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The Outlook for Commodities


The sector has shown strength, but it may be time to tread carefully.

Editor's Note: This article was written by Damien Cleusix (damien (at) It is part one of a five-part series on Global Tactical Asset Allocation. To read the second part, click here; the third part, click here; the fourth part, click here; and the fifth part, click here.

"Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again, and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."

-- W.Buffet, Harvard 1998

"The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy."
-- G.Soros, MIT 2004

Commodities: Valuations

There are various methods to gauge commodities valuation.

We use models analyzing the long cycles around production cash cost. The principle is the same as with margin at the whole economy level. That is, when the price is much higher than cash cost (margins are too fat) supply (competition) will increase and push prices (margins) lower, to a point where supply will be reduced sufficiently for a new cycle to emerge. To sum it up, this is true capitalism at work.

It's important to keep in mind that both supply and demand are very inelastic to price in the short- to medium-term for commodities but that demand is more elastic to growth than supply. This is something one can easily forget at the beginning and end of an up cycle.

Industrial metals tend not to fall below the 75th percentiles of producers cash costs on a
sustainable basis (Table 1). They only do this briefly at the end of a bear market.

This failed to materialize in 2009 because of China opportunistic stock building, which accelerated in 2009, and investment demand, which, after a dip during autumn 2008, started to increase again early in 2009. I've tried to document those two factors during 2009, but what about now?

We're now in a situation where the entire production curve is profitable for the copper, oil, and nickel markets, and price could lose 50% to 70% to get to the end of bear market valuation (for now the cycle remains up -- see graphs -- but with a lot of risks). Looking at production, one can see that many mines/wells/projects that were suspended around the end of 2008 and the beginning of 2009 are back on the board, so we're moving back toward demand destruction and supply increase.

Gold is trading significantly higher than cash costs (two to three times) but , even if this isn't something to push completely aside, I think gold's prospects are more closely linked to the future of the current monetary system.

As an aside, marginal costs of production have been declining since the 2008 peak. The major factors for the declines are decreasing energy and equipment prices.

Sentiment -- Crude Oil

Managed money is currently holding a very large net long position while producers and merchants are very short (Chart 1). The latter positioning can be partially explained by the huge contango, which makes arbitrage (storing and selling further down the curve) profitable but, with regard to managed money, local peaks in positioning tend to be coincident with short-term tops while you tend to see a divergence at the bottoms and tops. They will be net long with local peaks, but usually a lower peak than the preceding one at cyclical tops.

The Bloomberg Crude Oil Survey bull ratio has reached the 60% level, where the market has peaked shortly after (Chart 2).

The Mexico Finance Ministry, which successfully hedged its oil revenue in 2008, is at it again, but this time selling USD 57 puts to hedge its 2010 production.
No positions in stocks mentioned.

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