Oil markets in a flux as demand slows

Commodity markets suffered another bout of selling this week with heavy losses in oil leading the way. Global manufacturing continues to falter with data from China and the US both pointing towards slowing activity. The agriculture sector, which is currently more concerned about weather developments, held up with the DJ-UBS agriculture index rising by five percent, thereby ensuring a relatively flat performance overall on the DJ-UBS commodity index. 

This was in sharp contrast to the S&P GSCI, the other major commodity index, which fell heavily primarily due to its 70 percent exposure to the energy sector. By Thursday it had entered a bear market, having dropped more than 20 percent from its recent peak back in February. 

All the gains, apart from natural gas, occurred within the agriculture sector while oil headed for its biggest weekly loss in a year, having fallen for six weeks in a row.  Gold investors did not take any comfort from the US FOMC meeting which did little in terms of additional stimulus and in the end general risk adversity sent it downwards and looking for support once again. 

Oil prices fall as supplies struggle to find demand
Energy prices, apart from natural gas, extended their losses this week finding no support from the US Federal Reserve, despite the door being left open for additional stimulus, should this be required. Brent crude lead the downward slide with the premium to WTI crude narrowing to less than 11 dollars, the lowest level since January. The signs of slowing demand at a time of ample supply have moved the front end of the Brent forward curve into contango for the first time since January 2011. 

Contango may signal the return of floating storage
The dramatic shift in current and forward price expectations, as seen below highlights the fact that most of the selling has occurred at the front end. This is natural enough as it is primarily here you will find speculative investment flows and also where previous supply tightness would have been priced in. A move from backwardation, where the spot price is higher than deferred to contango - where the opposite occurs - makes passive long investments in crude oil less attractive as the investments will begin to accrue a negative roll yield just like we have witnessed in WTI crude for most of the time during the last four years and almost permanently for natural gas.

Although this contango on Brent crude could quickly be reversed on a supply shock or Saudi Arabia turning down the oil tap it could, if it continues to increase, signal the return of floating storage. This was a popular trade following the 2008-09 recession when oil for spot delivery became so cheap that trading firms bought spot and immediately locked in the profit by selling it at a higher forward price while storing the oil on hired Very Large Crude Carriers (VLCC) in between. 

Geo-political risk should not be ignored
The geo-political risk which helped drive prices higher during the first quarter has not gone away as the meeting between Iran and the five permanent members of the UN Security Council, plus Germany, in Moscow yielded no result. The planned EU and US sanctions will now take effect on July 1 and this will halt some of Iran’s exports. Importantly it will also ban EU insurance companies from covering Iran’s exports which could create a headache for Asian buyers such as Japan, South Korea, India and China. The lack of progress at the negotiation table over Iran’s nuclear intentions once again raises the risk of an Israeli military strike, something that will ensure a continued geo-political risk premium despite the on-going economic slowdown and its impact on global demand. 

Despite weak global demand picture
The main focus however in commodity markets and in oil markets in particular remains on the current deterioration of the economic outlook for several of the major economies. American stockpiles of crude oil have risen to a 22-year high while manufacturing activity in China, the world’s biggest consumer of base metals and second-biggest consumer of oil after the US, continued to slow in June. The HSBC Purchasing Managers Index fell to a seven-month low of 48.1 in June with a reading below 50 signalling contraction. China, which has accounted for more than 50 percent of global oil demand growth in recent years, still has several tools available for stimulating the economy. A further deterioration in activity will therefore increase the chance of this happening, which in turn should help support commodities, such as copper and other base metals, which rely heavily on Chinese demand.

Technical and fundamental outlook not aligned
The outlook, from a pure technical perspective, still points towards lower prices with the break out of the USD 100 to 126 trading range signalling a technical move towards the USD 74 area. Near-term support should be coming from the Relative Strength Indicator (RSI) which is telling us the market is now more oversold than at any time during the 100 dollar collapse in 2008. This indicates that the move this week has been much about distressed long liquidation. 

The fundamental picture however still points towards continued, albeit slower, demand growth which could signal that current levels are too low and primarily a result of risk aversion and long liquidation. Just like higher oil prices act as a global tax on consumers the one-third drop during the last three months will eventually help demand to recover. But with the current sense of unease there is no doubt that oil prices can easily overshoot to the downside before fundamentals will begin to reassert themselves. 

Silver at a 2012 low - gold outperforming
The negative impact on silver from slowing manufacturing activity has seen the metal drop to the lowest level this year and in the process it has reached the cheapest relative level to gold since October 2010. Gold, meanwhile, did not find any support from the US FOMC meeting with no new stimulus being provided and general risk adversity saw it head for the biggest weekly loss since December. 

Gold is currently unable to break out of its 1,525 to 1,640 range and continued range trading seems to be the most likely outcome.  A technical break below 1,500 carries the risk of a 100 dollar extension to the downside but with the US Fed having left the door open for additional stimulus we think that support will hold once again. Investment flows into exchange traded products continue with total holdings only 149k ounces below the recent peak.

Weather premium driving US crop prices
US crop prices continue to gyrate within some major ranges with up towards 90 percent of all moves being determined by weather developments and its impact on yields at this crucial time for the development of crops. The US National Weather Service has so far recorded 2012 as the warmest on record and among the top ten driest seasons. This has resulted in rallies on dry weather outlooks being stronger than the opposite, given the tight stocks of corn and soybeans which raises concerns whether current high projections by the United States Department of Agriculture with regard to yield and production can be achieved. 

One of the gauges being used to determine how the crop is progressing is the weekly crop condition report, normally released on Mondays during the planting season from May to October. The readings over the last couple of weeks have, not surprisingly, given the hot and dry conditions across the US corn and soybean producing states, been pointing towards a deterioration of crop conditions.

The price of corn rallied almost 12 percent following the weekly crop progress report which stated that only some 63 percent of corn was rated good or excellent as of June 17. This reading was down from 66 percent in the previous week and 70 percent a year earlier (above chart). The situation for soybeans was not much better, with approximately 56 percent of the soybean crop currently being rated good to excellent, down from 60 percent in the previous week and 68 percent a year earlier. 

One foot out the window
In the chart one can see that new crop soybeans remain within their USD 12.5 to USD 14.00 per bushel range while corn is gyrating between USD 5.00 and 5.75 per bushel. Again, as mentioned earlier, high volatility and sudden changes in direction can be expected in the weeks ahead and traders in the US Midwest will undoubtedly sleep with one foot out the window in order to sense any change in weather, at least that was what local grain traders in Chicago apparently did during the years of open outcry on the CBOT exchange.