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Written by: Nitesth Shah and Maxwell Gold | ETF Securities
Commodities to trade on own fundamentals
While many group commodities as one asset class, in reality each commodity trades on its own fundamentals. Historic correlation between commodities has been relatively low. In this outlook we will provide an overview of our views on major commodities within each sub-category.
Gold and silver: near term pressure, medium term strength
We believe the US Federal Reserve (Fed) is still on track to raise rates in December 2016. Although there was a degree of political uncertainty in the run-up to the Presidential election, Trump’s pro-growth policies are likely to be inflationary. In the short-term, gold and silver prices are likely to come under pressure as we approach the rate hike. However, we believe that the Fed will remain behind the curve and inflation will rise faster than the central bank will raise rates, keeping real rates very low. According to the Fed’s latest ‘dot-plot’ of its committee member’s assessment of appropriate policy settings, the Fed is only likely to raise rates twice in 2017. Low real rates are gold price positive. We believe that gold’s fair value is between the $1400-1450/ounce range.Silver has a close correlation with gold and hence we expect silver prices to rise. In contrast to gold, which trades like a currency, the physical supply and demand for silver also drives the silver price. Factoring in the decline in mining investment and rising industrial activity, we estimate silver’s fair value in the $22-24/ounce range.Speculative positioning in gold and silver has retreated from highs reached in July, but they remain elevated as investors seek a hedge against geopolitical risk. The Italian constitutional referendum, the French Presidential election and the German parliamentary elections are some of the items on the calendar for the coming year. When and if the United Kingdom (UK) will start the process of leaving the European Union (EU) has still not been resolved. Rising populism poses a threat to stability and investors will look to hedge this risk.
Oil market still on path to balance
We believe that oil will continue to trade in the $40-55/bbl (barrel) range until visible signs of a production cut-back emerge. The market is coming closer toward a supply-demand balance, but the path will be bumpy. Close to $1 trillion of investment cuts in the oil and gas industry since the start of the oil price crash that began in November 2014 will start to bite into supply in 2017.
OPEC (Organization of Petroleum Exporting Countries) has also agreed to cut production back to 32.5-33 million barrels (mb) per day of production, down from 33.4mb of production in September 2016. However, OPEC’s commitment is contingent on the participation of non-OPEC countries. Preliminary meetings between OPEC and several non-OPEC members have not shown any progress toward yielding a positive result. Large non-OPEC members such as Russia, Brazil and Kazakhstan are seeing new production come online as a result of investment put in many years ago. There are also a large number of OPEC countries looking for exemptions from participating in production cuts, placing the burden on countries like Saudi Arabia and other Gulf Cooperation Council members.Notwithstanding these difficulties, should OPEC manage to agree on how to apportion the cut at its November 30th meeting and stick to the quota thereafter, we could see the market come to balance as early as Q1 2017. But we believe that it will take until Q2 2017 for OPEC to taper production down to 33mb and the market will balance in Q3 2017.The US will continue to be price responsive. With short-term breakeven prices for shale oil at around $40/bbl we expect to see expansion in US production, which will limit upside on prices to $55/bbl in the first half of the year. President Elect Trump’s pledge to pursue energy independence could see US oil production rise. However, it is a 6-year goal and the necessary policy changes to increase production this year may not emerge.When we see sustained cuts to production in the second half of 2017 and production deficits eat into elevated inventories, oil prices are likely to trade above $55/bbl.Industrial metal correction before next rally
Industrial metals have had a strong rally in 2016 as supply deficits have become more widely recognized. Even copper, which had a lackluster first half of the year, has been rising sharply in recent weeks. Since not a lot has changed for the metals from a fundamental perspective, we fear that part of the gains reflects a speculative frenzy originating from China that could correct in the short-term.
Ahead of the 19th National Congress of the Communist Party of China to be held in Autumn 2017, Chinese authorities will seek political stability. That could mean that the reform agenda could take a back-seat and over-production of several metals could persist in China.Growing populism elsewhere is likely to increase spending on infrastructure which will boost demand for industrial commodities. For example, President Elect Trump has pledged up to a $1 trillion infrastructure spend (financed through a combination of tax credits and private sector borrowing). We believe that this will drive industrial metal prices higher after the short-term correction that we mentioned above takes place.Other political risks may also impact industrial metal prices. The Philippine’s recent threat of banning ore exports is one of them. However, President Duterte’s relationship with the US is likely to improve under a Trump administration and its new political alignment with China will likely keep ore exports flowing, at least to its largest consumers.