Saturday, January 31, 2015

Brian Gaynor: Volatile commodities set to be big news this year

The massive volatility in commodity prices, mostly price falls, was a major business story last year. There is a strong probability that commodity prices will continue to be an important story in 2015, particularly in Australia and New Zealand where commodities are significant export earners.

Crude oil prices plunged 48 per cent last year while coffee, which is the world’s second largest traded commodity, experienced a 50.5 per cent price surge.

The Thomson Reuters CRB Commodities Index slumped 17.9 per cent last year following declines of 5 per cent, 3.4 per cent and 8.3 per cent in the three previous years.

The index finished 2014 at the same level as December 2008 but 36 per cent below the December 2007 close.

There are 19 commodities in the Thomson Reuters CRB Commodities Index.

Crude oil has a 23 per cent index weighting followed by corn, soybeans, aluminium, copper, live cattle, gold and natural gas with a 6 per cent weighting each.

Coffee has a 5 per cent index weighting.

Australia has been particularly badly affected by these falling prices as its three largest commodity exports – iron ore, coal and natural gas – all experienced sharp price declines in 2014 (see table).

New Zealand’s export earnings have also been adversely affected by the large decline in dairy prices although meat, forestry and horticulture prices all performed relatively well.

What is the outlook for commodities in 2015?

Commodity prices are primarily determined by supply and demand and most of the major price movements over the past few years can be explained by these supply/demand factors.

Crude oil prices have fallen mainly because of the large increase in United States fracking-based production. This coincided with slightly weaker oil demand in China.

Crude oil prices have been extremely volatile over the past four decades with Brent Crude going from US$19 a barrel in 1973 to US$51 a barrel the following year.

It then surged to US$115 a barrel in 1980 before falling back to US$18 a barrel in 1999.

Crude oil soared to an all-time high of US$147 a barrel in 2008 but finished 2014 at just US$57 a barrel.

So far this year it has fallen a further 16 per cent, to US$48 a barrel.

Crude oil is Australia and New Zealand’s fifth largest commodity export but these figures are deceptive because both countries are also large importers.

Australia had a net crude oil trade deficit of A$10 billion for the November 2014 year.
This comprised A$20.9 billion of imports minus A$10.9 billion of exports.

Meanwhile over the same 12-month period New Zealand had a crude oil trade deficit of $6.5 billion, comprising $7.9 billion of imports and $1.4 billion of exports.

Coffee has been one of the more interesting commodities in recent years because of the huge increase in consumption and adverse climatic conditions, particularly in Brazil.

World coffee consumption has increased at an average annual growth rate of 1.9 per cent over the past 50 years, from 57.9 million bags in 1964 to 145.8 million bags in 2013.

This annual growth rate has accelerated to 2.1 per cent since 1990 and to 2.4 per cent since 2000.

Scandinavia, the rest of Europe, United States and Japan have historically accounted for most of the global coffee demand but demand in coffee-producing countries and emerging markets has expanded dramatically in recent years.

Coffee is a major growth beverage with 2.25 billion cups consumed worldwide every day.

Coffee prices rose dramatically in 2014 because of a drought in Brazil, which is the world’s largest producer.

The International Coffee Organisation believes that the coffee market will remain tight this year. Total production is forecast to be around 141 million bags compared with consumption of nearly 150 million bags.

Supply and demand factors have pushed crude oil and coffee prices in completely opposite directions.

The Australian iron ore sector is a classic example of the impact of a huge increase in production and exports over an extended period.

The country’s iron ore exports have surged from just 80 million tonnes in 1980 to 438 million tonnes in 2011 and 652 million tonnes last year.

Most of the iron ore goes to China where it is used to produce steel.

Steel is a major input in the construction of China’s high-rise apartments.

Iron ore prices have gone from just US$11.36 a tonne in 1968 to a high of nearly US$190 a tonne in 2011 but have subsequently fallen back to US$69 a tonne.

These prices, as well as coal and natural gas prices, will have an important influence on the performance of the Australian economy in the year ahead.

New Zealand dairy production has increased from 6 billion litres of milk in 1980 to 17.3 billion litres in 2011 and 20.7 billion litres in the latest year.

This represents a 3.4 times increase in milk production since 1980 while Australian iron ore exports have surged 8.2 times over the same 34-year period.

The recent decline in dairy prices is not surprising given the huge increase in dairy production in New Zealand, the world’s largest exporter.

Sustained increases in commodity production usually lead to short-term price corrections, particularly if demand flattens and stocks are high.

An important way to avoid these major price fluctuations is to turn commodities into consumer products.

New Zealand can do this with dairy products but it is impossible for Australia to turn iron ore or coal into supermarket products.

It is extremely difficult to predict how commodity prices will track in 2015 but we can make the following observations:

Commodities are vitally important to Australia and New Zealand because the top five commodity exports represent 55 per cent of each country’s total exports.

New Zealand is not as adversely affected by lower commodity prices at present as Australia because meat, logs and horticulture prices are holding up better than coal and natural gas prices.

Dairy prices picked up slightly in the December 16 and January 6 GlobalDairyTrade auctions whereas iron ore and coal prices remain depressed.Most international forecasters are taking a cautious view of commodity prices in 2015.

The World Bank is forecasting commodity prices to remain weak throughout much of the year.

It believes that the outlook for mining products depends on new production coming on board and “more importantly, on China’s growth prospects, as the country consumes almost half of global mining supplies”.

The bank believes that at this stage climatic conditions are generally favourable for agriculture production and this could limit any potential upside price movements.

The good news is that the decline in oil prices is the equivalent of a tax cut for global consumers.

New Zealand economists believe every 10 per cent fall in oil prices will raise our economic growth by about 0.1 per cent over the following 12-month period.

In addition, a 10 per cent petrol pump price decrease will lead to a 0.3 percentage point drop in headline inflation in the quarter following the oil price decline.

Thus, the decline in domestic petrol prices will boost consumer spending and reduce the potential for interest rate rises in the year ahead.

Commodity prices – 2014 was not a good year
% of exports
2014 price performance

1Crude Oil
3Natural Gas

1Iron ore
3Natural Gas
5Crude oil
New Zealand

5Crude Oil

Brian Gaynor is an investment analyst and the Executive Director of Milford Asset Management.   

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