Itaú BBA - Favorable Weather Reduces Grain Prices

Commodities Monthly Report

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Favorable Weather Reduces Grain Prices

August 7, 2013

We have implemented a new methodology for the ICI.

We have made downward revisions to our 2013 year-end forecasts for corn (to USD 5.5/bu from USD 6.0/bu), soybeans (to USD 12.5/bu from USD 13.0/bu) and wheat (to USD 6.8/bu from USD 7.3/bu), due to favorable weather in the United States.

Improvements in refining and distribution capacity of crude oil in the U.S. are consistent with a smaller WTI discount to Brent of around USD 5.0/bbl.

We have implemented a new methodology for the ICI. The revised index points to sharper drops in metal prices in 2013 (-9.7%) and 2014 (-7.0%).

Lower agricultural prices were offset by a rebound in metal and energy prices in July. The Itaú Commodity Index (ICI)[1] dropped by an average of 0.6% from the previous month, as a sharp decline in agricultural prices was offset by a rebound in metal and energy prices. Commodities were affected by two pieces of news from the United States. First, favorable weather has reinforced the likelihood of strong corn and soybean crops. Second, improvements in refining and distribution capacity have been narrowing the WTI discount to Brent crude.

Downward revisions in year-end grain price forecasts. The ICI Agricultural sub-index fell by 10.4% in July. The slide can partly be explained by the rollover of futures contracts for corn and soybeans, but favorable weather also played a role. Hence, we are cutting our year-end forecasts for corn (to USD 5.5 per bushel from USD 6.0 per bushel), soybeans (to USD 12.5 per bushel from USD 13.0 per bushel) and wheat (to USD 6.8 per bushel from USD 7.3). We now expect the Agricultural ICI to declineby 15.6% yoy (our previous call was ‑10.9%). Our base-case scenario incorporates a possible downward revision in estimates for the harvested corn and soybean areas in the coming months by the U.S. Department of Agriculture (USDA). If this revision does not materialize, prices may fall even further.

Metal prices erase part of the decline seen in 2Q13. The ICI Metals sub-index climbed by 5.2% in July, led by iron ore. The price recovery was partly motivated by signs that the Chinese government may be willing to defend its 7.5% target for GDP growth in 2013. Among the incentive measures the government could implement, we would single out higher investments in railways and the smart grid, which would boost demand for iron ore, copper and aluminum.

We maintain our call for a decline in metal prices. Despite the price hikes in July, we still believe that the market fundamentals are consistent with lower prices. Our forecasts for 2013 and 2014 remain unchanged. Our forecasts for the ICI Metals sub-index stand at -9.7% yoy and -7.0% yoy, respectively. A debate over potential reforms to the commodity markets in the U.S. (regarding the participation of financial institutions in the physical storage of commodities) may cause volatility in coming months, particularly for metals.

High oil prices are consistent with fundamentals. The ICI Energy sub-index rose by 4.1% in July and is now in level with 1Q13. High prices are consistent with market fundamentals, particularly in the case of crude oil. Refiners have been able to pass through higher crude prices to end-products, and production increases by non-OPEC nations are being offset by lower OPEC output, partly due to conflicts in Iraq and Nigeria. Adjustments in the U.S. market (which involve a relocation of refining capacity to the central U.S., increased pipeline capacity and lower imports from Canada) are driving down the WTI discount to Brent in 2013, and we now expect the discount to be about USD 5/bbl by year-end. We are thus raising our year-end forecast for WTI crude to USD 105/bbl from USD 100/bbl, while maintaining our forecast for Brent at USD 110/bbl. Following this revision, our 2013 forecast for the ICI Energy sub-index rose to 6.6% yoy for 2013 (up from our previous call of 5.7%).

ICI: New Methodology Improves Consistency With Global Commodity Moves

We have revised the series for the ICI and its sub-indexes to make them more consistent with the global macro scenario. International prices for 16 commodities (in USD, first maturity in the futures markets) are weighted according to each one’s global production value. The commodities are divided into three groups:

Agriculture: wheat, corn, soybeans, sugar, cotton, coffee and cocoa
Metals: iron ore, copper, aluminum, nickel, zinc, lead and tin
Energy: crude oil and natural gas

Our biggest changes were increased weightings for iron ore and copper, which lifted the correlation between the index and GDP growth in emerging countries (especially China) and reduced the impact of metals of lower relative importance (in terms of global production value), such as zinc. The inclusion of iron ore is an advantage over other commodity price indexes.

According to the new methodology, the decline we forecast for metal prices in 2013 and 2014 is even steeper. Using the previous methodology, our metal pricing estimates were -4.4% yoy for 2013 and -2.0%yoy for 2014. In the new index, the same price data leads to pricing estimates of -9.7% in 2013 and -7.0% in 2014. The difference is explained by the heavier weightings for iron ore and copper.

Starting in the next report, we will release a new index with weightings meant to incorporate the effects of commodity-price shocks on Brazilian inflation (IPCA). In this index, which will be called ICI-Inflation, international commodity prices (in USD, first maturity in the futures markets) will be weighted according to their significance for the IPCA.

Sugar and Ethanol: Weather Helps, but Exchange Rate Hinders Adjustments in Brazilian Production

Following two years of surpluses in the global balance for sugar, the sector should find a new equilibrium over the course of 2H13.

Sugar price declines in recent years have created incentives for a new equilibrium in the sector. International sugar prices have fallen by more than 50% since January 2011. Lower prices create incentives to restore equilibrium in the sector. On the demand side, cheaper prices boost consumption. On the supply side, lower prices squeeze profit margins, causing farmers to opt for other crops and to invest less in the remaining sugarcane plantations.

A decline in sugar production in Brazil is needed to avoid another surplus in the global balance. Our base-case scenario incorporates a decline in global production excluding Brazil amounting to 5 million metric tons, and an increase in consumption of 3 million tons. These adjustments are not enough to prevent new surpluses from being accumulated between April 2013 and March 2014. Hence, equilibrium between supply and demand depends on weather surprises affecting output in a producing region or on a large adjustment in Brazilian production. It is possible that current prices are already lower than equilibrium levels, but uncertainties and a sluggish response from production may create volatility in the medium term.

Weather conditions have delayed harvesting and lowered total recoverable sugar in the Center-South region of Brazil. Following a summer of favorable conditions for sugarcane plants, rainfall in April, May and June delayed the harvest. Furthermore, a recent cold spell possibly affected a large part of the crop, which may contribute to a decline in total recoverable sugar (ATR, in its Portuguese acronym). Taking these factors into account, we forecast a harvest of 580 million tons in the Center-South (our previous call was 590 million) and an ATR of 135 kg per ton of sugarcane (our previous call was 137 kg/ton). Hence, the change in the production mix in Brazil needed to prompt a decline in sugar output is not as large.

Depreciation in the Brazilian currency affects relative prices between sugar and ethanol, but sugar production should be lower than in the previous year. In addition to depending on harvested sugarcane, sugar production in Brazil depends on the allocation between ethanol and sugar. The allocation, in turn, depends on relative prices. Throughout 2012, relative prices favored sugar output. But in the early months of 2013, the drop in international sugar prices led relative prices to favor the production of hydrous ethanol, pushing a greater part of the harvested sugarcane into ethanol production. However, the recent depreciation in the Brazilian real drove sugar prices relatively higher (in USD) than hydrous ethanol prices (which do not react to exchange-rate depreciation when there is no pass-through to domestic gasoline prices). Consequently, the mix of sugarcane utilization for the remainder of the crop may once again favor sugar production at the margin. Still, our forecast is for utilization of 44.3% of the harvested sugarcane for sugar production in the 2013/14 crop, vs. 49.8% in the 2012/13 crop. Sugar production in the Center-South is estimated at 33.1 million tons, or 1 million less than in the previous crop.

We maintain our forecast for a sugar price of 17.65 cents/lb. at year-end. The downward trend in international sugar prices continued until mid-July, when a cold snap in Brazil led to some price recovery. Even with the local currency at weaker levels, the loss of sugarcane quality should cause sugar production in Brazil to be lower than last year, driving the global balance closer to equilibrium over the next three quarters.

Artur Manoel Passos



** The Itaú Commodity Index (new methodology) is a proprietary index composed of commodity prices, measured in U.S. dollars and traded in international exchanges, which are relevant to global production. Its sub-indexes are Metals, Energy and Agriculture.


[1]Series for the ICI and its sub-indexes were revised according to a new methodology, detailed in a specific section of this report.


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