Itaú BBA - Still Falling

Commodities Monthly Report

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Still Falling

August 6, 2015

Commodity prices resumed the downward trend in July, and we see most of the move as consistent with fundamentals.

• We revised our forecast for Brent crude downward, to USD 60/bbl from USD 70/bbl by the end of next year, because we incorporated efficiency gains in non-conventional output in the U.S., which will lead to lower equilibrium prices. 

• We also lowered our price forecasts for metals (the oil pass-through and weaker demand from China), sugar and coffee (on a weaker BRL).

The Itaú Commodity Index(ICI) plummeted 13.9% in July, resuming the downward trend after showing some stability in 1H15. The breakdown shows declines in all components: agricultural (-12.4%), metals (-6.6%) and oil-related (-19.1%). Our new scenario assumes a modest 5.2% increase in the ICI from current levels by year-end, so we see most of the recent decline as persistent and consistent with fundamentals.

Idiosyncratic factors explaining the slide in each commodity share a common narrative: shifts in the supply curve and prospects of weaker demand. Specific factors include lower risks for crops in the U.S., higher-than-expected oil supply and slower (and less commodity-intensive) economic growth in China. The strengthening of the U.S. dollar (at least the part that is exogenous to the drop in commodity prices) is also behind the move.

The shocks to some commodities spread to the others, reinforcing the decline. One example is lower oil prices, which reduce milling and transport costs, thereby reducing break-even costs for other commodities. Another is the decline in the BRL caused by lower iron ore and soybean prices, which spreads to sugar and coffee, given the weight of Brazil in global exports for these two products.

We now forecast a 14.1% drop in the ICI in 2015, following declines in 2011 (-6.5%), 2013 (-6.1%) and 2014 (-27.5%). The small gain seen in 2012 (+3.5%) and our scenario for 2016 (+5.0%) are modest in light of the downward trend seen since 2011.

We lowered our price forecasts for oil, metals, sugar and coffee. The combined effect is a revision of -10.1 pp in our year-end scenario for the ICI.

Grains: Less rainfall reduces risks to U.S. output

International prices for corn, soybeans and wheat slid in July, erasing virtually all the gains seen in the previous month. Corn, soybean and wheat prices fell 11%, 10% and 19%, respectively.

The main driver behind the move was the weather in the U.S.Rainfall has been closer to normal in the Midwest since early July, easing concerns over crops.

Rainfall levels remain intense in wheat-producing areas of South America, possibly reducing yields in the region.

In our view, excessive rainfall in June affected corn and soybean crops in the U.S. Our crop estimates stand at 338.7 million metric tons (mmt) for corn and 101 mmt for soybeans. These forecasts are respectively 5 and 4.7 mmt lower than the current scenario presented by the U.S. Department of Agriculture (USDA).

However, these estimated losses are not enough to change the outlook for adequate global supply.The drop in U.S. output is insufficient to prevent another crop-year of surplus in the global soybean balance. Regarding corn and wheat, the outlook for supply from Asia and Eastern Europe helps to sustain global inventories at high levels.

We maintain our year-end forecasts for corn (USD 3.8/bushel), soybeans (USD 8.8/bushel) and wheat (USD 5.1/bushel). This scenario is consistent with a slight decline in U.S. output, without further losses in other producing regions.

Soft commodities: Price drop influenced by weakness in the Brazilian currency

International sugar contracts fell in July, notwithstanding a partial interruption in sugarcane crushing in the Center-South region of Brazil due to the rain. The contract for the first delivery date slid to USD 0.108/lb. from USD 0.120.

The drop in sugar prices is driven by depreciation in the Brazilian real, given that the main adjustment factor to balance the market is a shift in sugarcane usage toward ethanol (so that there is less sugarcane available to produce sugar). A weaker BRL (without changes in ethanol prices in Brazil) increases sugar supply from Brazil, leading to lower international prices.

We lowered our year-end forecast for international sugar prices, to USD 0.11/lb. from USD 0.132/lb., as we incorporated the weakness in the Brazilian currency and its impact on global sugar output.

We also reduced our year-end forecast for coffee to USD 1.25/lb. from USD 1.4/lb., due to the spillovern effect of the Brazilian currency (albeit less intense than for sugar prices) and favorable weather in several producing regions.

Metals: Cost deflation and weaker demand from China

Prices for metallic commodities extended declines in July. Iron ore fell to USD 51/ton from USD 55/ton, while copper slid to USD 5,230/ton from USD 5,765/ton.

Drops were driven by the outlook for lower demand from China and more evidence of cost reductions, due to the oil pass-through (reducing processing and transportation costs) as well as corporate investments. In a context of slow demand growth, cost reduction leads to lower prices.

We cut our price forecasts for metallic commodities, as we incorporated evidence of lower costs and the outlook for slower (and not so commodity-intensive)economic growth in China. These are the adjustments in our price forecast for year-end 2016:

- Iron ore: to USD 50.0/ton from USD 55.0/ton;

- Copper: to USD 5,562/ton from USD 6,090/ton;

- Aluminum: to USD 1,730/ton from USD 1,850/ton;

- Zinc: to USD 2,060/ton from USD 2,360/ton.

Our metals index projects an accumulated drop of 21.1% during the year, while the year-over-year forecast is a decline of 19.9% (Dec 14 vs. Dec 15).

Oil: Lower prices for longer

Oil prices extended their declines. Brent crude fell to USD50/bbl, while WTI crude dropped to USD46/bbl, going back to their mid-March lows and erasing most of the partial recovery observed between March and May.

Factors specific to the oil market were a bigger driver of the move than the macroeconomic scenario. Efficiency gains in non-conventional output in the U.S. are enabling the country to produce more than expected in the face of falling investments (and they will likely continue to do so). These developments reduce production costs, leading to lower equilibrium prices. Furthermore, OPEC production has been climbing during the year, and this trend should continue following the nuclear agreement between Iran and P5+1 (the five permanent members of the U.N. Security Council plus Germany). Growing supply forces high-cost producers to make even bigger adjustments in output, postponing the convergence to equilibrium prices.

The outlook for greater supply in the short and medium term led us to reduce our price forecasts. We cut our year-end price forecasts to USD 56/bbl from USD 70/bbl for Brent, and to USD 51.3/bbl from USD 66/bbl for WTI. Convergence to equilibrium prices (we estimate Brent crude at USD 60/bbl) was delayed until the end of 2016.


Artur Manoel Passos

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