Materials Risk explains: How El Niño affects commodity prices

A deadly mudslide that killed hundreds of people in Colombia earlier this month may portend the spread of more extreme weather conditions. Local weather forecasters have blamed the wet weather that has hit the region on the weather phenomenon known as El Niño.

First observed in the 19th century by Peruvian fishermen, the recurring weather phenomenon is known to affect Australasia as well South America. Its climatic effects can reach as far as West Africa triggering downpours or droughts. Previous episodes have had a significant impact on crop yields and the price of agricultural commodities as well as metal and energy prices.

According to the Australian Bureau of Meteorology six of the eight models that it tracks suggest that an El Niño may develop in July. South Africa’s weather service and global forecasters agree, predicting that El Nino will form again in the southern hemisphere winter or spring, which falls between July and September. El Niño events tend to develop between April and June and reach their maximum strength during December and February. According to Columbia University conditions usually persist for 9-12 months, but can occasionally last for up to two years.

Should El Niño return, it will be the first time the Pacific has swung from warm to cool and back again over a three-year span since the early 1960s. The reason weather forecasters are so concerned is that sea temperatures off the coast of Peru have warmed significantly in recent weeks. This has brought heavy rain to the region, but also means that as the sea currents spread west it will result in a warming of the Pacific Ocean, increasing the risk of an El Niño developing.

Two factors, in addition to its severity, will influence the impact that El Niño will have on crop yields and prices. The first is the timing of El Niño event. The impact of which will vary depending on what stage of a crop’s lifecycle (e.g. sowing, growing, harvesting) it occurs at. As the two maps below illustrate the impact of El Niño varies considerably depending on whether it occurs during the summer or winter months (see maps below). The current outlook suggests that if it does occur El Niño will reach its maximum strength towards the end of 2017 – figure 2 below.

The second factor that determines the degree to which commodity prices are affected by El Niño is the degree of geographic production concentration. Some crops, like palm oil, are grown in one specific region whereas others are grown globally. The main commodities to be affected by El Niño are typically those ‘softs’ that are located around the tropical regions.

Coffee – The warm weather that El Niño brings in June to August aids the Arabica coffee harvest as the crop solidifies and warmer weather protects against the spread of the roya fungus (which thrives in wetter conditions). However, drier El Niño weather in December to February may have negative impacts on the next Arabica crop, helping to support coffee prices as the event continues.

Cocoa – Cocoa output has been volatile regardless of El Niño due to the majority of its production occurring in west Africa which has geopolitical, funding and energy issues.

Palm oil / soybeans – This is perhaps the crop with the biggest exposure to El Niño on account of 90% of production occurring in Indonesia and Malaysia. Whilst palm oil plants are fairly resilient during an event, dry weather tends to impact production growth and yield trends in the following 12 months. Though any increase in palm oil prices tends to be capped by increased soybean production, as palm oil is substituted by soy oil.

Sugar – El Niño’s impacts on sugar production are greatest when it brings too much rain to Brazil and drought to India (which, together, produce 38% of the world’s sugar). India’s sugar production is for its domestic market as it has the highest per capita sugar consumption in the world (consuming 15% of the world’s sugar). In Brazil, El Niño means fewer days for crushing and causes lower sugar content in the cane as the wet conditions cause the plant to store less sugar.

Perhaps surprisingly though the commodity that has typically seen the biggest impact on price during the 20 year period to 2015 has been nickel. This has been because dry weather in Indonesia (up until recently one of the main exporters of nickel ore) lowered the water levels in canals, preventing the metal from being exported.

Other metals may also be impacted by the arrival of adverse weather. In Peru for example heavy rains have flooded zinc mines in the past triggering price spikes. Gold demand may also be hit if a weak monsoon results in a poor harvest. Indian farmers are large buyers of gold and so any fall in their incomes could hit purchases of the precious metal.

Globalisation of markets and trade should, all else being equal, diminish the impact of any region-specific decline in output. For this reason grains such as wheat and corn tend not to see a significant weather related impact on yields from El Niño. That being said, regional weather conditions may still result in prices responding violently to a perceived or actual threat to output.

 

Finally, El Niño also reduces the risk of hurricanes in the US Gulf. El Niño increases wind shear in the Atlantic, acting as a block to tropical storms from forming. As hurricane activity has subsided in recent years the typical seasonal bounce in crude prices in late September/October has been much less pronounced.

Historically El Niño creates a risk premium for many commodities that tends to be reflected in prices and volatility. But crucially for investors and physical commodity traders this tends to happen only once an event is underway.

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Demand and supply: Rewriting history

“No other industry begins to offer the data problems that are presented by petroleum,” – John Blair

The production of basic statistics and forecasts about oil reserves, production, consumption and stocks ought to be a matter of routine. You just stick a gauge at the end of a pipe and measure the amount of liquid flowing through (in the case of oil) right? Unfortunately, it’s not that simple, and the problem isn’t limited to just oil, but all commodities.

Doubts about the reliability of energy statistics were a major part of the “energy crisis” that erupted during the 1970s. As late as 1968, the United States had an estimated 4 million barrels per day of spare crude production capacity and thousands of wells across Texas and Louisiana were being operated for fewer than 10 days per month. But just four years later spare capacity had suddenly dropped to zero, every well was at maximum production, domestic output was falling, and politicians began to speak of an energy crisis.

The OPEC oil embargo, announced in October 1973, intensified the sense that something had gone badly awry, leaving the USA unprepared. Politicians and the media blamed a conspiracy between domestic producers and OPEC for engineering the crisis to drive up prices and profits.

Congress held hearings amid a sense that the statistics and forecasts prepared by oil and gas producers and the U.S. Department of the Interior had been either inaccurate or deliberately manipulated. One outcome of the crisis was the creation of a new U.S. Department of Energy and within it a new Energy Information Administration (EIA) in 1977 to produce more accurate and independent data. Another was the creation of the International Energy Agency (IEA) in 1974 to gather better statistics and bring greater transparency to the international energy markets.

Prior to the energy crisis, most data and forecasts were confidential and under the control of oil and gas producers themselves. After the energy crisis, data collection and forecasting would be led by impartial civil servants at national and international levels.

Improvements in data collection and forecasting in the United States, led by the EIA, have largely quelled controversy about domestic US oil production, consumption and stocks. But that doesn’t mean they are free from error or revision. Indeed, information on international markets remains much less comprehensive and accurate, mostly as a result of data collection problems in emerging markets and the deliberate secrecy of the major oil producing countries, particularly those who are members of OPEC.

According to a recent study by the Wall Street Journal, annual estimates of global crude demand by the IEA have been revised up for the past seven years (up until 2016) by an average of 880,000 barrels per day. And there is little evidence that demand estimates from other institutions are any more accurate. The EIA have also underestimated consumption over the past seven years, with the annual figures being revised up by an average of 2.3 million barrels a day.

Revisions to oil supply estimates are typically much smaller than for demand and are often about correcting overestimates for crude production. The IEA’s supply data has been revised down 60,000 barrels a day on average over the last seven years, according to the Journal analysis. That means the oversupply usually ends up being smaller than initially thought.

Demand is much harder to estimate than supply. Unlike supply which can be estimated from the pre-announced expansion plans of a relatively small number of companies, estimating demand involves billions of consumers worldwide and many millions of companies of all shapes and sizes.

The history of discrepancies underscores how commodity markets often trade based on, and pundits provide price forecasts using incomplete and often significantly revised data. And remember, the oil market is by far the largest, most liquid, most important commodity market in the world. If such big revisions are made in the oil market, then imagine how difficult it becomes to estimate demand and supply and then forecast prices in much smaller markets like lead, live cattle or lithium.

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Where do we stand in the commodity cycle?

Many investors in commodities could be forgiven for thinking that the good times are back. Since the start of 2016 one measure of commodity prices is up over 41%. The best performing commodity, natural gas is up over 70% in the past twelve months while both crude oil and zinc are up around 50%.

Investors and other with an interest in the outlook for commodity markets might assume that because some commodities have gone up sharply then others are sure to follow or that the recent increase in commodity prices heralds more extensive, longer term gains. Indeed, net positioning among investors in commodity futures contracts is at record levels, reflecting optimisim of further gains. The question is more than just academic. Investors in particular might be emboldened by recent gains and think that this is just the start of a whole new super cycle.

But rather than try and know the unknowable (i.e. the future) it far better to try and understand where we are now in the cycle. In the world of investing nothing is as dependable as cycles. Commodity price cycles rise as demand overwhelms the pace of supply to respond before eventually supply overwhelms demand before the cycle eventually returns to square one, and it begins again.

Research examining centuries of commodity price data has tended to sketch a pattern of 15–20 year super-cycles (a period of rising prices), followed by a slide in prices over the following 10–15 years when excess investment leads to a flood of supply.

The most recent super-cycle in commodity prices had its origins in 1998, when prices approached their lowest for 20 years (equal to depression levels, when adjusted for inflation). This was followed by the emergence of China as an industrial force, which drove commodity prices up in the first decade of the 21st century. Most industrial and agricultural commodity prices peaked in 2011 with oil peaking in mid-2014.

Stating the obvious here but that would mean that the down cycle in commodities has been less than half of previous commodity cycles. Is that really realistic? Has all the excess baggage (debt, overcapacity etc.) that was built up in the boom times really been rung out of the system?

A cursory look at any long term chart showing nominal commodity prices shows that even within long periods of rising or falling prices there are still lengthy periods when prices run counter to the longer-term trend. In addition, not all commodities will necessarily behave in the same way during the period of a commodity cycle. We have highlighted before that commodity prices are prone to sharp price spikes or drops even within much longer term cycles.

Related article: Copper and oil prices: Lower for a bit longer?

And that begs the question, if this is the start of a new super-cycle then what are the catalysts? And more importantly are they strong enough to drive commodity prices back to and beyond the highs achieved in 2011?

The prospect of a weaker US dollar and rising inflation expectations are perhaps the main two macro factors that have driven investors towards commodities over the past year. Coupled with a sense that prices for many commodities had hit a bottom early in 2016 funds have moved back towards the sector. Nearer term a rapid expansion in credit in China as well as curbs on production at domestic coal plants has increased demand for seaborne coal, in turn boosting prices of iron ore and many other metals. Producers have also taken direct steps to influence the supply-side too from Glencore’s decision to shut-in significant amounts of zinc output to OPEC’s agreement to cut output. But arguably there isn’t yet at least a powerful enough driver of commodity demand (or persistent curtailment to supply) on the horizon that could drive gains longer term.

Most commodities are arguably then still in the normalisation part of the commodity cycle. This is where oversupply and low prices incentivise production cuts and encourage incremental demand growth. Once through this there is the rebalancing phase as falling supply and rising demand lift prices, eventually returning the supply-demand balance to equilibrium.

History suggests that this rebalancing phase tends to be associated with the sharpest increase in prices. This is probably the phase that industrial commodities such as zinc, lead and cotton and more recently copper and oil have been going through. Agricultural commodities such as corn, soybeans and wheat could be next.

Once commodities move through the rebalancing phase, the trajectory typically becomes less certain due to the length of time and the many variables involved. Analysis of historical cycles by Cohen & Steers estimated that commodities move from rebalancing to tightening approximately 70% of the time.

What is the inference from the rebound in commodity prices? Investment banks, other pundits and the media are becoming increasingly confident in their attitudes to commodities. Although the peak might not be here just yet, it always pay’s to look to the opposing side when one side of the boat becomes too crowded. Goldman Sachs recently likened the credit driven rally in commodity prices to the 2008 boom in commodity prices. There is no sense, yet at least of euphoria in the market where investors are getting ahead of themselves.

The size of the net long position will require prices to increase further or otherwise risk investors pulling funds out of commodities. The possibility of a stronger US dollar coupled with rate hikes in the US could put a lid on further gains in commodity prices. A sharp rise in US shale crude production combined with a return to historical levels of OPEC compliance could finally break out the narrowing in crude price levels to the downside. China meanwhile may well slow during the rest of 2017 putting pressure on industrial metals in particular.

There is a possibility that this commodity super-cycle and those of the future may become shorter and shallower. More data and importantly more accurate data on the stock of commodities in use at any one time, the expansion of ‘manufacturing like’ processes in US shale oil and gas to other commodities and more liquid and sophisticated hedging tools may enable both producers and consumers to more accurately balance commodity supply and demand.

That could be the future. With oil being one of the primary driver of cost across many other commodities a stable equilibrium around $50 per barrel could prompt less volatility in other commodities. The more likely outcome though is the way it has always been, that oil and other commodities are never in equilibrium, always moving further away and towards it but never stable.

For now though be cautious about extrapolating gains in industrial commodities out too far. There are likely to be further disappointments ahead before fundamentals justify higher prices.

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