Itaú BBA - No action, no rebound

Commodities Monthly Report

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No action, no rebound

December 10, 2014

The Itaú Commodity Index (ICI) has fallen by 10% since the end of October,

• In the absence of a reaction by OPEC to lower oil prices, we now forecast a Brent crude oil price of USD 70/bbl at YE15, so as to balance supply and demand. This change represents a material revision from our previous forecast of USD 95/bbl.

• We have also lowered our price forecasts for iron ore and copper, after incorporating lower cost assumptions and evidence of inventory accumulation.

The Itaú Commodity Index (ICI) has fallen by 10% since the end of October, once again affected by crude oil prices. Lower prices for iron ore and copper are also contributing to the decline. These trends have driven the Metals and Energy sub-indexes to drops of 6.4% and 20.1%, respectively. Meanwhile, the Agriculture sub-index has risen slightly, by 2.7%, but is not showing any clear trend given the absence of relevant news.

We have lowered our forecasts for crude oil prices, assuming the absence of action by OPEC. This assumption became more sound following the cartel’s decision to maintain its current output, despite an oversupply in the global balance. Without action by the cartel, the market balance will be determined primarily by global demand and the supply reactions of other producing countries to the lower oil prices. According to our estimates, the price of Brent crude must remain at USD 70/bbl (please see the next section for details) to balance supply and demand, which would represent a drop of more than 30% compared with the equilibrium price before 2014 (USD 110/bbl).

We have also cut our YE15 price forecasts for iron ore (to USD 70/ton from USD 85/ton) and copper (to USD 6,500/ton from USD 6,850/ton) after incorporating lower cost assumptions (new scenario for crude oil) and evidence of inventory accumulation in China, as import volumes in 2014 have exceeded the demand levels that are consistent with China’s current rate of economic growth.

The ICI-Agricultural fluctuated without a clear trend in November, with diverging paths for different commodities. Prices for soybeans, cotton and sugar fell, but prices rose for corn and wheat. The summer harvest ended in the U.S., and frost fears did not materialize. The planting of the summer crop in the Southern Hemisphere advanced amid more favorable weather conditions in November, compared with the previous month.

The adjustments in our price forecasts for crude oil, iron ore and copper have led to a revision of ‑13.3 pp in our YE15 forecast for headline ICI. The new scenario points to stability for the ICI index compared with current levels. We previously expected some recovery for the index in 2015.

The ICI is down 25.8% year-to-date. Breaking down this consolidated result by sub-index, we find that agricultural fell by 7.8%, metals slid by 26.7% and energy tumbled by 35.8%. Since 1990, price declines of this magnitude for commodities have taken place only twice before, in 2001 and 2008.

Crude oil: Estimating equilibrium without OPEC cuts

Given the oversupply in the global market, some expected a coordinated reaction by OPEC after the cartel’s ordinary meeting on November 27. 

The decision to maintain current output (i.e., to take no action) led to new declines in oil prices, which have fallen by 14% since the decision, to around USD70/bbl (after dropping by 29% since the beginning of the year).

Taking into account the economic incentive to make some production cuts (increased revenues), there are several possible explanations for the cartel’s decision:

  • Member nations believe that OPEC action would not be effective, leading only to smaller market shares.
  • Internal negotiations failed to lead to a credible agreement. Rich OPEC countries (Saudi Arabia, United Arab Emirates and Kuwait) may force the more vulnerable countries (including non-members such as Russia) to absorb a larger share of the supply cut.
  • Saudi Arabia is seeking to weaken Russia and Iran through lower oil prices, as both of the latter countries are more vulnerable to price declines.
  • The cartel is seeking to intensify the uncertainty surrounding future prices in order to discourage investment in costly non-conventional output.

OPEC may lower its production ahead, but for now we assume a scenario in which the cartel does not act effectively to address oversupply. Hence, equilibrium in the market (with a current oversupply of 1.0-1.5 mbpd, or nearly 1.3% of global production) will be attained entirely through price adjustments.

In order to find the equilibrium price, we estimated the reaction of global supply and demand to lower prices in the absence of OPEC action:

  • Supply reactions tend to be slow. A significant share of global output comes at total costs that are higher than current oil prices. However, empirical evidence suggests that suppliers do not cease production from working wells, so reactions to oversupply manifest themselves in declines in investments in new wells.
  • The price elasticity of demand is low but may be the main source of adjustment in the short term. We estimate a price elasticity of demand of -0.05 in the short run.

We have reduced our YE15 price forecast for Brent crude to USD 70/bbl from USD 95/bbl. Adjusting for exchange-rate moves, a slide to USD 70/bbl from USD 110/bbl would represent a 32% decline in prices. Including the price elasticity of demand, global oil consumption would correspondingly increase by 1.5 mbpd, enough to rebalance the market.

Given the new scenario for Brent crude, we lowered our forecast for WTI to USD 66.0/bbl from USD 91.0/bbl.


Artur Manoel Passos

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