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COMMODITIES IN 2011

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CONTENTS 2011: A Promising year for Commodities Factor 1 :- Tighter Market Equilibrium Factor 2:- Chinese Monetary Actions Factor 3:- Physical-Backed ETFs to relate with market balance Inflation and The New world order by Commodity Conclusion

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2011: A Promising Year for Commodities 2011 promises to be the year of commodities. Every global event in the last three years has either been triggered by commodities or has, in a roundabout way, led to increased influence of commodity prices on the macro-economic environment. The recent events in Egypt are a case in point. Even in the ongoing currency wars, commodity currencies like the Australian Dollar and Brazilian Real have shown genuine muscle and there is nothing on the horizon to show that the trend is changing. The stimulus money allocated by several governments worldwide saw a race to acquire natural resources across the world due to increased awareness of this issue. Moreover, underlining the global economic uncertainties, gold prices continue to hit new highs with no signs of abatement. Therefore all signals point to 2011 being a year of where prices are likely to continue climbing and therefore commodities will be the best place to invest in 2011. Demand will come from several places, but the key will remain rising raw material requirement to feed their infrastructure programs in China and India. Similarly, several governments worldwide are printing money and using it to spur infrastructure growth and a lot of this money simply finds its way into commodities like copper which are the

basic building blocks (which is why copper also seems to have a fairly

direct correlation with the global economy). Of course, there is a price at which commodities will simply be too expensive to consume but it’s hard to put a number on it and in any case it is a dynamic number depending on various factors. Nevertheless, we have seen prices crash in 2008 due to steep run ups and we have to see if a similar magic number is reached this time round too.

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The last time crude oil rebounded strongly from US $ 147 a barrel, today it is already around 90 and still moving up causing budgets to go haywire in many nations including India. But it does seem that there is a long way to go before this situation actually gets triggered and therefore several commodities are likely to continue to see firm prices for a variety of interlinked reasons. Expect political action globally as a reaction to increased costs. Like many other countries, agri-prices will be politically sensitive for us but some price rise may be beyond our control – the incessant rise in crude oil prices will once again entice farmers to convert land currently used for food crops for growing ethanol and other energy alternatives. But being wiser after our last experience, it is a good idea to have a strategy ready to offset this.

Factor 1: Tighter market equilibrium Heavy market surpluses were seen in most commodity markets in the wake of the global recession in 2009 as demand fell well below production. In 2010, deficits began to reemerge – first in copper and more recently in the oil market. On the demand side, the global recovery as being ‘back on track’ after double-dip worries in mid-2010 suggests that consumption of raw materials should continue to prove healthy. US and German data has surprised on the upside in recent months, and even the weak spot during the upturn – Japan – has been showing signs of stronger than previously projected economic activity. Asia is still going strong, and our economists see the apparent frontloading of policy rate hikes in China as positive in reducing the likelihood of more aggressive tightening measures and a harder landing at a later stage.

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Supply-side issues are also surfacing in key markets. Although these problems may partly be caused by a setback in capital spending during the credit crunch, we believe capacity constraints are for now more structural than cyclical in nature. In short, mine supply is struggling to expand in copper and nickel – the announcement of mining super taxes in both Australia and China will only add to the costs associated with production expansion in the sector. Even in the aluminium industry where smelting capacity is ample, costs are picking up in the form of both input (bauxite/alumina) and energy, thus supporting output prices. Finally, oil majors are facing an increasingly uncertain environment on the supply side as the prospects of expanding output in non- OPEC countries are growing bleaker – the Macondo oil spill is likely to increase safety standards and insurance premia for deepwater drilling. On balance, we think inventories are set for further draws this year. We expect the crude oil, copper, nickel and corn/maize markets to experience deficits for 2011 as a whole. Buffers as measured by stocks-to-consumption levels are thus set to decline significantly. Specifically, we look for OECD forward-demand cover of oil products to decline from currently 60 days to around 57 days; this would still be an elevated level compared with the 52-54 days historically preferred by OPEC. As a result, we believe that OPEC will keep production close to current levels; indeed, the cartel still seems wary of the sustainability of the global recovery in energy demand. All in all, we expect further tightening of market balances in oil and metals markets this year. For consumers, this is essential because in a backwardation market it is possible to lock in expenses below the prevailing spot price. From an investor point of view, this is also crucial as the roll yield obtained from traditional index/futures investment becomes positive when the curve is downward-sloping. As a result, we expect to see investor inflows into commodities grow further.

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Factor 2: Chinese Monetary Actions In 2011 the developed world will see governments focusing on reducing budget deficits and central banks preparing exits from (near) zero interest rate policies. Meanwhile, the focal point in emerging markets will be reining in credit growth while fiscal policy could remain relatively loose in order to accommodate structural needs for investment in e.g. infrastructure. Although other Asian countries such as India are growing in importance, China remains the central consumer in the developing world. The People’s Bank of China (PBOC) is set to conduct a minor shift in policy from being accommodative to being ‘prudent’ – in Chinese terminology this usually means neutral. Following the Christmas Day rate hike, we look for higher policy rates to be frontloaded into H1 where growth is expected to be strong and inflationary pressure most severe. The Chinese authorities will probably continue to use a combination of higher reserve requirements, Yuan appreciation, and constraints on credit growth in order to curb inflationary pressure. The latter tool should be particularly effective in dealing with the booming property market which is still a key concern. Although no target for credit growth has been announced yet, it will probably only see a modest decline. Also, even if China raises interest rates as expected, a real one-year deposit rate will still be negative. Despite higher interest rates, the impact from monetary policy on growth could actually be positive in early 2011. This is because the considerable focus on the part of policymakers and banks on achieving the annual targets for credit led to relatively tight credit conditions towards the end of 2010. During Q1, banks should thus again has ample room to expand its loans. This could boost investment demand and imply a strong start to industrial activity in the New Year.

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Overall, commodities are thus unlikely to be severely constrained from the monetary side when it comes to China in 2011. On impact, news of tighter policy measures could still spur sell-offs in particularly base metals, but in the longer term we think that measures that limit the risk of a hard landing for the economy will eventually be perceived as positive by the market. Recent hints that China will use a stronger CNY to rebalance the economy are also positive for cycle-sensitive commodities as this will increase the likelihood of longer-term growth sustainability. Gold may suffer from fading risks of a global currency war though as safe-haven flows should wane.

Factor 3: Physical-backed ETFs to relate with the market balance The introduction of physically-backed Exchange Traded commodity Funds (ETFs) has been a major issue over the last couple of months in the base metal markets. We have already seen ETF Securities introduce physically-backed ETFs. JP Morgan has announced it will introduce physically-backed ETFs together with iShares. Rusal, the world’s biggest aluminium producer is also expected to introduce an aluminium ETF. Commodity ETFs based on futures have been available for several years. However, the new ETFs are different. They are not backed by futures, but by physical commodities. Hence, by definition they interact with the physical market balance contrary to traditional ETFs that by definition only interfere with the futures market. In theory, physically backed ETFs could be introduced in all kinds of commodities which have a reliable market price. However, as the investor has to bear the costs to storage, insurance, shrinkage etc, physically-backed ETFs have, or will to our knowledge, only be introduced in base metals and precious metals. Many precious metal ETFs are backed by physical assets today as the storage costs are very low. Hence, we focus here on the base metal market.

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The impact on the physical market will depend on the popularity of the new instruments and tightness of the market. The latter can be described by the size of the inventories and the spare capacity in the single market. In this note we assume that the introduction of physically-backed ETFs will not affect supply in the short term, as most base metal prices are already well above marginal costs in the industry. Aluminium has the highest stock value well above USD10bn. However, it has to be noted that a significant amount of aluminium is already tied up in financial deals, i.e. aluminium sold at the forward price to take advantage of the contango structure in aluminium. It is estimated that last year up to 80% of the aluminium stored in exchangemonitored warehouses was sold forward. Hence, even though aluminium inventories look plentiful, physical ETFs could have a significant impact on aluminium prices. Copper is the second-largest base metal measured by the value of LME stocks. Copper has some very strong fundamentals and is well known for its correlation with the global business cycle and Asian growth. Hence for the investor looking for a sustained global recovery, it is an obvious choice and we expect investors to continue buying heavily into copper in 2011. Lead, nickel, tin and zinc are volatile metals and are not expected to attract the same investor interest. However, the nominal values of the LME stocks are quite small and it would only take modest investor interest in the smaller base metals to have a significant impact on the physical market balance. To put the value of the LME inventories into perspective, it can be noted that in the first nine months of 2010, according to the World Gold Council, investors invested USD12.9bn in gold ETFs and similar products. Hence if physical ETFs become popular, they could potentially affect the base metal market strongly.

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Inflation & The New World Order by Commodity During the past decade, Finished Goods PPI has risen roughly 35% while the CPI was up about 30%, which seems to suggest producers typically pass through most of the cost increases to the end market. So, Commodity prices jumped to two-year high on expectations for global economic growth and lower U.S. forecasts for agricultural inventories. The Food Price Index compiled by the U.N. Food and Agriculture Organization (FAO) surged 25% in 2010 and hit an all time high in December, at the level even worse than the food crisis in 2008. FAO acknowledged that this is unlikely the peak yet. And if you think the 25% spike in food prices seems extreme, wait till you check out the Non-Food Agriculture (NFA) prices. The Economist tells that the NFA prices were up almost 80% in 2010! NFAs are agricultural materials with heavy industrial applications such as cotton and rubber. 

Fixed-price terms gone for good

Now, many posit that since raw materials now account for a smaller percentage of input costs, the record commodity price inflation will not necessary translate into price increases in end markets. However, the argument was valid in the pre-China era when commodity prices were relatively predictable, easier to hedge, labor costs were low in the developing countries where most of the manufacturing activity took place and fixedprice and/or fixed-escalation clauses were the norm in contract terms. 

Commodities weigh on cost structure

With record surging commodity prices, raw materials are becoming a bigger component of company’s cost structure. Many goods and services producers are now starting to

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index their supply contracts to input materials to adapt to this New World Order of Commodity. For example, the latest such movement involved rare earth metals, which are key materials in Fluid Cracking Catalysts (FCC) used in the refining process to produce gasoline. WSJ reported that due to the skyrocketing rare earth metals prices, chemical companies have started indexing the cost of their catalysts to rare-earth price movements. WSJ further noted that the added costs from rare earth metals, although not significant to make consumer notice, are enough to make some refiners to think about cutting production. This just illustrates either the cost gets passed through, or there could be production cuts as a result--both translate into higher prices for consumers. 

Raising prices could mean losing business

As inflation expectations and commodity prices are rising, corporations could face headwinds when they need to start raising prices, and lose business, due to a still weak consumer market, or face margin and the subsequent stock price pressure.

Conclusion In today’s environment, the best way to hedge inflation is probably to invest--through patience and discipline--in commodities on pullbacks. And keep in mind there are two things for certain--inflation will be steadily rising no matter what time frame you are looking at and prices of commodity and stock will have pullbacks. Given this situation, it appears that every investor must go overweight in commodities in his portfolio and the list should contain not just gold but also copper, cotton, crude oil and silver which seem set to ride the price wave in 2011. Most people have already figured out that 2011 will be the year of commodities. Those who haven’t will find out soon enough.

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COMMODITIES IN 2011 Special Report By CapitalHeight