Itaú BBA - Focus is on Demand, for Now

Commodities Monthly Report

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Focus is on Demand, for Now

October 1, 2012

Lower risk aversion and the adoption of even looser monetary policies by G3 central banks provided a boost to basic and precious metals.

Volatility and mixed performance.

Developments in the global economy dominated commodity asset prices in September. Lower risk aversion and the adoption of even looser monetary policies by G3 central banks provided a boost to basic and precious metals. Energy and agricultural prices, which had the best performance in the commodity asset class, declined from their peaks in August as investors favored equity positions over commodity plays, perceived to be overcrowded.

Our Itaú Commodities Index (ICI) forecast changed marginally this month. We currently expect ICI to post an increase of 24.6% YoY in 2012, down from 25.7% previously and marking a decline of 9.2% YoY in 2013, from -9.7% YoY in our last report.  We expect grain prices to remain high, energy prices to stay unchanged and metal prices to be lackluster, mirroring moderate growth rates for China and the rest of the world.

The upward trend in agricultural prices was interrupted by a combination of factors, including a speedy harvest of U.S. corn and soybeans, the much awaited return of rains in the center-south region of Brazil and also profit taking after almost three months of uninterrupted gains. We expect prices to resume their upward trend in coming weeks, as demand still needs to be rationed ahead of the South American harvest in the first quarter of 2013.  Looking forward, the main drivers of grain prices will be overall demand behavior and also climate conditions during the South American crop season.

Oil prices suffered in the past few days. We believe the movement was influenced by profit-taking and not justified by fundamentals. We are revising our year-end oil prices to $112/bbl in  2012 (from $108/bbl) and $116/bbl in 2013 (from $112/bbl) to accommodate looser financial conditions, greater geopolitical risk given the failure of diplomatic talks with Iran, and the increased chance of military action after the U.S. elections in November.

Precious and base metals rebounded sharply in September, with gains of 5.0% and 10.8%, respectively. Both QE3 and the package of higher infrastructure investments announced by China were the main reasons behind the movement. While we believe that more monetary expansion will likely keep precious metals in the spotlight, we don’t think the rally in metal prices will be sustained, especially since the impact on growth rates is likely to be very mild. Consequently, we have maintained our medium-term forecasts calling for only slight gains in metal prices.

Weather: Climate Risk Still High

As harvest is in full force in the northern hemisphere, the climate risk has shifted to south side of the globe. Given the importance of South America grain production to the replenishment of global inventories, what are the prospects for climate conditions in the coming months? The good news is that the drought affecting the region since the end of July is bound to end. The atmospheric conditions were preventing cold fronts from Argentina from entering the growing region in Brazil, but these conditions have finally changed, allowing the return of much-needed rains.

The extended lack of rain delayed the planting that should have started in the second half of September and now will probably be shifted to the first half of November. The consequence of the delay could mean a higher risk of frost and lack of rain for the winter crop of corn, which is planted immediately after the harvest of soybeans.

And what about the weather for the summer crops?  While at the beginning of the year meteorologists forecasted a full-fledged El Niño affecting the growing season, with above-normal rainfall, the current models now predict a mild and short-lived El Niño, which could prove to be closer to neutral weather conditions. While years of El Niño are usually associated with above-average yields, neutral conditions are associated with high volatility of final productivity.

Therefore, weather will most likely continue to cause high volatility in the coming months, with markets paying close attention to rain forecasts, especially during the most critical phases of plant growth.

Agriculture: Shifting Focus to Demand

Grain prices have suffered a decline in the past few days, affected by a number of factors that include profit-taking after two months of almost uninterrupted price gains, a speedy harvest in the U.S. (pressuring the spot market).. Nonetheless, we still believe that prices will resume the upward trend in the coming weeks, as demand still needs to be rationed and climate risk could add a premium to prices, given the uncertainty over South American crops.

Looking at supply in the U.S, most of the uncertainty is gone, with the latest USDA estimates pointing to a YoY decline of 13% in corn production and 14% in soybeans. The seasonal harvest in the U.S. is underway, and farmers are not retaining stocks, instead choosing to sell immediately in order to benefit from high spot prices and avoid an increase in aflatoxins, which are present in drought-stressed corn. This selling pressure in the spot markets is helping the decline in grain prices.

We believe that the recent decline in prices could be short lived, as demand still needs to adjust to the depressed supply, given the current low level of inventories.

The adjustment in corn demand appears to be happening faster than expected in the U.S., with ethanol production already adjusting to just above USDA estimates. We don’t have online indicators for corn-feed demand, but the reduction in feedlot placements and anecdotal evidence of liquidation in both poultry and hog stocks points to a decline in this category of demand. U.S. corn exports also declined in past weeks, as the main U.S. buyers appear to have left the markets, waiting for better prices. Nonetheless, as corn crops elsewhere in the northern hemisphere were also lower than expected, we believe that this decline in exports will be short-lived. The bottom line is that as demand is already adjusting, we are revising our year-end price forecast downward, to $9 cents/bushel from $10 cents previously.

We maintained our forecast for year-end wheat prices, even with the decline in corn prices, as the impact of the drought in Europe and Former Soviet Union countries is still not fully accounted for, and there is still the possibility of government-imposed restrictions on exports to Russia and neighboring countries.

Soybean demand is presenting a different picture. Both U.S. domestic consumption and exports are trending upwards instead of making the expected adjustment, given the increase in prices since June. Seasonally-adjusted annualized demand for soybeans is almost 40% above the level expected by the USDA, meaning that prices will need to be much higher in order to bring these numbers down to levels consistent with supply and inventory levels. Therefore, we revised our year-end forecast upward, to $19 cents/bushel from $18 cents/bushel previously.

Sugar: Stable Weather Conditions Ensure the Expected Large Surplus in Global Balance

Weather conditions in the main exporting countries were unchanged over the last few weeks. Reflecting this stability, No. 11 raw-sugar future prices stayed between $0.19/lb and $0.21/lb.

Despite the fact that prices are low compared with the average in the first half of 2012 ($0.23/lb) and 2011 ($0.27/lb), prices remain well above production costs in Brazil’s center-south region and are more remunerative compared with ethanol.

Harvest evolution in Brazil’s center-south region still suggests a crop of 500 million tons, with ATR (Total Recoverable Sugar) yields lower than last year and well below historical levels.

Global sugar production is expected to increase more than demand in the 2012-13 season, as the area allocated to sugar crops grows in the major producing countries (India, Thailand and China) from the previous season. Hence, supply-demand balance for sugar is set to show sizable surpluses in the 2012-13 season, suggesting that prices are to remain around $0.20/lb for a while.

Energy: Japan Helps Fossil-Fuel Demand in a World of Weak Growth

After Brent crude prices reached $117/bbl on September 13, prices fell quickly to $109 on rumors of a release of strategic reserves by the U.S. and increasing supply by Saudi Arabia. Since then, prices have recovered a little and are trading around $110.

International Energy Agency’s last Oil Market Report showed oil supply falling slightly in August from upwardly revised July estimates, as OPEC liquid production growth failed to offset unplanned outages in non-OPEC countries. Imports from Iran were estimated to have increased to 1.1 million barrels/day in August, from below 1 million barrels/day in July. Impact from selected shut-ins and maintenance is expected to be smaller in 4Q12 compared with the two previous quarters. Demand projections have been revised upwards, even without improved economic prospects, as Japan replaces idled nuclear generators after last year’s disaster.

The updated information is marginally bullish for crude prices, with a slightly stronger demand in a global scenario of weak growth. The improvement in non-OPEC supply in 4Q12 was already expected, and stronger imports from Iran will probably lead to higher pressure for more sanctions.

The increase in Iranian exports since July’s low is expected to continue in September. Given the lack of progress in the negotiations over Iran’s nuclear program and the increase in Iranian exports since July’s low level, U.S. and European officials will probably tighten sanctions further. Following the elections in the U.S., we may see a tougher stance towards Syria and Iran, leading to greater geopolitical risks.

In Japan, the government announced a new energy policy.  According to the announcement, Japan will now aim to be nuclear-free by the decade beginning in 2030. Nuclear plants will be decommissioned as they reach 40 operating years. Several nuclear reactors remain disabled, and a new security regulation is being set before they are allowed to restart. The gap in nuclear power will be partially filled by renewable sources (there is a fairly big fiscal package to stimulate growth in the sector), but also by fossil fuels.

Looking forward, we are revising our Brent crude price forecast upward, from $108/bbl to $112/bbl by the end of 2012, and from $112/bbl to $116/bbl by the end of 2013. The three main reasons behind this revision are: i) oil demand is reacting well to prices above $ 110, ii) a trajectory of a weaker dollar throughout 4Q12 and 1Q13, and iii) we expect increased geopolitical risks after the U.S. elections.

Giovanna Siniscalchi

Artur Manoel Passos

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