Commodities Fundamentals Still Intact

While headlines are dominated by the daily flip-flops of European and American political leaders, commodity supply fundamentals continue their generally bullish track. While it is impossible to predict the outcome of Oligarch clashes in the Western world, the subterranean drum beat of continued growth in emerging market demand and increasing costs on supply curves can be explored more objectively.

Currently, the most compelling story in commodities is in grains. Let’s first take a step back to the spring of this year. Coming into the planting season, the market was exceptionally worried about corn inventories and this worry had led to a rally in the price of corn to $7+. Inventories in soy and wheat were less dire, but both of these grains rallied along with corn, as planting intentions implied a net loss of acreage for soy and increased demand for wheat. While the market had perhaps gotten a bit ahead of itself, there is little doubt that hopes and expectations were pinned on an exceptionally good season in North America to replenish inventories. Unfortunately, that is not what we got. Instead we got a spring of epic floods, with historic flooding along the Mississippi River, the Missouri River, and the Red River. Not only did this result in lost acres (i.e. acres where nothing was planted) it also resulted in an exceptionally late planting for all three crops. Spring wheat, corn, and soybeans have all been consistently behind schedule in 2011. As if this were not enough, it has also been a year of exceptional drought in Texas and Oklahoma, with dire crop stress for winter wheat and cotton. Finally, the exceptional heat in Texas since June has now moved into the Midwest and is currently creating a record heat wave (Figure 1.) Based on current forecasts, July will set a new record for heat in the United States on an electric demand/population weighted basis. This heat wave is particularly troubling since it comes at the crucial silking stage for much of the nation’s corn crop. Finally, while the heat is actually good in the sense that it accelerates maturation of a late-planted crop, the lateness of the planting will increase the risk of frost and freeze damage as we approach the harvest season.

Figure 1 Near-record dew points across much of the Midwest. For those readers who have never experienced 75+ dew point, that is the point where you consider climbing into your fridge. This will cause considerable heat stress on crops and livestock across the region.

Let’s review the facts for grains: historically low inventories to start the year in corn, massive floods in the Dakotas and Mississippi valley, oppressive drought in Texas, plus an historic heat wave. It is difficult to exaggerate the importance of the North American crop, and this year is shaping up to be troubled at best.

Moving on to natural gas, it has been stuck in much the same range of trading for 2011 as it was for 2010, basically oscillating between and per million BTU. While the supply story continues to be exciting for our country’s domestic energy prospects (and bearish for price), there are now several tailwinds that are starting to work in favor of natural gas price. First, industrial demand has picked up, increasing 6% YOY to April. Second, natural gas continues to gain market share at the expense of coal and nuclear power. This was particularly true in the second quarter this year as nuclear power had exceptionally long shut down period attributed to both flooding and extra due diligence after the Fukushima event. The gas/coal substitution is a more persistent story and will be even more important in the years ahead.

Comparing the BTU equivalent price of natural gas and coal shows that the price advantage of coal has dropped close to zero over the past few years (Figure 2). Since coal is a dirtier fuel with more associated costs, plants will often switch to natural gas before prices are at par, although the price point for substitution varies greatly with geography, access to gas, type of coal, etc. However, taken as a whole, it is likely this substitution effect will accelerate in 2012 as a result of the recent EPA ruling which sets stringent new requirements for sulfur dioxide emissions. The new EPA ruling will likely require the retirement of numerous dirty coal plants, and increase natural gas demand by 1+ BCF/day. This is a bullish development for natural gas.

Figure 2 Discount for Appalachian coal to natural gas per BTU, 2007-present. The converging prices has led to increased coal to gas substitution.

The supply side of natural gas continues to be bearish as rig efficiency improves and companies continue to focus their efforts on proving reserves above and beyond making a profit. This apparently lemming-like behavior makes a little more sense when seen from the perspective of pleasing shareholders, who value proved reserves above all else. On the other hand, we have continued to see rigs moving away from natural gas targets to crude oil targets. An important consideration from this angle is that once a rig moves to crude oil target, it would be very difficult to move it back to a natural gas target, based on the much more attractive economics for oil targets. In fact, based on current estimates, it would take a price of $12-$14 a BTU in natural gas to shift an oil rig back over to gas. Another potential bullish development (which belongs in the category of speculative), is the increasing costs for water. Since shale gas is incredibly water intensive this is a very real consideration, and perhaps nowhere more-so than in Texas, where a historic drought is currently affecting the state.

Moving to petroleum, there appears to be significant strength in the market despite the IEA release of crude, economic weakness, and threats of more IEA releases. From one perspective, this seems to point to an incredibly bullish story that underpins long-term supply and demand fundamentals in crude. However, petroleum might be the market most vulnerable to a sell off if the debt crisis in Europe enters a more destructive phase. While a “risk off” event would cause the price to fall for most commodities to the extent that demand and projected demand could be revised down quickly and dramatically, the global nature of petroleum products and the large income elasticity of demand would make it among most susceptible to a sell off.

Precious metals have had another historic rally over the past two weeks, with gold breaking to new highs in dollar and Euro terms. The genesis for this rally seems to be the combination of Euro debt issues and the political wrangling in Washington over the deficit and debt ceiling. It is impossible to predict how these issues will resolve, but it is understandable why many market players would view that the likely scenarios would result in a massive asset flow into gold and silver. However dominant this perception is, my personal view is that short-term exposure to precious metals could be exceptionally volatile and a crisis could have unpredictable effects in the short term.

Finally a cursory look at meats reveals a two-tiered view. In the short term, heat stress on the herd and continued high grain prices may actually pressure prices down, particularly in spot and near month futures as farmers cull herds. However, there have already been substantial reductions in herd size, and there is only so far farmers will cull the herds given current meat prices. Obviously, in the medium term, reduced herd size and higher input costs are very bullish factors for meat prices.

In summary, it appears that on a micro basis, many of the commodities remain well supported by fundamentals. Grains and meats supplies look to be low and threatened while global demand continues to grow. Petroleum demand has softened a bit into midyear but there is clearly strength in the market despite a release of 60 million barrels into the market by IEA. Even natural gas, the traditional “dog” of the commodity market, appears to have some bullish tailwinds to its story. However, in this crazy world we live in, all the current “fundamentals” could become irrelevant overnight with a sufficiently disruptive debt/political event in Europe or the US. Precious metals provide a dichotomous alternative to other commodities at this juncture. While they are susceptible to a short term sell off, they also could provide invaluable insurance in a true worst-case scenario.

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