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This article was originally published on Valuewalk.com. For additional insight and analysis, see the author comments at the end of this document.

There is a new market environment in the commodity complex, notes Goldman Sachs research. Taking a page out of the recent interest rate environment in the developed world, the “low for longer” tag applies to the oil market, which is leading the commodity complex lower against a hawkish US Federal Reserve regime.

In the supply and demand tug of war, commodity blues are due to supply

Commodities, down -10% year to date, have been the loser in a diversified portfolio. Their day would likely come if inflation grips the developed world, where wage growth fears have started to stoke inflation concerns.

When they look at the past six months to understand the relative commodity slump, Goldman’s Economics Research team of Hui Shan and Jeffery Currie think one of the two core performance market drivers, in this case supply, is at issue.

In the supply and demand price discovery construct, demand is often considered to have a reasonably direct correlation to economic conditions. Correlations vary from commodity to commodity.  The price of copper, used extensively in manufacturing, is correlated to economic conditions to a greater degree than the adornment metal of gold, for instance. Oil is a commodity that is correlated to economic conditions, but to various degrees and at different economic levels than copper.

It is this divide that Shan and Currie consider, saying, in essence, the commodity blues in the price of oil is not due to demand, but rather supply.

Goldman on commodity blues: “Fundamental rules of commodity investing have been underappreciated”

Shan and Currie think the “fundamental rules of commodity investing have been underappreciated,” pointing to what listed derivatives professionals consider core to market price discovery: the supply and demand construct. In this case, they say it is the supply picture that is currently driving prices.

Commodity prices are “anticipatory” and the shape of the futures delivery curve, which benchmarks different points in a year that a buyer can take delivery of the underlying product such as oil, “is a reliable barometer of demand and supply fundamentals.”

The fundamentals to which are at issue amount to a tug of war between buyers and sellers that has been a core point of analysis of market prices since the day futures markets began. Shan and Currie set up the basic construct before explaining how and why commodity prices are currently underperforming:

If spot prices were to rise too high on expectations of a deficit market in the future, oil would flow out of storage, crushing spot prices. Year-to-date, the movements in the curve shape for near-dated oil contracts have pointed to strengthening fundamentals. In other words, demand growth has been catching up to the excess supply.

Commodity blues are about supply and demand construct

Using this explanation as the construct, an old problem for the OPEC oil cartel and the supply and demand construct is at play: too much production is depressing prices.

On an idiosyncratic basis, the oil sell-off was in part due to “unpredictable factors” from higher than expected production coming out of Libya and Nigeria, two somewhat unstable regions in an increasingly volatile oil production environment.

But it is not just the oil market. Goldman observes that certain metals markets are already responding to supply driven impetuses.

Steel, bucking the lower commodity trend by being up 19% year to date, is higher due to China shuttering many of its Medium Frequency Furnaces. Once again an idiosyncratic market input is on display in the case of nickel, which is down -9% year to date. In the increasingly volatile Philippines – the current president has signaled a shift towards China – the failure to shutter or at least suspend mines is resulting in increased supply.

Goldman says that any trading strategy that has a time horizon beyond the current supply cycle might be “self-defeating.” This leads to a nuanced outlook of being “cyclically bullish but structurally bearish.”

 

Insight / Analysis / Opinion: 

So much of PhD analysis that misses key economic signs, such as the US Fed consistently unable to see a recession coming or failure to recognize the 2008 financial crisis coming, is due to not recognizing core performance drivers. A major difference between practioner analysis of markets and some academic analysis, is practioners start their analysis by recognizing what influences markets and putting analysis in a useful and non-obfuscated language.