Itaú BBA - Not fully reversing the decline

Commodities Monthly Report

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Not fully reversing the decline

October 1, 2014

The Itaú Commodities Index has fallen by 7.8% since the end of August

• We revised downward our forecasts for prices of major commodities, seeing this year's drop as consistent with fundamentals (supply surprises, dollar strength and slightly lower global growth).

• The revised scenario considers lower profit margins for commodity producers. We forecast a hike of 5.7% between the current levels and the end of 2015, meaning that the decline of 15.2% accumulated in the year will not be fully reversed.

The Itaú Commodities Index has fallen by 7.8% since the end of August, again with declines in all three components during the period. The month's performance can be explained by the strength of the dollar against other currencies, increasing concerns with China's economy and the failure of agricultural producers to prevent further price drops.

The ICI now accumulates a 15.5% drop year-to-date, after falling 6.1% in 2013. The breakdown by components shows declines in all three sub-indexes: agricultural (-18.7%), metals (-22.4%) and energy (-10.0%).

The drop posted in the year is consistent with the combination of surprises to global supply, strong dollar and slightly lower global growth. Our top-down models suggest that the surprises to supply explain approximately 50% of the retreat, followed by the macroeconomic environment characterized by a strong dollar (40%) and global growth slightly lower than expected (10%).

The three major supply shocks in the year are:

  • Super crop in the US;
  • Slow reaction of high cost iron ore producers to lower prices;
  • Strong increase in ex-OPEC oil production, while the OPEC production has not been affected by conflicts.

We reassessed our estimates of sustainable prices, lowering price forecasts. The result is a downward revision of 5.9 pp in year-end 2015 ICI. The new scenario is an increase of only 6.0% from current levels. I.e., the drop in the last two years will not be reversed, with producers' profit margins standing at lower levels.

The reassessment occurs by incorporating a faster price movement towards production costs (more details in the specific section).

Overview: moving towards lower profit margins for producers

The past decade brought increased production margins following growth in demand. The hike in producers' profit margins occurred over the past decade, as global demand for each commodity outgrew supply (largely due to high growth in China), increasing prices. The resulting higher prices enabled projects and technologies that increased production. The marginal cost of production gradually increased, but less than prices.

Demand has decelerated starting in 2011, while high margins encouraged an increase in supply. The oil, iron ore and soy markets illustrate this environment of high production margins:

  • Brent crude oil remained above USD 100.0 per barrel, enabling unconventional production techniques, with total costs below USD 80.0 per barrel.
  • The average price of iron ore stood above USD 140.0/t between 2011 and 2013, while projects to increase production in Brazil and Australia have taken place with total costs (including shipping to China) below USD 90.0/t.
  • The average soybean price stood above USD 13.00 per bushel between 2011 and 2013, while the marginal production costs are about USD 10.00 per bushel (under normal weather conditions).

In short, a relevant part of commodities' price drops and performance in recent years involves the reaction of production to the high prices of the past.

We do not expect a reacceleration of growth in demand for commodities, therefore we do not see fundamentals for a strong rebound in prices ahead. 

At the same time, high production costs and the continued increase in demand suggest difficulties to additional sharp drops.

Grains: producers are unable to sustain prices

Declines in corn, soybean and wheat prices in September. Corn and wheat prices resumed the downward movement in the month, falling by 10.6% and 13.2%, respectively. Soybean prices continued the decline started in June and dropped by 16.2% in the same period.

Consolidation of surplus scenario. Climate uncertainty decreased, with the advance of harvest in Europe and the beginning of harvest in North America. The evolution consolidates the surplus scenario for  corn, soybeans and wheat.

We reduced our price forecasts for year-end 2014 (in USD per bushel): soy from 10.0 to 9.2; corn from 4.0 to 3.4; and wheat from 5.5 to 4.0.

The revision takes into account the fact that producers failed to sustain prices. Now there's a combination of marketing delays, excess supply and little room for demand to increase in response to low prices.

The reaction of producers will likely take place only by the next US harvest. We are not expecting a reaction from the southern hemisphere in the summer harvest that began to be planted. Thus, prices will likely remain low in the 1S15.

Sugar: prices detach from fundamentals in the short term

Sugar forward contracts decreased throughout September, reaching the lowest level of the past three years.

The performance in the month may be explained by the combination of buyers' high inventories, with excess supply from Thailand. This assessment is reinforced by the loss of correlation in international prices of sugar with hydrous ethanol (chart below), coupled with the slow pace of exports from Brazil in September.

We revised downward our forecasts for sugar prices, incorporating a smoother transition from surplus to deficit in the global balance. We forecasted international prices at USD 0.168 per pound by year-end 2014 (previously: USD 0.188) and USD 0.18 by year-end 2015 (previously: USD 0.206).

Oil: downward revision in forecasts

Oil prices remained low in September. Brent prices stood below USD 100.0 per barrel, well below the average in 2013 (USD 108.1). WTI prices remained close to USD 94.0 per barrel (2013 average: USD 98.0).

The year 2014 will likely be the second consecutive year that ex-OPEC oil production grows faster than global demand. 

In 2013, prices remained high as conflicts reduced output in key OPEC countries, facilitating cartel coordination. 

Despite the conflicts, the production is not being affected in 2014. The conflicts in Iraq, Ukraine and Libya involve relevant oil producers (in the case of Ukraine, it affects Russia), but production remains relatively stable.

Without any "help" from negative production shocks, the richest countries in the cartel should take the initiative to reduce global supply, offsetting the increased production of ex-OPEC countries led by North America.

Even if some reduction in OPEC production occurs, we forecasted lower oil prices. We revised our forecast for Brent prices from USD 105.0 to USD 100.0 per barrel by year-end 2014, remaining at this level in 2015. We reduced our forecast for WTI prices from USD 101.0 to USD 93.0 per barrel by year-end 2014.


Artur Manoel Passos

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