Key points

  • Commodities may struggle to find direction in coming months as support from a stronger euro is outweighed by weaker global growth prospects.
  • We have revised our short-term oil profile down, but left our 2012 forecasts unchanged as we see little change to oil fundamentals longer term. Risks remain on the upside though.
  • Near-term, base-metals forecasts have been taken down somewhat. We see fairly limited upside to most metals in Q3 and Q4 due to weaker demand.
  • We have kept our grains forecasts unchanged this month.

Early May sell-off offers healthy correction

The early-May commodity markets witnessed a marked sell-off with silver dropping almost 30% in a few days after the CME raised margin requirements. Coupled with increasing market worries over the sustainability of USD125/barrel for oil, oil prices started to decline sharply as well. The plunging oil price had ripple effects and also led base metals and grains to plummet. On the whole, we see five reasons for the sell-off which also highlight that that the recent experience was a healthy correction not a change in direction for the commodities complex in the medium term.

First, the market started to question whether the world economy would be able to endure oil prices close to USD130 for much longer. Indeed, late-April/early-May weakness in gasoline spending was starting to come through in the US with prices closing on the psychologically important USD4/gallon. Alongside the news of Osama bin Ladens death catalysed the sell-off in our view.

Second, the market was caught long commodities (not least oil) when the sell-off started and hence many investors were forced to eventually exit their positions and take losses. This series of long liquidations significantly contributed to the sell-off as the market had been close to record long oil on average since the MENA crisis began earlier in the year.

Third, the market was caught long the euro as well as the ECB failed to honour expectations that Trichet might signal a June rate hike at the May press conference. The single currency was sold off extensively its decline against the greenback also helped to reinforce the rout in dollar-denominated commodities.

Fourth, we believe that the market had run somewhat ahead of fundamentals in both oil and metals markets. Notably, the current cycle has been characterised by commodity prices rising in expectations of tightening market balances in the future rather than on contemporaneous supply and demand movements, which has been the case in previous business cycles. Commodities used to be a late-cycle performer, but investor behaviour may have changed this. The market may recently also have taken stock of still elevated forward-demand cover for oil (at least in the OECD) and stocks-consumption ratios signalling comfortable markets for many base metals and some grains alike.

Finally, it is evident from recent PMI data out of China and the US, for example that the global economy is set to enter a period of weaker activity in coming months. Such a soft patch for global growth should dampen demand growth for cycle-sensitive commodities such as oil and metals somewhat and could limit price upside. Meanwhile the People’s Bank of China remains focused on taming inflation and market fears of further tightening measures, either in the form of higher reserve requirements and/or policy rate hikes, have also dented sentiment in commodity markets lately.

Overall, we expect to see commodities range-bound but with risks still primarily on the upside for the rest of this year. We are looking for oil and base metals to struggle to find a clear direction in coming months: on the one hand, our FX strategists call for a stronger euro from current levels points to some tailwinds but, on the other hand, our economists expectations for data to continue to point to a soft patch in global growth should be a constraint for prices to move higher. For in-depth analysis of fundamentals in the different commodity sectors, see our recent Commodities Quarterly.

Oil: range-bound but risks on the upside

We would not be surprised to see Brent crude trade in the USD110-120/barrel range for quite a while. Notably, we see USD115/barrel as fundamentally justified: our fair-value model point to USD110 but on top of that we would argue that at least USD5 is justified due to MENA uncertainty.

However, risks are still primarily on the upside in our view: if demand growth turns out stronger than we currently project and/or if Opec refrains from increasing supplies as we believe it will over the summer, the oil market could tighten significantly more than the market is looking for at present and spur another round of price surges in the black gold.

Further out, we look for oil to recover from current levels although we still see a risk that price could suffer somewhat in coming quarters as the world economy faces an environment of weaker growth. Our oil projection is significantly above that of the forward curve. As a result, we advise clients with un-hedged 2012 oil expenses to use the current setback to position for higher prices next year.

We have revised our short-term oil profile down slightly after the latest correction, such that we now see Brent averaging USD114/barrel this year (previously: USD116); we have left our 2012 average unchanged at USD119/barrel as the sell-off was based on little fundamental news in our view.

Base metals: watch Chinese activity

CRU reports that demand for aluminium remains healthy - not least in the US. However, risks are surfacing, not least in China where inflation concerns are fuelling tightening fears and a rise in aluminium smelting activity is adding to supplies. The attractiveness of financial deals as measured by the spot-15M spread at LME has declined markedly in recent month and may hint at some weakness in light metal going forward.

For copper, the picture is slightly different: demand is still struggling to recover after the price surge back in February scared away many buyers and CRU reports that consumers continue to be covered with contracted material. The recent price declines appear to have lured back some buying but with the construction sector still lagging behind the market has yet to tighten as much as we expect.

We have cut our near-term base-metals forecasts somewhat for most metals (expect aluminium, which has been left unchanged) to reflect the new lower levels to which the May sell-off has taken us. We see fairly limited upside to most metals in Q3 and Q4, as a period of weaker demand should take its toll on the sector, but expect prices to edge higher again as 2012 progresses and the soft patch is behind us.

Grains: look out for crop progress

The monthly WASDE report from USDA overall struck a bearish tone when the first estimates for ending stocks 2011/12 were given. Notably, the report to some extent reversed the picture that has been painted in grains markets recently with one-way bullish views on corn as the report made clear the fact that increased plantings of not least corn (and to some degree wheat) on the back of recent price surges will in fact lead inventories to rise (at least in the US) to be partially re-built this season. This is especially the case for corn, which has seen plantings shoot up significantly this season. For soybeans, the picture is broadly the opposite of corn with lower plantings weighing on ending stocks as corn plantings have crowded out soy in US fields.

For wheat, the report was largely neutral in our view, drought in key areas were viewed as harmful for harvest yields and thus outweigh a small rise in plantings. However, it is worth noting that the weekly crop progress has come in on the weak side with first estimates in the low-30% (compared with around 60% at the same time last year). This suggests upside to our forecast for wheat (we are still projecting some further declines).

We have kept our grains forecasts unchanged this month except for CBOT wheat, which has been taken down a little beyond Q2 to reflect our lower EUR/USD profile.