Black gold top performer amid tight supply

This week the sovereign debt crisis moved up another gear with attention switching from Greece to Italy. Disillusioned investors worried about the lack of progress sold Italian government bonds which in the process reached unsustainably high yield levels above seven percent. Italy’s government bond debt is the third largest in the world and bigger than the other four troubled Eurozone members combined which in effect means that Italy is too big to fail but also too big to save and therefore desperately needs to get their house in order.

Towards the end of the week however a little light at the end of the ‘Euro-tunnel’ emerged with Greece finally installing Papademos as head of a technocratic unity government while Italy seemed to be on the verge of appointing another technocrat, the former EU commissioner and very respected, Mario Monti to lead a new government. Italian bond yields dropped back after the European Central Bank (in a sign of support) stepped in and aggressively bought its bonds.

The dollar continued its ascent against the Euro as German interest rate levels fell below the US for the first time in 11 months. Investors now receive a negative return when buying secure short-term German government bonds and it shows how capital preservation has become an overriding concern for many.

Commodities weathered the storm quite well with the Reuters Jeffries CRB Index trading flat over the week with rising energy prices offsetting declines primarily in agricultural commodities and base metals.

OPEC raises oil demand forecast and IEA issues warning
In its annual Wold Oil Outlook OPEC raised its medium-term forecast for oil demand expressing surprise about the economic recovery over the last two years. It did however say that the recovery has become more fragile in recent months and another recession cannot be ruled out. It also raised the reference price for this decade by 10 dollars to a range of $85-$95 a barrel acknowledging that some members need higher prices to balance their budgets as social spending has increased dramatically, especially after the Arab Spring.

The International Energy Agency, which is known for putting pressure on oil producers, warned in a report that oil prices could spike above the all-time high of 147 dollars a barrel after 2015 if the Gulf decides to cut spending on oil exploration in favour of increased social spending.

Oil in Euros near 2011 peak
The spike higher in oil prices over the last month is having an adverse impact on the fragile state of the economic recovery. Measured in Euros the cost of a barrel of Brent crude is less than five percent away from the April peak, which is very unwelcome news for a region that is already heading towards recession and increased winter demand.

Despite the stronger dollar WTI crude continued its climb towards the technical target of 100 dollars per barrel while the discount to Brent crude narrowed again as Libyan oil continued to reach the market faster than expected. The weekly data on U.S. stockpiles showed unexpectedly large draw downs in domestic crude and products while Iran’s alleged pursuit of nuclear weapons carries the risk of increased geopolitical tensions.

 
Source: Bloomberg

Near-term price support but be careful
Tightness in the energy products market ahead of increased winter demand combined with geopolitical tensions is causing the backwardation in the market which makes oil for prompt delivery more expensive than deferred. WTI and Brent both have the potential of another five dollars to the upside. We do not however see much value at these levels considering our continued positive outlook for the dollar plus the ongoing uncertainty concerning the outlook for global growth which carries the risk of a setback once bottlenecks and tension ease

ETP flows support gold
The recent rally in gold, which reached but failed to breach 1,800 dollars per ounce, has been supported by a renewed pick-up in interest for Exchange Traded Products trading gold. Total known holdings calculated by Bloomberg have risen by 66 tonnes from the October low to 2,310 tonnes which is only 20 tonnes from the peak seen back in August. ETP investors are generally viewed to have a much longer investment horizon as the product is non-leveraged, unlike futures which are favourites among hedge fund traders.

During the 15 percent correction that hit gold back in September investments in gold ETP’s only saw a 3.7 percent reduction totalling 86 tonnes with investors generally not forced or inclined to pull out of what had been a very profitable trade. The ETP market therefore seems to be telling us that investors are positioning themselves for the next push higher but with so many fresh longs having been established in a relative short period of time technical traders could be tempted to drive it lower in order to check the strength of support. Look for consolidation between 1,680 and 1,802 with an eventual break in either direction setting up the next 100 dollar move.

 
Source: Bloomberg

Industrial metals pressured by demand outlook
The growing recession fears in Europe saw the London Metals Index drop by 3.5 percent as investors switched their focus back to the slowing demand, not least after China released a smaller than expected trade surplus. Staying with China, the news that it imported the most copper in October since May 2010 had a limited impact as it was seen primarily as a response to lower prices and the need to restock after having been absent from the market over the summer.

U.S. grain prices lower as competition bites
Grain prices dropped this week after a benign U.S. government crop report further eased some of the supply worries that had marred the sector earlier this year. The strengthening dollar has seen U.S. exports come under increased pressure from more competitive prices on wheat from Russia & the Ukraine and from South America on soybeans. The latter dropped to a one-month low before finding support ahead of the October lows.

Corn meanwhile seems the best supported as tightening supply on the back of a cut in yields, rising Chinese demand and rising energy prices which are supporting the production of ethanol.  The worry is that the recent low prices could put already low stock levels under pressure due to the increased demand this has triggered. Downside risk comes from a large speculative position held by hedge funds combined with some risk of producers selling out after having hoped to see higher prices following the above mentioned crop report.

Cocoa down and out of ‘flavour’
The price of cocoa has dropped to a 28-month low as lower growth forecasts, especially in Europe - which is the largest chocolate consumer - have lead to buyers reducing their orders on concerns that the demand for economic sensitive luxury items such as cocoa could come under pressure. The slump in demand comes at a time where supply from the two top growers, Ghana and the Ivory Coast, remains healthy as the harvest is progressing well. Hedge funds have been short cocoa futures since September but have used the recent sell-off to book some profit thereby somewhat cushioning the fall.