Know your commodity indices!

Over the past six months various newspapers and broadcasters have sought to explain the apparent weakness in commodity prices by trotting out what has happened to one commodity index or another, explaining that commodity prices hit their lowest for x number of years. But what exactly is a commodity index, why should you care anyway and are newspaper reports just picking the one that best fits the story?

In general a commodity price index is a fixed-weight index or (weighted) average of selected commodity prices, which may be based on spot or futures prices. It is designed to be representative of the broad commodity asset class or a specific subset of commodities, such as energy or metals.The value of these indexes fluctuates based on their underlying commodities and can be traded by investors on an exchange.

Just take the four indices shown in the chart. Each of them have been used to describe how commodity prices have developed. While the RICI and CRB indices have finished broadly flat over the past twelve months, the S&P GS Commodity index is down almost 15% while the Bloomberg index is somewhere in between.

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All of them measure different things (commodities), in very different  ways and for different purposes.

The CRB index includes 19 commodities and has been adjusted 10 times since 1957 to reflect changes in market structure and activity. The Goldman Sachs index currently contains 24 commodities is weighted based on the average quantity produced of each commodity over the past five years and is much more weighted towards energy than the other indices. The Bloomberg commodity index meanwhile adjusts regularly based on price movements, requiring that no single commodity can comprise more than 15% or less than 2%. Finally, the RICI index is probably the broadest based of the indices including 38 commodity futures contracts from 13 international exchanges. Unlike many of the other indices the index has altered little since it was established and perhaps gives a more consistent measure over time.

If that wasn’t enough, don’t forget currency movements. All of the four commodity indices highlighted are prices in US dollars. Since most currencies tend to be priced in dollars, movements in your home currency versus the dollar can significantly affect the relative movement in commodity prices that you face.

These commodity indices are designed to enable investors easier access to a range of commodity markets at low cost. But do they actually reflect the commodities that your industry or your country actually use? There’s also The Economist, the IMF, the World Bank and plenty of others.

All of which makes it very difficult to say exactly what commodities are doing…but it won’t stop headline writers and investors trying.

Natural gas prices: fear of freeze or fundamentals?

The so-called ‘polar vortex’ is set to return to the US this week leading to fears that natural gas prices will spike. The polar vortex is basically a large pocket of cold air that normally sits over the polar region but that sometimes gets dislodged south leading to bitter cold over the US and Canada. The same weather phenomenon hit North America last winter leading to natural gas prices topping $6 per million British thermal units (mBtu) in February. Cold weather boost consumption of natural gas, the fuel is used to heat about half of the homes in the US.

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Natural gas prices are currently around $4.40 mBtu, up almost 25% over the past fortnight and are almost $1 mBtu higher than this time last year. However, there are a couple of factors that could keep any rise in prices in check this winter.

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First, supply growth. Genscape forecasts that total gas production in the Lower 48 will be about 5.1 Bcf/d greater than last winter. This is expected to be countered by lower imports from Canada (1 Bcf/d) and rising exports to Mexico (0.2-0.3 Bcf/d) leaving total supply up around 3.9 Bcf/d compared with last winter.

Genscape estimate that even if the upcoming winter season registers the same temperatures as last winter, demand would grow 2.2 Bcf/d. Crucially much less than the anticipated growth in supply.

“Even under an extremely cold winter scenario, that demand growth will not be sufficient enough to outpace the production growth. And as such, even in an extremely cold demand winter, will not be enough to absorb the growing market length. That’s going to have implications for prices not just this winter, but into the future seasonal markets ahead.”

Second, inventories. U.S. gas inventories stand at nearly 3.6 trillion cubic feet, within 7% of the 5-year average level for that week of the year. According to Pimco, without an extraordinary cold spell stockpiles are likely to hold around 700 billion cubic feet more than they did at the end of last winter.

However, with natural gas prices strongly negatively correlated with temperature and with investor attention perhaps focused on the events of last winter rather than the markets actual fundamentals, natural gas prices may over react, focusing on the immediate short term cold rather than longer term fundamentals.

Related article: US natural gas prices could triple in manufacturing renaissance

Related article:Are commodity markets efficient?

Ironed out: Iron ore price war and steel prices

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.

However, as Clyde Russel over at Reuters highlights this concern is misplaced.

Imports in the first nine months of the year were 699.1 million tonnes, a gain of 16.5 percent on the same period last year. This increase actually represents an acceleration in the rate of growth from 2013, when imports expanded 10.2 percent for the whole year. If maintained for the rest of the year, the rate of growth for 2014 would be the strongest since 2009, hardly the sign of a weak market.

And from Citi

The situation with iron ore is similar. Just as fracking did not begin yesterday, so iron ore’s problems did not begin recently. We believe they began when consumers were faced with annual price increases of up to 70% during the ‘Supercycle’. This was good for business at the time however it was a short term strategy, and immediately guaranteed a flood of new producers in the future as well as overambitious expansion plans from the majors. Mines and ports take time to build and new companies take time to find capital and then to build mines. The iron ore problems we see now were therefore birthed many years ago and will not suddenly disappear tomorrow in our view.

Although demand concerns have played a part, it is primarily a supply side story with the worlds top five iron ore producers expected to bring around 400 million tonnes of new supply to the market over the next three years.

The major miners are betting that they will be able to force the highest cost producers, particularly Chinese producers from the market. However, given that much of China’s iron ore industry is state owned and their priority is jobs rather than profit its difficult to believe that significant capacity will be shutdown, even if it becomes loss making.

New analysis from Goldman Sachs expects current prices to remain low with the marginal cost level (the cost for the last tonne of iron ore demanded by the market) forecast to be around $65-$75 per tonne in 2017. Given iron ore’s crucial role in steel making and their long term correlation, steel prices could well have further to fall and stay under pressure for some time.

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