Oil and Industrial Metals To Remain Under Pressure

Commodities are back under pressure, sending ripples through various assets classes,  The risks appear bearish for energy and industrial metals, therefore we expect major exporting nations to continue to underperform in their currency and equity markets.

Commodities are back under pressure, sending ripples through various assets classes. Let’s start with a recap of recent moves and drivers.  In short, it looks like the risks are still bearish for energy and industrial metals, but not so much for agricultural commodities.  We believe that the currencies and equity markets of the major exporters of industrial metals and energy are likely to continue underperforming.

OIL

Both the charts and fundamentals suggest to us that there is further downside ahead for oil.  On the fundamental side, the deadline to reach a deal with Iran was extended again, but an agreement seems close at hand.  Talks in Vienna have been ongoing for 10 days, and comments suggest a lot of progress has been made.  The National Iranian Oil Company hopes to bring exports back to pre-sanctions levels within three months after the embargo ends.  This would mean exports of around 2.5 mln barrels per day, up from around 1.4 mln barrels per day on average in 2014 (according to the EIA).  For comparison, Russia (the world’s second largest exporter) averaged about 4.8 mln barrels per day in 2014.

Pressure is also coming from steadily increasing supply and price cuts from OPEC.  US output is also making cycle highs near 10 mln barrels per day, and last week marked the first increase in US drilling activity in 8 months.  On the demand side, downside global growth risk from China and EU are likely to keep a lid on energy demand.

Chart 1

Technically, Brent is leading this move and has already broken the 62% retracement objective from its March-May bounce, which sets up a test of the March low near $52.50.  Further losses would set up a test of the January cycle low near $45.20.  WTI is dragging lower, and is about to test the 62% retracement objective from its March-May bounce near $49.88.  A break below that level would set up a test of the March low near $42.00.

IRON ORE and COPPER

Iron ore prices are back below $50 per metric ton. The April-June rally proved to be short lived.  Recent losses have accelerated due to concerns about slower construction activity in China as well as reports suggesting that Australia and Brazil are set to increase supply.  Iron ore futures are down nearly 25% since mid-June, and set to test the April low near $47.  Similarly, copper futures are off nearly 20% since May levels.  There was a new cycle low in copper today below 240.  Charts point to a test of the December 2008 low near 125.

Chart 2

AGRICULTURAL

As we discussed in a previous report, the El Nino phenomenon will be an important risk factor this year.  Recently, a series of tropical cyclones has helped it build strength.  El Nino this year has an 85% chance of lasting through winter 2015-2016, according to an updated forecast released last week by the National Oceanic Atmospheric Administration (NOAA).  Experts warn about significant climatic changes this year such as heat waves in Asia, strong rain in South America, and cooler summers in North America. Data taken from Agriculture.com suggests that in general, El Nino tends to result in strong crop yields in the US, especially for soybeans.

Chart 3

Recently, however, corn and soy futures have risen sharply, up 18% and 10% since mid-June, respectively.  This was largely due to floods in the US Midwest.  Also, a recent report by the USDA claimed that U.S. farmers planted the smaller area for corn since 2010, helping push up prices.  Wheat prices have also risen.

INVESTMENT IMPLICATIONS

It should come as no surprise that the equity markets in the commodity exporting countries are underperforming within EM.  MSCI EM is down -3.4% year-to-date (YTD).  MSCI Brazil (-15.5% YTD), MSCI Chile (-10.4% YTD), MSCI Colombia (-22.7% YTD), MSCI Mexico (-5.1% YTD), and MSCI Peru (-10.8% YTD) are all underperforming.  MSCI South Africa has held up remarkably well (+0.3% YTD), as has Russia (+11.4% YTD).  We suspect these two will eventually be dragged lower and play some catch-up with the Latam bourses.  MSCI Indonesia (-6.6% YTD) and MYR (-3.7% YTD) are underperforming modestly, and could also see some catch-up losses ahead.

On the FX side, it’s no coincidence to us that charts are pointing to many exchange rates going back to 2002 levels.  In our view, that’s when the commodity super-cycle began.  For instance, oil and copper both began their multi-year rallies in November 2001.  That boom fuelled growth and exchange rate appreciation for the commodity exporters.  That boom has ended, and so we have to look for adjustments in the exchange rates.  Here is a summary of the main ones:

  • USD/BRL is lagging the wider move in Latam currencies, and has yet to test the cycle high near 3.3150 from March.  Long-term charts still point to a test of the all-time high near 4.0 from October 2002. However, extremely high carry will certainly play a role in slowing down the move.
  • We saw a new cycle high for USD/CLP today near 650, the highest since January 2009.  The November 2008 high near 686 is very close, and after that is the 700 level.  Long-term charts now point to a test of the all-time high near 760 from October 2002.
  • We are seeing a very similar dynamic for USD/COP.  It’s close to matching the cycle high near 2700 that was set back in March.  That was the highest level since mid-2004.  There are some intermediate targets, but long-term charts now point to a test of the all-time high near 2980 from January 2003.
  • USD/MXN made a new all-time high near 15.86 earlier this week.  Further gains seem likely, though we are in uncharted territory.  There is an upward sloping channel on the monthly charts dating back to the 1994 devaluation.  Top of that channel now comes in near 18.60.
  • USD/PEN is making new cycle highs near 3.20.  This is the highest level since early 2009, and the February 2009 high near 3.2670 is within sight.  Long-term charts need a break of the 3.23 area to set up a test of the all-time high near 3.66 from September 2002.
  • USD/RUB has been rising, but is still far short of the all-time high near 80 from December 2014.  Intermediate target is the January high near 71.80, but we first have to trade through retracement objectives near 59.97 and 62.76.
  • USD/ZAR has been rising, but has yet to test the cycle high near 12.71 from early June.  Long-term charts point to a test of the all-time high near 13.84 from December 2001.
  • USD/IDR is making new cycle highs near 13400.  Long-term charts point to a test of the all-time high near 16950 from June 1998.
  • USD/MYR has been rising, and is now above the peg rate of 3.80 that held from 1998-2005.  Long-term charts need a break of the 4.14 area to set up a test of the all-time high near 4.8850 from January 1998.