants prepare for the risk of disruption ahead.

The last time that hurricane’s severely damaged the states crop was in 2004-05. In 2004, three hurricanes — Charley, Frances and Jeanne — hit the citrus-growing regions of Florida while in 2005 Hurricane Wilma did more damage to the areas. The hurricanes crisscrossed the state in such a way that nearly every acre with citrus groves was affected in some way. In the worst case, trees were uprooted, while in other instances nearly ripened fruit was blown off trees or trees were damaged. Previous to that, the last devastating storm was Hurricane Andrew in 1992.

Expectations matter. And so orange futures prices could move higher over the next couple months as traders try to price in the expected degree of damage risk from hurricanes.

This year at least the risk is looking relatively low. According to Colorado State University’s Tropical Meteorology Project, a “weak to moderate” El Niño is expected to limit tropical storm development over the Atlantic basin for the 2017 hurricane season. Note that the estimated probability of El Niño forming has declined in recent weeks, from almost 70% to below 50% currently.

The university predicts a total of 11 named storms for this year’s hurricane season. Only four of these storms are predicted to be hurricanes; two of these are predicted to be major hurricanes — reaching Category 3 to 5. They estimate that there is a 24% chance a major hurricane will make landfall on the East Coast.

The devil is in the detail however. Even though overall hurricane activity may well turn out to be lower than normal, all Florida needs is one major storm (a return of Charley, Frances and Jeanne) to devastate the crop once again.

For now at least the coast is clear.

Related article: How El Niño affects commodity prices

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Is the main driver of industrial metal demand about to shift into reverse?

The Chinese manufacturing purchasing managers index is closely watched for signs of an uptick in demand for commodities. The reason for this is that it gives a forward view of the potential demand for industrial metals such as copper, nickel and aluminium and to a lesser extent energy and agricultural commodities. Since the start of 2016 all the signs have pointed up as Chinese manufacturing activity surged higher, and metal prices have followed in lockstep.

But what if there is a more important, even more forward looking indicator of potential demand?

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A recent note from PIMCO highlights the role that credit plays as a leading indicator. China’s “credit impulse,” as its known measures the change in the growth rate of aggregate credit to GDP, bears close watching: It has tended to lead the Chinese manufacturing Purchasing Managers’ Index (PMI) by 9-12 months and the U.S. Institute for Supply Management’s (ISM) manufacturing index by about 14 months.

Whats been happening to the credit impulse? Here’s PIMCO.

The sharp downturn in the Chinese credit impulse starting in 2016 portends a material drag on Chinese growth in the year ahead. Looking back on the past three years, the Chinese credit impulse turned positive sometime between late 2014 and mid-2015. Given China’s exchange rate volatility in August 2015, it took longer than normal for credit to gain traction. The Chinese credit impulse peaked in March 2016 and slowed sharply after the second quarter. It is only now that the impact of that reduced stimulus should be felt. PIMCO has already factored credit-related drag into its Chinese growth outlook, but the decline in the credit impulse has been sharper and more extreme than many expected.
The question now is not if China slows, but rather how fast. Equally important perhaps is the extent to which commodity prices will correct lower, especially in light of the current enthusiasm about the potential strength of the global growth cycle. The impending slowdown in China could be compounded by ongoing government efforts to rein in shadow bank credit; the cost of policy mistakes rises once the credit impulse goes into reverse.

All of which means the outlook for industrial metals could look a lot bleaker in the second half of 2017.

Related article: Where do we stand in the commodity cycle?

When will the 5 year agricultural bear market come to an end?

Whether it is wheat, corn or soybeans prices have been falling since 2012 as enormous harvests and stocks bursting at the seems weighed on market sentiment.

Grain and bean futures have been pricing in a lot of bad news recently with funds holding a record short position. Given the slew of bearish news investors have had to digest in recent years it was perhaps not surprising that prices have been pricing in so much bad news.

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Although wheat futures in particular prices surged earlier this week as some of those positions unwound – traders taking their cue from bad weather in the US – the longer term picture has been grim.

Although each of the three main agricultural commodities (soybeans, wheat and corn) have seen frequent attempts to break the long term downward trend only wheat futures have managed to achieve it, if only briefly – earlier this year in March and this week.

The main agricultural commodity futures markets remain heavily in contango indicating that the markets are still heavily oversupplied. Year ahead futures contracts are 10%-13% higher than the front month traded contract. If the futures curve is in contango, as they are now then a farmer may want to put his grain into storage and sell it at a higher price in the future.

Other commodities have seen strong price rebounds over the past year. Industrial metals (zinc, lead and more recently copper) and energy (coal and oil in particular) have risen sharply on stronger, more broad based economic growth and restrictions on supply (whether that is planned as in coal in China and oil in OPEC) or unplanned (strikes in copper mines in Chile). The natural extension of this is that we are now at, or very close to a recovery in grain prices.

Related article: Where do we stand in the commodity cycle?

Other indicators also point to a recovery in prices. Higher oil prices increase the input costs for farmers, and they are important in driving corn prices since corn can be used in ethanol as well as in food or animal feed.

Related article: Wheat prices: The top 10 most important drivers

Weather related factors could play a larger role in supporting higher prices should El Niño return. The World Meteorological Organisation sees a 60% probability of the weather phenomenon returning later this year. But even here the evidence is mixed. Compared with tropical agricultural commodities such as coffee and cocoa the impact on wheat, corn and soybeans tends to be limited. In part this is due to their geographical diversification – a disruption to supply in Australia doesn’t tend to coincide with a fall in output in the US.

If this is the bottom of the market then watch the price of wheat. Historically it has signaled a change in market direction well before corn or soybeans.