Itaú BBA - Unfavorable Macro Scenario for Commodity Prices

Commodities Monthly Report

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Unfavorable Macro Scenario for Commodity Prices

July 2, 2013

Concerns related to China and rising yield curves in the U.S. dragged down commodity prices.

    •    Prices dropped in June, driven by renewed concerns over the Chinese economy and rising interest rates in the U.S.

    •    Base and precious metals are the most affected by the combination of restrained expansionist monetary policy in the U.S. and worse growth prospects for China.

    •    Agriculture: Estimates of larger-than-expected corn acreage adds downside risk to our year-end forecasts.

Concerns related to China and rising yield curves in the U.S. dragged down commodity prices. Until June 17, commodity prices had been resistant to higher U.S. Treasury yields and their impact on emerging market assets. But the combination of a rising yield curve in the U.S. after the FOMC meeting and renewed concerns over the Chinese economy created sell-off pressure, particularly for gold and other precious metals.

Price declines were mostly for base metals and precious metals. The Itaú Commodity Index (ICI) fell 1.3% from the end of May, as the sub-index for base metals sank 7.3%, hurt by worries over China. Gold prices dropped 11.0% from one month earlier, driven by the increase in long-term real interest rates in the U.S. The agriculture and energy sub-indexes ended June at the same levels as at the end of the previous month.

Given the outlook for slower growth in China and a stronger U.S. dollar, we revised our forecast downward for the ICI in 2014. We now expect the ICI to stagnate next year, compared with our previous forecast of +1.4% yoy. The main change is for base metals (to -2.0% yoy from +2.4%), followed by energy (to -1.3% yoy from +0.7%). These declines are to be offset by the expected 1.3% rise in agricultural commodities.

For year-end, our ICI forecast was maintained, but the estimate for copper was revised downward, and we now see downside risk for grains. The ICI is forecast to fall 3.9% during 2013, as we incorporated a less-favorable scenario for prices in earlier months. The most significant change involves copper, as the recent price dynamics and the less-favorable evolution in China led us to revise downward our estimate for year-end to USD 6,800/ton from USD 7,100/ton previously. The main risk is in our forecast for agricultural commodities. The official estimate for corn acreage in the U.S. was much higher than expectations. If this is confirmed, agricultural commodity prices should be lower than current forecasts. However, delays in planting may have interfered with the survey, so we will wait for further information.

Commodities vs. macro fundamentals: base metals and precious metals will be the most affected

Commodities react differently to the change in stance by the U.S. Federal Reserve and to the performance of the Chinese economy:

  1. A less expansive stance by the Fed pushes down commodity prices (through dollar appreciation), particularly precious metals (through rising interest rates). A less expansive stance lifts the yield curve and strengthens the greenback against other currencies. The increase in nominal interest rates is taking place without an increase in inflationary expectations, thus lifting real interest rates and reducing the attractiveness of precious metals as a hedge against inflation. Dollar appreciation leads to lower commodity prices, through demand (higher prices in other currencies leads to lower consumption) as well as supply (through lower costs in U.S. dollars for producers). Finally, the overall impact on aggregate demand is ambiguous. The rise in U.S. (and global) interest rates, which causes contraction in the global economy, was driven by better prospects for the performance of the U.S. economy, in a situation that is expansive by nature. If the change in stance by the Fed had been prompted by deterioration in inflation expectations, the slowdown in aggregate demand on a global level would put downward pressure on commodity prices.
  2. Slower growth in China leads to lower prices for cyclical commodities, especially base metals. Slower growth in China drags down commodity demand. Considering China’s large share of the global demand for base metals, this is the most affected group, followed by crude oil and other energy-related commodities. Grain demand is not affected so much because part of the slowdown results from the rebalancing of the Chinese economy, which involves disposable household income outperforming GDP. In case of a hard landing, grains would also be affected, but this is not the base scenario.

Grains: instead of answers, new questions

There was little news on fundamentals in June (except for June 28). The U.S. Department of Agriculture (USDA) made only a few balance adjustments in its World Agriculture Supply and Demand Estimates (WASDE) report, released on June 12. Moreover, weather conditions were consistent with sustained favorable prospects for the next crop in the Northern Hemisphere.

The premium on corn and soybean contracts for delivery before the next crop increased. With few adjustments in fundamentals until June 27, corn and soybean contracts for delivery in July held to the upward trend seen in recent months, reflecting currently low inventories, while contracts in the longer-end of the curve were driven down by the expectation of excess supply after the harvest in the U.S.

Data released by the USDA on June 28 intensified the move seen during the month, with current inventories below expectation and corn acreage much larger than expected:

  • Revised estimates for corn, soybean and wheat planted areas were released, as well as estimates for the inventories of the three commodities as of June 1 (all related to the U.S.).
  • The big surprise was corn acreage. While a drop of 2 million acres was expected, the report pointed to an increase of 100 thousand acres. Following the revision, the estimated crop is now 9-10 million metric tons larger than in the scenario that assumed a decline in the planted area.
  • Forecasts for soybean and wheat acreage were close to market estimates, increasing slightly from the USDA’s previous scenario.
  • Inventories were lower than in the USDA’s previous scenario and lower than market expectations for the three commodities. Hence, beginning stocks for the 2013-14 crop year should be revised downward: -3 million tons for corn and -1 million tons for soybeans and wheat.
  • That led to a sharp decline in corn prices for delivery after the U.S. harvest, also driving down prices for soybeans and wheat. With lower current inventories, contracts for delivery in July went up after the report was released. Hence, price moves seen throughout the month were intensified in the last working day in June.
  • It is possible that delays in planting have hampered the estimate for corn acreage (the survey was done in the first and second week of June), so that the real impact of weather conditions on acreage and yields will only be known later on.

Our forecasts for year-end were maintained, but the new estimate for the planted area in the U.S. adds downside risk. Our price forecasts stand at USD 6.0/bushel for corn, USD 13.0/bushel for soybeans and USD 7.3/bushel for wheat. These forecasts rely on the expectation that weather conditions (and incentives for producers) limited the planted area in the U.S. and that delays in planting prevented this reduction from being reflected in the USDA survey. If acreage forecasted by the USDA is confirmed, the strong surplus in the corn balance would lead to lower equilibrium prices (about USD 5.0/bushel), also affecting soybean and wheat prices.

Live cattle: high prices ahead 

The first half of the year was marked by lower prices in the U.S. and higher prices in Brazil. Live cattle prices in the Chicago Mercantile Exchange ended June at USd 118.2/lb., falling 9% year to date. The drop was driven by higher costs for feedlot placements and worse pasture conditions, due to a severe drought late last year. In São Paulo, cattle prices on the BM&F ended the month at BRL 99.8 per arroba (15 kg), rising 4% year to date. The price increase in the domestic market was led by strong demand from beef processors in recent months, among other factors.

Our forecasts for year-end are USd 130/lb. at CME and BRL 102 per arroba on the BM&F. Looking ahead, we expect fundamentals to be consistent with a price hike for live cattle in the international and domestic market.

Pasture conditions recover in the U.S. After an end of the year influenced by  severe drought in the nation, which hurt pasture quality and feedlot placement costs, the outlook seems consistent with a smaller supply of live cattle in the U.S. In the short term, the recovery of pasture quality will likely provide incentives to keep herds in the pasture for longer periods. Furthermore, the expectation of lower grain prices will also benefit feedlot placements, as production costs will be lower. In the longer run, the high volume of females slaughtered this year should reduce the supply of live cattle in 2014.

Record-high exports from Australia. Australia, another large beef producer, has been struggling with weather conditions in recent months. Due to a severe drought in some parts of that country, the conditions for keeping cattle in pasture worsened, forcing ranchers to anticipate slaughtering. Data from the Department of Agriculture, Fisheries and Forestry (DAFF) showed that the weekly slaughtering average in May went up 18% from one year earlier. More slaughters and the consequent decline in cattle prices allowed Australia to increase its market share in some parts of the globe, including the Chinese market, leading to record-high exports in the period. However, we expect this gain in competitiveness to be temporary, as the supply of Australian cattle should decline in coming months because slaughters were anticipated.

Strong demand from beef processors boosts prices in Brazil. May is a month usually marked by a decline in live cattle prices in Brazil, because pasture conditions deteriorate as the dry season starts and the supply of animals for slaughter increases. This year, however, not only was the price decline less than expected, but the rebound in prices was also faster. This price behavior was driven by strong demand from beef processors, sustained by higher domestic consumption and the fast pace of beef exports. For the next months, even if the slaughter rate stabilizes in Brazil, we see rising prices in the domestic market. From the demand side, exports are still likely to be fueled by robust external demand and by the devaluation of the local currency. From the supply side, a more-rainy-than-usual period should be better for keeping animals in pastures. The record-high volume of bullock slaughters early this year will likely cause a decline in the supply of Brazilian cattle next year. The risks to the scenario in the short term involve mainly lower poultry prices, driven by lower grain prices.

We believe live cattle prices will be supported at high levels in 2014. With the elevated volume of slaughters in the U.S., Brazil and Australia and the expectation of lower grain prices, the outlook for next year is for a reduction in the global cattle supply, supporting prices at high levels.

Crude oil: weakness in emerging economies challenges high prices

Price hike interrupted by the FOMC meeting and by concerns over China. After climbing nearly 6% during the month, Brent crude prices (first due date) fully erased this gain after June 19, driven by a combination of constrained expansionist monetary stance in the U.S. and by renewed concerns over China. The average price for the month stood at USD 103.3/bbl, the same as in May. The price ended June at USD 102.0/bbl.

Our year-end forecast is USD 110.0/bbl, with a downward bias. We still forecast USD 110.0/bbl by the end of 2013 as operational refining capacity resumes (increasing demand for crude) and production slips because of conflicts in several producing nations. But the slowdown in emerging economies (especially China) or fewer sanctions against Iran may keep prices at lower levels in the second half (USD 105.0).

Symmetrical geopolitical risks: conflicts may hurt output in many nations, but elections in Iran increase the likelihood of fewer sanctions against the country. Internal conflicts in Iraq and Nigeria are still a risk for global supply. Conflicts in northern Africa may once again hurt production in Algeria and Libya. On the other hand, the election of a moderate candidate in Iran may refresh negotiations with P5+1 [1], so that we may see an easing of sanctions against the country in the second half of the year. Fewer sanctions would help Iranian exports, ensuring a looser global balance.

Stagnation in U.S. output and economic surprises help to sustain narrow discounts in WTI to Brent crude. After advancing by 1.1 mbpd in 2012, crude oil output in the U.S. lost steam. In 2013, crude production increased 3.7% through June 21, down from 11.8% in the second half of 2012. Flat production combined with faster-than-expected economic growth in the U.S. led WTI to be traded at a lower discount than in the past. In order for the discount to widen again, either production must go up or activity indicators must show some deterioration.

Artur Manoel Passos

Verena Paiva

[1] The five permanent members of the U.N. Security Council, plus Germany


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

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