Commodities - what a difference a year makes

It’s been a long time since mid-2011, the last time commodity prices rallied like we saw in 2016. Since 2011, a sustained period of weakness came from weaker demand from China, as well as chronic oversupply and overcapacity with miners, as they say, ‘making hay’. Ultimately, oversupply saw iron ore – Australia’s largest commodity export – slump from US$187 per tonne in early 2011 to just US$40. Meanwhile, oil was hovering around 16 year lows this time last year as OPEC members suffered from (self-inflicted) wounds as they maintained output in the battle for market share with newer shale oil producers.

2016 was a different story however. Iron ore prices rallied nearly over 80% and coking coal – the coal predominantly used for making steel – surged 189 per cent over the year. Zinc was also on a tear – up 75 per cent over the year and so the list of metals (and agricultural commodities) goes on.

So what changed?

Commodity price began to stabilise – and then rally – in 2016 as excess supply worked through the system, supported by Chinese government stimulus spending. Between 2011 and 2016 many smaller producers were squeezed out of the market as the cost of production exceeded prices. Ultimately this assisted the market to rebalance while companies with deeper pockets, such as Rio Tinto and BHP Billiton were well-placed for the rebound.

For oil, against significant scepticism, on 30 November 2016, OPEC surprised markets with an agreement to reduce output by 1.2 million barrels per day (mbd) to 32.5 mbd which in turn boosted oil prices which had already showed signs of recovery over the year.

The materials sector is the second largest in the Australian share market and overall returned 39 per cent in 2016. This made it a top performer as Chart 1, below illustrates:

weight versus return chart

Chart 2: Commodity prices since 2008

commodity prices chart

Where to from here?

Donald Trump’s business-friendly agenda and campaign talk of heavy infrastructure spending has supported the 2016 rally into 2017. If he carries through with his campaign promises, it would likely feed through to Australian commodity exporters with increased demand for materials, including iron ore, copper and aluminium. This however hinges on whether Trump can get his plans through Congress or whether his plans will be watered down. For that, only time will tell.

Another interesting side-note from the US election is any potential impact Trump’s proposed policies will have on the value of the US dollar. Talk of trade barriers between Mexico as well as China should lead the US dollar lower, while Trump’s business tax cuts and corporate profits repatriation talk are a boon for business, conversely sending the value of the US dollar higher as demand surges. How this tug-of-war plays out, again, only time will tell. In the short term, however, US dollar volatility will be the likely result.

This is important because commodities are priced in US dollars, and ultimately a weaker US dollar makes commodities cheaper for global players and therefore increases demand.

Looking ahead, we predict earnings upgrades from resource stocks because spot commodity prices are currently well above analyst expectations. We believe commodity prices remain firm but limited price upside exists given the supply capability of the miners and the below average demand given slower global growth. Management teams of resource companies appear far more confident in the outlook though and a high probability of M&A exists as a result. In this environment, it may be wise to stick to the tier 1 asset owners, low cost producers and well-capitalised companies like Woodside Petroleum, Rio Tinto and BHP Billiton.

Important
The information contained in this newsletter is provided on behalf of the IOOF group of companies and is intended for financial adviser use only. It is given in good faith and has been prepared based on information that is believed to be accurate and reliable at the time of publication. Any examples are for illustration purposes only and are based on the continuance of present laws and our interpretation of them at the time.