Commodity Rally Fades and Investors Look to Oil

Commodity market fundamentals have not improved yet.

The rapid speculative rally in commodity markets is already petering out as focus returns to oversupplied markets, but dipping into a few choice assets could yield strong returns later this year.

Fund managers say crude oil and some soft commodities may see tightness, while political uncertainty could boost gold. But for industrial metals such as copper, reliant on Chinese demand, prospects are poor.

The frenzy of buying is reflected in the bellwether Thomson Reuters/Core Commodity CRB Index that tracks 19 major commodities, sitting near its highest since December and up 18 percent since February.

But gains have mostly been fuelled by a lower U.S. currency, which when it falls makes dollar-denominated commodities cheaper for non U.S.-firms; a relationship exploited by funds for short-term trading strategies.

"Fundamentals haven't improved yet, supply and demand haven't balanced out," said Standard Life Investments' global thematic strategist Frances Hudson.

"The big moves this year were because of the dollar, which could cause more volatility. Chinese funds have abandoned equities in favour of commodities, it could be a bubble."

Prices crashed in January as markets tried to price in headwinds to global growth from higher U.S. rates and a rising dollar.

The Fed has left its policy on hold so far this year, but the ebb and flow of opinion on U.S. rates and dollar volatility will remain a feature.

"Commodities are trading in a wide range and we may be near the upper end of that in the short term," said Jane Davies, senior portfolio manager at HSBC Global Asset Management.

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Later in 2016 though, diverging fundamentals could set investors up for relative value trades.

A favourite is oil, which fell below $30 a barrel in January, its lowest since 2003. It has since recovered to $47.

Falling output and stronger demand are expected to lead to inventory draws and a balanced market in the second half of this year.

Allianz Global Investors UK equities portfolio manager Matthew Tillett cites reaction to the failure of talks in Doha, aimed at freezing oil output as an example of the changing mood; the knee-jerk response of tumbling prices quickly reversed.

"If that meeting had happened a few months ago, oil would probably have dropped 20 percent, fundamentals are starting to assert themselves," Tillett said.

Also attractive is coffee, where shortages could occur due to severe weather patterns. A Reuters survey showed the first deficit since 2009-2010 could total three million 60-kg bags in the 2015-2016 year ending in September.

Jon Andersson, Head of Commodity Investments at Vontobel Asset Management, sees potential for significant upside in sugar "where adverse weather in India and southeast Asia are likely to cause global deficits".

The International Sugar Organization forecasts the global sugar deficit for 2015/16 at five million tonnes.

Meanwhile, Britain's referendum on membership of the European Union in June and the U.S. Presidential election in November could throw a spotlight on gold, used by investors as a store of value in times of political and financial uncertainty.

For industrial commodities, the vital component is China, where improving economic data recently reinforced the rally with Shanghai rebar steel futures jumping around 50 percent so far in 2016 after six years of losses and Dalian iron ore futures rising some 60 percent.

Both are retreating in the face of the Chinese exchanges moving to curb volatility with higher transaction fees and margin requirements.

Copper too has slipped from the four-week high above $5,000 a tonne seen last week as caution returned to a market where miners are focused on cutting costs rather than output to offset slowing demand growth in China, which accounts for nearly half of global consumption.

"There has been no pick up in physical copper consumption, without real demand from consumers, this latest rebound is unsustainable," said Tiberius Asset Management Chief Executive Christoph Eibl.
 

By Pratima Desai and Simon Jessop