The commodities price drop in focus: is now the time to explore the market?
You may have noticed that membership of the FTSE 100 Index isn’t cast in stone. Depending on their stock performance, companies drop out as new companies take their place and this movement in itself can say a lot about how certain sectors are holding up.
The reshuffle that took place in March of last year provides a good illustration of this. Wealth management specialists, St James’ Place and construction giant, Barratt Construction were promoted to the top tier. Meanwhile, along with Tate & Lyle (whose fortunes had been hit by the growth of cheaper sugar production in China), the other company leaving was Amec, supplier of goods and services to the oil, gas, mining, and renewable energy sectors.
This reflects a wider picture. In contrast to financial services and real estate, commodities (with some exceptions) appear to be in freefall. As a report from AJ Bell demonstrates, Amec is one of 14 commodities based companies that have crashed out of the FTSE 100 in the last three years. Meanwhile, last month’s share price collapse of mining giant, Glencore provided further evidence of how precarious this sector is at present.
Unless you are confident that a particular price has bottomed out, this is not the type of backdrop against which you will be tempted to take a long position. Short term, however, there may be opportunities both in the commodities derivatives markets and in relation to stocks of companies that operate in the sector.
Here, we attempt to put together a picture of what’s been happening and what traders should be looking out for over the coming months.
Why have commodities lost value?
In most cases, the answer to this can be summed up in one word: China. What’s more, although the Chinese stock market slump over the summer certainly didn’t help matters, the seeds of the trend go back somewhat further.
The last few years has seen China scale back massively on major infrastructure projects. This is bad news for producers of those commodities that are used in construction and civil engineering, (iron ore and copper, for instance). In those areas where China is a net producer, (e.g. aluminium), the problem commonly boils down to increased production against a background of weak global demand.
Although there are trends common to many commodities, by no means is it the case that they share the same fundamentals. As an illustration, consider the following:
Oil
The price of Brent Crude remains in the doldrums because of one simple fact: supply exceeds demand by a considerable margin. Despite flat demand, Opec countries are continuing to produce at a near all-time high rate. Production from outside Opec has held up strongly too; with increased shale extraction in the US helping to add to the glut.
In the short and medium term, the view from analysts is that save for a geopolitical flashpoint, only if there is a concerted effort to reduce production are we likely to see a reversal of the current trend.
Iron ore, steel and copper
Iron ore seemingly bottomed out at the end of July at below $50 a tonne, followed by a slight rally, driven in part by lower exports from Brazil and Australia. The gains were mostly short-lived, with mid-October witnessing a 10 per cent drop in price over the course of eight trading sessions, triggered by soft Chinese economic data and warnings from industry insiders that there was still a significant production glut.
Closer to home, we’ve seen the effects of the global collapse of steel prices manifest in UK plant closures and layoffs. China got the blame, both in terms of overproduction and dropping demand from its internal market. There is little to suggest that a recovery here is around the corner; although longer term, the signs from Beijing are that it is at least attempting to address its production glut problem and has apparently banned new steel production initiativesuntil 2017.
Twice this year, in July and September, copper hit 6-year lows below the $5,000-per tonne mark. Even though inventory levels are low, a lack of demand (not least from the Chinese construction sector) means there is little scope for significant upward movement in the near future – with commentators suggesting a further decline to $4,500 by the end of 2016.
Trading in industrial commodities: what to look for…
The People’s Bank of China doesn’t really do forward guidance. Take the surprise move on 23 October to cut interest rates by quarter a percentage point; one consequence was a series of brief price rallies across oil and the base metals. For short positions keep an eye out for any indications that Chinese policymakers are about to roll out measures (such as rate cuts or major infrastructure projects) to stimulate market activity and/or internal demand.
Gold
Against this backdrop, is gold benefitting from investors flocking to it as a safe haven? It seems not. Market watchers are bearish on gold – albeit for very different reasons than for other commodities. An interest rate rise in the US is considered imminent; something that makes holding a non-yield producing commodity considerably less attractive.
Once incremental rate rises start kicking in, expect gold to decline in value accordingly. For instance, Goldman Sachs predicts a staged fall from its current level of around $1,165 an ounce to $1,000 over a period of 12 months in line with gradual US Fed rate increases.
Trading in gold: what to look for…
The markets are primed for a rate rise. Consequently, any indication that the Fed is temporarily kicking interest rate increases into the long grass should be regarded as something that will give gold some brief upward momentum.
Stock prices: lessons from Glencore…
In 2011, when Glencore went public in London, it was the biggest flotation in UK history. Founded in 1974 by Belgian-born commodities trader Marc Rich, the company was focused initially on trading metals and oil. Steadily, the company diversified and acquired stakes in the likes of lead and zinc mines and aluminium smelters, with a heavy and often controversial emphasis on debt finance. At flotation, Glencore was valued at $60 bn. Two years later, Glencore completed a merger with international mining company, Xstrata, resulting in the creation of a company with 190,000 employees across 50 countries.
In August of this year, Glencore’s disappointing financial results against a backdrop of record low commodity prices was enough to see the company’s share tumble by 10 percent to 159p. The company’s heavy reliance on debt financing was coming back to haunt it; a plan of action to reduce the debt wasn’t enough to reassure investors, culminating in a 28 percent share price drop in a single day (28 September). Fears of an all-out Glencore collapse triggering a “Lehman moment” appear to be unfounded and the price has since rallied to around the 112p-mark.
Two takeaway points for traders spring out from all this. Firstly in terms of long-term holdings, it highlights the need for diversification across multiple asset classes. Glencore’s portfolio was huge – but it was (and is) focused largely on commodities and metals, all of which were affected by very similar downward market trends.
Secondly, for short-term positions, it offers clues on how to predict movement. The price collapse came at the end of September. A week later came the recovery – and key to this was the release of seemingly credible information that the company was operationally stable – and indeed, that it was open to takeover offers. Look out for similar data releases when attempting to predict movement on shares you have under consideration.
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