Commodities: More room to navigate in 2012

Commodities: More room to navigate in 2012

During 2H2011, we described the commodity markets as navigating a narrow course between the whirlpool of a
potential economic crisis on one side and the rocks of supply constraints on the other side. As we enter the new
year, we find that reduced risk of a large-scale global financial crisis as well as signs of increased supply have
provided the markets with more room to navigate on both sides.

During the second half of last year, we described the
commodity markets as navigating a narrow course between
the whirlpool of a potential economic crisis on one side and the
rocks of supply constraints on the other side. As we begin the
new year, we find more room to navigate on both sides. On the
demand side, the risk from an economic whirlpool has
lessened in the near term. The most recent data suggest that
the transmission of economic weakness outside of Europe is
either modest or delayed, which, combined with aggressive
policy action to help ease European bank funding issues, has
reduced the risk of a large-scale global financial crisis. While
our economists still expect a recession in Europe, the
economic data and outlook beyond Europe in the US and Asia
has been improving, shifting demand risks to the upside.

While it is tempting to argue that the more positive outlook for
the economy and commodity demand will make it more likely
that the markets run up against the rocks of supply side
constraints, in many commodity markets there are tentative
signs that supply is also surprising to the upside, including the
quicker than expected return of Libya, higher than expected
Saudi Arabian production, the end of labour strikes at the large
Grasberg copper mine in Indonesia and the end of agriculture
export bans from India, Russia and Ukraine. However, while
current supplies may be surprising to the upside, and we await
more data to confirm this, important risks remain that the
markets will experience substantial supply shortfalls in 2012,
particularly given recent events in Iran and Nigeria.

Nonetheless, the increased risk of both more demand and
more supply than expected gives the commodity markets much
more room to navigate in 2012, increasing the likelihood of
avoiding either large price spikes or large price collapses. This
gives us more confidence in our mainline forecasts, as before
we viewed the risks to our forecasts as extreme and the
outlook very binary – either the European debt crisis would
drag the world into a sharp recession, leading to a collapse in
prices, or the market would slam into supply constraints,
creating sharp price increases. On net, we maintain our price
forecasts, but are reassessing the balance of risks around our
price targets in most markets. We view gold and copper as
providing the best value opportunities relative to our view of
fundamentals in 2012, particularly as both came under sharp
selling pressure in 4Q2011 as European banks sold dollarbased
assets to raise US dollar liquidity. However, while we
view both precious and industrial metals as having the most
upside from current levels, the risks to the upside in oil are
substantially greater given the stronger fundamentals and
recent events surrounding Iran and Nigeria. Unlike precious
and base metals, crude oil prices have largely held up in line
with supply-demand fundamentals, but we continue to see a
strong case for crude oil fundamentals tightening further in
2012, taking crude oil prices higher.

On net, we expect a 3- and 12-month return for the S&P GSCI
Enhanced Commodity Index of 5% and 15%, respectively.
While there could still be a significant downside to these
forecasts if financial contagion from the Eurozone were to lead
to a global recession, the likelihood of this risk has declined
recently. On the other hand, a continuation of the run of better
than expected economic data presents an upside risk to these
forecasts. The balance of these risks has changed towards the
upside since the last GOAL, justifying an upgrade in the 3-
month allocation to Overweight. Thus, we now recommend an
overweight to commodities on both a near (3-month) and
medium-term (12-month) horizon.

Energy
We expect 22% returns on the Enhanced Energy index on a
12-month horizon.

Petroleum: Balance of risks skewed to the upside
We continue to expect global crude oil balances to tighten in
2012, pushing prices higher to our 12-mo target of $127/bbl for
Brent crude oil. The reduced risk of an economic whirlpool post
aggressive policy action and stronger macro data in the US
and Asia reinforce this view. However, providing an offset to
the better demand outlook are also higher than expected
current supplies with the quicker than expected return of Libyan
crude and stronger than expected Saudi production to supply
refiners and prepare for implementation of a potential EU
embargo on Iranian oil. This additional supply has put
downward pressure on crude oil prices. Although recent news
suggests that the ban may be phased in over a period of six
months, we believe that once the details of the EU embargo
become known and new supply relationships become
established, this downward pressure will dissipate. We
ultimately expect European refineries to replace the Iranian
crude with Saudi barrels, clearing the current surplus, while
China absorbs the surplus of Iranian crude, in part to fill its
strategic reserves.

Further, limited OPEC spare capacity with Saudi already
producing at its highest levels in 30 years – in addition to low
global oil inventories – leaves the oil market extremely
vulnerable to any incremental disruptions. Significant risk
remains that as tensions escalate, brinkmanship in the Persian
Gulf could lead to the closure of the Strait of Hormuz. The
Strait of Hormuz, with flows of 17 million b/d is the world’s most
important oil shipping chokepoints, accounting for roughly 35%
of all seaborne traded crude. However, we believe closing the
Strait is not in anyone’s interest, including Iran’s. An attempt to
close the Strait would likely be met by a strong military
response from the West to reopen the waterway, and a release
of strategic reserves to supply the market in the interim. This is
likely the reason why the crude oil market is not embedding an
“Iran premium” into the price of oil. Consequently, we expect
prices to remain well supported even if tensions with Iran
subside. Recent developments in Nigeria also pose a
meaningful downside risk to supply and upside risk to prices in
2012.

Natural gas: US still oversupplied, but policy likely to
be a growing driver
The US natural gas market remains substantially oversupplied,
led by continued strong growth in shale gas production and
exacerbated by a mild start to the Northern Hemisphere winter.
We maintain that US natural gas prices will remain under
pressure in the near to medium term in order to curb natural gas
production growth, and more importantly, to incentivize further
fuel substitution in the power generation sector to rebalance the
market. The delayed implementation of environmental
regulations suggests that this substitution will need to be
entirely induced by weaker prices (as opposed to policy) in
2012. This shift, along with the mild weather, has led us to
expect lower natural gas prices in 2012, averaging
$3.10/mmBtu over the year. However, in 2013 and beyond, we
believe that policy shifts will begin to help tighten the North
American gas balance, ultimately clearing the surplus and
boosting prices over the medium to longer term.

In contrast to the over-supplied North American market, the
global natural gas market has tightened substantially in the
recent period as the wave of new liquefaction capacity has
wound down at the same time that new non-OECD entrants
into the LNG market and greater needs from Japan to
compensate for nuclear outages have boosted demand for
global natural gas supplies. This has supported spot LNG
prices in Asia at 4-5 times the spot price in the US. Although
European prices have not been as high, approximately 2-3
times the US price, owing to weak economic activity in Europe
and, more recently, to an extremely mild winter, we believe that
the divergence between North American and global natural gas
prices will remain a key feature of the markets over the next
year.

Industrial metals
We expect 25% returns on the Enhanced Industrial Metals
index on a 12-month horizon.

We continue to expect moderate upside across most of the
metals complex in 2012 driven primarily by an end to destocking
in Europe and Chinese policy easing against limited
supply growth in some markets, particularly copper in 1H2012.
Initial data suggest double-digit declines in apparent European
demand in late 3Q2011 likely largely on de-stocking, and
anecdotal evidence suggests that this dynamic worsened in
4Q2011, pushing apparent demand down by 20-50% between
August and December. While we are not positive on European end-use demand in 2012, we
believe that a simple recovery of apparent demand to end-use
demand will likely help push copper prices back up to our 6-
month target of $9,000/mt.

We believe the increased metal availability from the substantial
fourth quarter de-stocking in Europe that helped put downward
pressure on metal prices was ultimately largely taken by China
and was reflected in the record Chinese copper imports in
December. Despite significant concerns over Chinese
commodity demand, these record imports seem to have been
mostly absorbed into the domestic market, as Chinese
consumers ended de-stocking at prices 20%-25% below
September levels. Nonetheless, there is still significant concern
around Chinese demand from construction, white goods and
industrial manufacturing, all of which showed signs of
significant slowing in late 2011.

Going forward, the key to the metals markets will be the “gap”
between the weakness today versus the demand strength
expected to be created by both the monetary and fiscal
stimulus that is likely to occur in 2012 with the now observed
reduction in Chinese inflationary pressures. In December we
have already seen significant evidence of substantial loan
growth helping to stimulate domestic demand. More
specifically, we believe that some of the fiscal support will be
targeted at metals intensive industries including construction
(social housing, as well as helping first-time buyers in the
market), consumer appliance, and automotive industries (the
latter potentially through a scrappage scheme). These
developments would be incrementally supportive for metals
markets and pose upside risk to our forecasts, which assume
slower than trend Chinese metals demand growth in 2012.

Precious metals
We expect 18.5% returns on the Enhanced Precious Metals
index on a 12-month horizon.

Still expecting upside on low US real rates
We expect gold prices will continue to be driven in large part by
the evolution of US real interest rates. However, the
relationship between real interest rates and gold prices has
opened up to the widest levels in the current cycle. This wedge
between gold prices and real interest rates as measured by 10-
year TIPS was driven by a substantial surge in the demand for
US dollars during December. This new demand for dollars was
mostly from European banks using the gold market to source
US dollar liquidity when their funding from the US money
markets dried up, which created a significant amount of gold
selling. In turn, the re-convergence of gold and real interest
rates is dependent upon how long this dollar-funding liquidity
squeeze lasts, forcing European banks to source US dollars
from the gold market. We believe that many European banks
will likely exit or sell many of their US dollar based businesses
in 2012, which will likely substantially reduce this US dollar
demand from the gold market, pushing gold prices back up
inline with real interest rates. Further, following ECB’s
aggressive action on funding through the LTRO the near-term
pressure on European bank funding has eased significantly.
Accordingly, we maintain our 12-month gold target of
$1,940/toz.

Agriculture
We expect -3.5% returns on the Enhanced Agricultural index
on a 12-month horizon, and 8% returns in the Enhanced
Livestock index.

La Nina weather conditions present upside risk
Agriculture prices declined sharply in 2H2011, driven by
favorable growing conditions outside of the US, which pushed
the stocks of many crops to more comfortable levels. However,
despite the relatively high level of global inventories, the US
corn market remains tight.

Tighter US inventories, owing to a dry summer in the US
leading to a poor yields this past year combined with resilient
US feed and fuel demand, will likely keep corn prices
supported over the first half of 2012. However, the premium
that this creates over soybean prices will unlikely be
sustainable as next year the agriculture markets will need to
limit the decline in soybean acreage against larger corn
acreage, and the only way to achieve that is through a relative
rise in soybean prices. Accordingly, while we favour corn over
soybeans in the near term, further out we favour soybeans to
incentivize farmers to rotate some acreage towards soybeans.
Near term, the outlook for agriculture is very much determined
by weather in Argentina and Brazil, which are currently
experiencing a return of La Nina weather conditions. A
significant shortfall in South America production would further
support the outperformance of soybeans over corn.

We still expect cattle to outperform lean hogs
We expect that demand for meat will continue to improve,
driven largely by strong EM income growth. We expect live
cattle prices to outperform lean hog prices in 2012 on tighter
supplies with sharply lower cattle on feed placements in coming
months against a modest hog herd expansion. A sustained
slowdown in US GDP growth would put our expectation for
cattle over hog outperformance at risk as it could support
domestic demand of lower-cost pork to the detriment of highercost
beef.