Itaú BBA - Higher food and energy prices

Commodities Monthly Report

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Higher food and energy prices

August 30, 2012

August saw another rise in commodity prices, propelled by oil and grain. Metal prices continued to decline.

Commodities Monthly Review

We are proud to introduce the Commodities Monthly Review, by our new team covering commodities. Please take a look at our report, attached and copied below. The Commodities Monthly Review will present our insights on commodities and will feature both price forecasts and special themes of interest. In our debut report, we look at the prospects for grain and energy markets in the coming months and offer our thoughts on sugar prices. 

We hope you enjoy reading it.

Ilan Goldfajn

Commodities Monthly Review - Higher food and energy prices

Drought in the U.S. and better sentiment in global markets are driving food and energy prices higher.

August saw another rise in commodity prices, propelled by oil and grain. Metal prices continued to decline, reflecting the pessimism over Chinese demand. We are revising our forecasts for the Itaú Commodities Index marginally for 2012 and 2013, to 25.7% YoY and -9.7% YoY, respectively, from 27.4% and -10.6% YoY.

Higher food and energy prices will likely affect consumer prices in the coming months. While higher gas prices at the pump directly impacts income and cost levels, the effects of higher grain prices on the economy are harder to estimate. We believe that emerging economies, with heavier weight of food in consumer prices could suffer the most from higher international food prices.  As for developed economies, and especially the U.S., they will likely perceive increases in the food CPI as higher grain prices are felt throughout the Food industry.

Our scenario for commodity prices includes a continuing of the upward trend in grain prices, propelled by higher-than-expected supply losses and the necessity of restricting demand on a worldwide basis. Despite the recent increase in oil prices, we forecast stability in Brent prices through to the end of the year, with less supportive fundamentals than in the beginning of 2012.

The bear market for metal prices persisted in August. Iron ore prices were the highlight, falling below $100 per ton for the first time since 2009 and posting a 35% year-to-date decline. Disappointing Chinese activity data, supply gains in the coming year and a surge in speculative trading are behind downward movement in iron ore prices.  We believe that the current price decline is an undershooting, and that prices should regain some traction in the coming months. Nonetheless, the lower-than-expected demand growth rates coupled with strong supply gains in 2013 should make the recovery a very slow process. We expect iron ore prices to reach an equilibrium below $130 by mid-2013.

Grain prices: still going up

Grain prices resumed their upward trend over the past few days after maintaining the gains of June and July. As soybean and corn crops are approaching maturity, the supply loss due to the extreme drought this spring and summer in U.S. made itself felt: an almost 20% decline supply YoY. With uncertainty over the supply shock easing, the market will likely focus on two questions in the coming quarters: i) how will demand adjust to less supply, and ii) how will climate conditions affect the next crop in South America?

Another question is how consumption will adjust to the meager supply numbers. Part of the adjustment could come from a stock reduction, helping to smooth consumption over a bad crop year. Unfortunately, this is not possible because current inventory levels are at historic lows. Therefore, demand will have to adjust the hard way. Corn demand in the U.S. is divided between food, feed, exports and ethanol production. Ethanol production follows an EPA mandate, and therefore the space for free-market reduction is limited. The bulk of the adjustment, therefore, will have to come from exports and domestic consumption, a process likely to be painful given that corn substitutes also suffered from the effects of the drought, both in supply and in prices.

Current soybean demand remains strong, even with the price increases in the past few months. According to our calculations, given the supply shock in the U.S. and the limited supply in Brazil and Argentina, at the current pace of demand, world inventories will not last until the start of the South American harvest in mid-February. Therefore, prices will still have to go up in order to sufficiently ration world demand.

While the southern hemisphere spring crops were hurt by climate conditions, meteorologists forecasted an El Niño weather pattern for the spring and summer during the growing season in South America. While El Niño still is the base-case scenario, now forecasts point to a short and mild El Niño, implying more-or-less neutral conditions rather than the wetter and warmer weather that El Niño usually brings. Weather conditions will still create uncertainty, especially given the importance of the supply from South America.

The natural conclusion is that prices will still have to go up in order to sufficiently restrict demand, and volatility will probably remain high and dependent on prospective climate conditions for the South American crop. 


Sugar: improved weather conditions

Sugar prices were heavily affected by an improvement in weather conditions during the last four weeks. Sugar No.11 Future prices fell from $24/lb on July 23 to below $20/lb by the end of August, despite the BRL remaining flat and better sentiment in global markets. A drier climate in Brazil has led to an increase in sugarcane crushing to levels above last season for the same period.  At the same time, increased rainfall in India, the second biggest supplier, has reduced the rain deficit in producer regions, leading to an improvement in crop prospects.

Weather forecasts have changed since last month and now provide a better supply outlook. In Brazil, the base case is that the climate may remain dry until October. Therefore, if our new scenario of five to six weeks with a relatively ample harvest (compared with 2011-2012) occurs, the odds of a center-south crop under 490 million tons is very low. Consequently, we are switching back our forecast for the 2012-2013 crop in Center-South to 500 million tons (2011-2012: 494 million tons). It is worth mentioning that, despite a marginal improvement, cane yields remain lower than last year.

In India, weather prospects also point to a further reduction in the rain deficit, which will ease the supply constraints that had been expected.

Looking ahead, current sugar prices are still well above production costs despite the recent slump in prices. Hence, the negative price trend could persist for a while, albeit at a slower pace. The eventual increase in the ethanol mix in Brazilian gasoline or a new increase in gasoline prices provide significant upside potential for sugar prices.

Energy: prices partially disconnected from medium-term fundamentals

Oil prices have continued to edge higher during the last weeks. This trend can be attributed to several factors. First, an overall improvement in macroeconomic sentiment led to risk-on behavior, increasing equity prices and weakening the dollar. Second, increasing geopolitical risk for the oil supply in the Middle East, given the situations in Iran and Syria, has driven prices higher. Finally, supply was affected by maintenance stoppages at several North Sea wells, disruptions in the Gulf of Mexico caused by tropical storm Isaac, and by reduced exports from Iran and Saudi Arabia.

Iran is facing sanctions against its energy and financial industries due to its nuclear program. The sanctions involve not only banning new contracts on imports of petroleum and petroleum products, but also a ban on the provision of insurance and reinsurance to the country and its companies.

Looking ahead, we expect Brent prices to remain around $110 in 2012 as supply disruptions fade and sluggish economic growth holds back oil demand growth. If prices continue to increase, the U.S. may release strategic reserves in order to pressure gasoline prices. 


Source: Bloomberg and Itaú.

** The Itaú Commodity Index is a proprietary index composed of those commodity prices, measured in U.S. dollars and trade in international exchanges that are relevant to Brazilian consumer inflation. Its sub-indexes are Metals, Energy and Agricultural.

Giovanna Siniscalchi

Artur Manoel Passos

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