Not quite a merry Christmas for commodities

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Oil has turned even more slippery, writes Austin Lobo

Following a decision at the December 4 meeting of the Organisation for Petroleum Exporting Countries (OPEC) to continue to chase market share rather than support prices, crude prices seem to be headed lower. A widely expected hike in US interest rates is not likely to bring cheer to commodities, either.

Crude prices fell to their lowest since the 2007-08 financial crisis and seem to be headed towards US$20 a barrel. However, analysts believe it is not so much the decision to maintain market share as the rift in OPEC that triggered crude’s downward journey.

The year-old market-share strategy was taken by Saudi Arabia, the largest and economically strongest member of the cartel. The strategy aims to stamp out production from non-OPEC members, notably shale-oil producers in the U.S. The strategy seems to have borne fruit—shale-oil production in the U.S is slowing. Economically weaker members of OPEC, however, have been feeling the pinch. Countries like Nigeria and Venezuela want higher prices, but no member is willing to cut its own production. Saudi Arabia and countries in the Persian Gulf indicated they were willing to reduce production if Iran, Iraq and non-OPEC countries did so too.

The global supply glut of about 1.5 million barrels a day has been driving prices lower. Add to that warm weather and a consequent drop in demand for heating oil, which will further drive down prices. Analysts see no let up in the downward spiral—some see prices falling to less than US$30 a barrel in the near term.

The dip in prices has come at a cost to oil producers. The International Monetary Fund believes the Saudi Arabian government expenditure in 2015 will reach 50.4 percent of GDP, up from 40.8 percent a year earlier.

Meanwhile, demand has been plummeting with China — the world’s largest energy consumer – leading the way. Chinese exports in November posted their fifth consecutive month of decline, slipping by a higher-than-expected 6.8 percent year-on-year. Chinese November imports fell by 8.7 percent year-on-year.

The slowdown of the world’s second largest economy has impacted demand for commodities across the board—from iron ore to coal and oil. The decline in demand has left Chinese producers with excess, which is pushing them to sell overseas.

Given the Chinese slowdown, analysts believe the market may begin to distinguish between commodities instead of lumping them together as an asset class. On the one hand are commodities whose prices are largely a function of demand. These include commodities such as precious metals and energy.

On the other hand are commodities that might have supply-side hurdles. These include agricultural commodities, mainly food, for which demand remains constant or keeps increasing. Here, weather conditions and demand play a role in determining their prices. Dry weather in countries like Indonesia, Australia and India is causing supply-side concerns to commodities such as cocoa, sugar and palm oil. Commodities like wheat, corn and soybean may not be as heavily impacted but much depends on the area under Rabi cultivation.

In the midst of this unfolding drama of crop and climate, the US Federal Reserve is likely to raise interest rates at the end of its meeting this week. Over the past nine years the U.S. has been keeping borrowing costs down to boost spending and to soothe an economy hit by financial crises. Now, the Fed Chairperson Janet Yellen believes the labour market has improved and she expects inflation to improve as well. It is widely believed that the US will raise rates. A rate hike is likely to boost the value of the greenback and make gold less lustrous as a safe haven.

The Governor of the Reserve Bank of India (RBI), Raghuram Rajan, said on December 11 that he expected U.S. rates to be hiked by no more than 25 basis points and that the RBI was ready with measures to deal with any adverse reaction to the hike in India.

For all that assurance, the fact remains that the commodities situation is unlikely to improve unless the Chinese economy recovers and demand steams into the markets once again. It’s going to be a bad Christmas and a New Year for the world of commodities.

 

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