Oil and natural gas prices in the US have historically tracked each other on the basis of relative energy values (oil has around 6 times the energy value of gas). Up until around 2008 any difference in relative values has been rapidly arbitraged away over a period of a few years or so. However, since 2008 the difference in relative values blew out to enormous proportions. While the collapse in oil prices since mid-2014 has brought energy markets more into line there is more to do which could have implications for both crude (WTI) and natural gas prices.
Only a few weeks ago the chocolate manufacturers Cadbury’s announced that it was changing the recipe for its Creme Eggs provoking an eggstreme reaction from its British fans. The change – a reduction in the cocoa content from 20% to 14% has been blamed on recent high cocoa prices. This is unlikely to have been the first or indeed the last example of so called ‘shrinkflation’ by manufacturers desperate to sidestep rising commodity costs. So are consumers going to have to get used to less cocoa in their favourite chocolate?
Often forgotten, the steel making ingredient iron ore is the second largest commodity market by value after crude oil while steel itself represents 95% of global metal production. Developments in the iron ore price are a crucial cost component in modern economies, in turn influencing the cost of other commodities (think steel pipes for oil wells).
Iron ore prices fell to $75 per tonne this week, down 44% since the start of the year and the lowest level since June 2009.
Much of the attention for the price fall has focused on concerns over weak Chinese demand, government efforts to reduce pollution and longer term thoughts on the Chinese economy re-balancing towards consumption and away from infrastructure and investment.
Lower commodity prices appears to have fed through to manufacturers in October with input price inflation falling to a 6 month low, according to data from Markit. Prior to 2012 there was a very close relationship between the Reuters / CRB Commodity Index and the global manufacturing input price, but this appears to have broken down to some extent. This may reflect recent currency movements, in particular the decline in the yen raising the cost of purchasing imported commodities price in dollars for Japanese manufacturers.
On the face of it the latest indications of Chinese manufacturing activity indicating somewhat of a stabilisation in activity in May should support copper prices. To recap the preliminary HSBC reading of activity in May rose to a five month high of 49.7, an improvement but still in contractionary territory. Given that the Chinese manufacturing sector is a key source of demand for copper this should, if sustained lead to higher copper demand and prices in the months ahead.
However, balancing this view is the potential for weakness in the country’s construction sector, the other main source of copper demand. Goldman Sachs conclude that a “two year property downcycle is imminent…driving 10%-15% price cuts in most cities with 15% volume contraction from 2013 levels in 2014E-15E”. A policy response could help support the property market, maintaining support for copper and other commodities important to the construction sector. However delays in implementation could pose significant downside risks. “We believe China has the flexibility (in terms of potential policies, e.g. RRR cut, mortgage easing, removal of L/D ratio, etc.) to prevent a severe property downturn. However, we are concerned about the timing of their implementation, if any, as possible delays could lead to further slowdown in the property sector and a fall in fixed asset investment (FAI).”
Food manufacturers have got used to low food price volatility during 2013. That all changed in the first few months of 2014 as adverse weather, disease and geopolitical concerns has affected the outlook for food production from Brazil to Ukraine. Is food price volatility about to return with a vengeance?
To recap agricultural prices have risen sharply since the start of 2014. First, the weather. Drought in Brazil has raised fears that crop yields for coffee, sugar and soybean farmers will be severely reduced, while drought in West Africa has reduced the output of cocoa. Second, disease. The coffee leaf rust disease has affected output of coffee in Central America while the Porcine Epidemic Diarrhoea virus has decimated large amounts of pigs in the US. Finally, geopolitical concerns have returned. The on-going tension between Ukraine and Russia has heightened concerns that wheat and corn exports from the region will be affected.