COMMODITY: FALL AND ITS IMPLICATIONS

The interconnectedness of global economy is presenting a situation where the images are changing faster than what a kaleidoscope can show with few twists and turns. It was hard to believe, till a couple of years back, that India will be facing a deflationary like situation. Inflation measured through the WPI has remained in the negative for seven months in a row; this is after both WPI and CPI on an average remained at a higher single digit or in lower tens for most part of 2012 and 2013. One of the important factors that led to higher inflation was higher commodity prices globally. And since India remains a net importer of commodities, including crude oil and precious metals forming almost 45 per cent of the total imports, this would indirectly seep into our economy and result in higher inflation.

The commodity prices, though having peaked in 2011, witnessed a drastic change in the situation last year. These prices have relentlessly been failing without much support. Crude oil price, for example, since the second week of May 2015, has lost almost one-fifth of its price. This is after losing almost 50 per cent in the previous year i.e. 2014. Though there was an increase in crude oil prices in the first few months of 2015, they have once again regained their downward path. From an Indian perspective, we give more attention to the crude oil price as it plays a crucial role in determining the fate of both government finances as well as a large part of India Inc.

Nonetheless, if we look around and see other commodities, their fate is not very much different from crude oil. The Thomson Reuters CRB Index, which is a commodity futures price index and measures price direction of overall 19 commodities including petroleum products, is down by 31 per cent in the last one year (Chart 1). Most of the commodities are trading at their 52-week low. Like crude, commodities such as iron ore, steel, and copper are hovering at their 52-week lows. Copper is down 25 per cent year till date, Singapore iron ore spot is down 38 per cent and China steel is down 55 per cent.

[PAGE BREAK]

Why Are Commodity Prices Falling?

There are a few specific reasons that are leading to such a fall in the commodity prices; however, the most significant is the slowdown in the global economy in general and Chinese economy in particular. As per IMF’s latest projections, global growth for 2015 is 3.3 per cent, lowered from 3.5 per cent earlier and the lowest since 2009. Besides 2015, IMF is likely to lower its 2016 global growth numbers too, which is currently pegged at 3.8 per cent. This will primarily be led by only 4.7 per cent growth in emerging market economies, down by 100 basis points from the earlier estimates. IMF has cut its growth forecast for the global economy twice in the last six months. Lower global growth means lower demand for commodities and hence lower prices.

China: The Big Daddy of Commodity

What is really hurting global growth and commodity demand is slowdown in Chinese economy, which till a few years back, was the growth engine of the global economy. The world’s second-largest economy in absolute term and largest in terms of purchasing power parity (PPP) had accounted for about a quarter of global GDP growth over the last decade. And it’s not only the growth that matters but the type of growth. Given its resource-intensive growth, China has a disproportionate influence on commodity markets. According to various estimates, China constitutes 44-47 per cent of global aluminium and steel consumption; 23 per cent of global primary energy (oil, natural gas and coal) consumption; 25-30 per cent of petrochemical (polymer) consumption; and 45-50 per cent of overall global aluminium and steel production capacities.

The Chinese economy, after hitting a growth rate of 14.2 per cent in 2007, has posted growth of 7.4 per cent in 2014 and IMF has estimated Chinese GDP growth of 6.8 per cent and 6.3 per cent in 2015 and 2016 respectively with potential downside risks. The slowdown in Chinese economy impacts the global commodity prices in two ways. First, as illustrated above, it reduces the demand for the overall commodities. Besides impacting the demand side, China also plays an important role in terms of supplies. China is also a substantial global commodity producer with significant domestic reserves of many commodities such as coal and iron ore, and the world’s largest producer of wheat and rice. China has been the world’s largest producer of steel for the past decade, producing almost half of the world’s steel, three times as much the United States and Japan combined. Therefore, slowdown in Chinese economy is going to increase the supply of many commodities, which will seriously impact the prices of commodities.

Commodity and US Dollar: The Inverse Relation

The third most important factor impacting crude oil prices is strengthening of the US dollar. Therefore, it is no coincidence that as the US dollar is strengthening, commodity prices are falling. The explanation for this relationship is that since commodities are priced in US dollar, rise in US dollar will lead to fall in commodity prices as the dollar strengthens to reflect its increase in purchasing power. This is visible from the graph below (Graph 1) which plots the movement of the US Dollar Index, which measures the value of the dollar against a basket of six foreign currencies, and the CRB Index for the last one year.
[PAGE BREAK]

Moreover, the financialization of the commodity, which means growing presence of financial investors in the commodity market, has changed the rules of determining the commodity prices. Besides demand and supply, what plays an important role in determining the commodity prices is also the overall liquidity and attractiveness of the commodity as an asset class. We are already witnessing redemption pressure from the commodity-dedicated global fund as investors have withdrawn around USD 1.5 billion from commodity funds in the month of July 2015, on track to be the largest net outflow since March 2015, further putting pressure on commodity prices.

Regardless, if we look at the historical relation between commodity prices and the US dollar, the correlation is not so obvious. For example, during the boom years of the 1990s there was almost no relationship between the US dollar and commodity prices. Then, in the recovery after the dotcom bubble bursting from 2003-2006, the relationship weakened again. However, we need to look at what had happened earlier to commodity prices when we were approaching US Federal Reserve rate hikes. This is because any hike in policy rates by US Fed will further strengthen the US dollar and weakens the commodity prices. We find that June 1999 – May 2000 and June 2004 – June 2006 were the periods of both rising interest rates and commodity prices.

According to a report by Schroders’ Multi-Asset Group, between 1990 and 2015, 61 per cent of the time there was a negative correlation between the US dollar and commodities, and 39 per cent a positive correlation. This 39 per cent can be further subdivided into 23 per cent for both commodities and US dollar rising and 16 per cent for both US Dollar and commodities falling.

Nevertheless, every cycle has its own characteristics and needs to be assessed against the respective macro-economic and financialmarket backdrops. There was positive correlation between USD and commodity prices when the global economy was in a much better shape and was witnessing acceleration. Currently, however, we are staring at deceleration in global growth and hence may not see the same impact of rising commodity prices in case of tightening of policy rates by US Fed.

Commodity Prices: Pain to Persist

Commodity prices globally underwent an extraordinarily strong and sustained boom from the start of the millennium. The rise was so strong that it has been characterised as a ‘super cycle’. Since 2012, however, it has been losing its momentum that has been accentuated in the last one year. Going forward, all the three important factors discussed above are not helping the commodity prices to prop up.

The Chinese economy, after growing at an average rate of 10 per cent for more than three decades starting 1979, is showing signs of fatigue. This year i.e. 2015, according to various estimates, the Chinese economy is expected to grow below 7 per cent, well below its last 20-year average. This is despite the government’s effort to bolster economy through bold monetary policy easing and providing fiscal stimulus. In the month of June, China’s central bank PBOC cut its one-year benchmark lending rate by a quarter of a percentage point to 4.85 per cent; at the same time it also lowered the reserve requirement by half a percentage point.
[PAGE BREAK]

The government also announced that it has set aside USD 260 billion for spending in infrastructure to boost the economy. However, the main downside risk to the economy in the short term is the sharp correction in the stock markets, which could translate into financial turmoil and dampen growth. Moreover, the government is trying to change the structure of the Chinese economy, which is dominated by investment and export to consumption-oriented, which may not require the same type of commodities, thereby impacting the demand.

The prices of commodities will also remain dampened due to an expected rate hike by the US Fed by the end of the year. Most analyst expect the first hike in September, but Federal Reserve chair Janet Yellen has emphasized that any increase will be determined by the latest economic data. In a statement issued after its latest meeting, US Fed said that economic activity has been expanding moderately in recent months and even noted that the job market, housing and consumer spending had all improved. This clearly signals that a rate hike is imminent and commodity prices will remain under pressure. This might also entail more money flowing out of the commodity market, and thereby keeping commodity prices under check.

Commodity Prices and Indian Equity Market

Any fall in the commodity prices creates its own winners and losers both in terms of country and market. Therefore, fall in commodity is adversely impacting various commodity exporting countries like Brazil, Australia and many Gulf countries. However, it bodes well for countries like India that remains net importer of commodities. This holds true if currency is not working against us. In last one year we see that Indian rupee has not depreciated the way commodity prices have slumped. Nonetheless we should not paint the entire Indian Inc with same brush.  There are some companies that are clearly benefiting out of this rout in the commodity prices while there are some that are taking the brunt of this fall. A case in point is BPCL, which is trading at its 52-week high and NMDC that is trading at its 52-week low because it is feeling the pinch of fall in commodity prices. In CNX Nifty, almost 30 per cent of the companies are directly impacted by the movement in commodity prices and similar is the case with BSE Sensex. Hence it becomes important for us to study the impact of the direction of commodity prices. So what is the net impact of all these factors on the final direction of the frontline indices?
[PAGE BREAK]

To know this we did a regression analysis between the Sensex monthly returns and CRB Index monthly change between January 2006 and July 2015. There emerges a surprising fact, which is that there is a positive contemporaneous correlation (same month with no lags) between movement in commodity prices and Sensex returns. What this means is that when there is a fall in the commodity prices the Sensex also falls and vice versa. What explains this conundrum is that it takes some time for the impact of fall in commodity prices to trickle down to corporate earnings and finally into equity indices. This is proved if we try to find the correlation between the movement of CRB Index and Sensex with a lag of two quarters. There is a negative correlation between them. This negative correlation with a lag effect is not difficult to understand. As companies carry inventory of normally anywhere between 30-60 days, the real impact of fall in commodity prices is reflected only after this high-cost inventory is cleared.

An analysis by CRISIL of about 250 CRISIL-rated companies including refiners, traders, polymer processors, and bulk and specialty chemical manufacturers, expects aggregate inventory losses of players in the oil chain to be around Rs16,000 crore in the third quarter of FY15. These companies have an average total inventory holding of about 45 days; it typically ranges between 30 and 60 days, depending on the location of plant, processing time, and price outlook.
[PAGE BREAK]

Impact on Various Sectors

What does the above narrative boil down to? In the following paragraphs we will talk about some of the important commodities and sectors and how companies in these sectors are going to get impacted.

Crude Oil

Crude oil, which is often called “black gold” has lost much of its sheen in the last one year. The reason for this is the simple economics of supply and demand. According to US’ Energy Information Administration (EIA), global liquid’s production continues to exceed consumption, resulting in inventory builds. Global oil inventory builds are estimated to have averaged 2.2 million barrels per day(b/d) through the first half of 2015 and are projected to average 1.5 million b/d during the second half of the year. The expected inventory builds in 2015 are on top of an estimated 0.9 million b/d increase in 2014. By 2016, inventory builds are expected to moderate to 0.6 million b/d. This will check any price rise anytime soon and crude price touching above USD 100 per barrel is relic as of now.

Suppressed crude price augurs well for oil marketing companies like HPCL, BPCL and IOC directly as it will reduce their subsidy burden on kerosene and LPG (petrol and diesel are decontrolled). It will also benefit companies that use crude or crude derivatives as inputs, such as manufacturers of plastic products, synthetic textiles, tyres and paints that will see margins expanding due to lower input costs. FMCG companies that use crude oil derivative-based raw materials and also for packaging will stand to profit from this fall in crude oil prices.Companies engaged in exploration and production such as Cairn India and ONGC will see their realisation declining and hence impacting their performance.

Metals

Metal prices are witnessing a multi-year low thanks to the concerns discussed above. What is also more worrying is that we do not see respite coming soon. China’s latest manufacturing Purchasing Managers Index (PMI) fell to a final reading of 47.8 in July, a two-year low. A number below 50 indicates economic contraction. China continues to have an outsized impact on the metal prices and slowdown of activities in China does not bode well for metal prices.

Ferrous Metals: We believe steel companies will find pressure on the sales front as realisations are set to decline with prices of steel down by 5 per cent in the last one quarter due to cheap imports largely from CIS countries and China, which resulted in price cuts. Hence, all the major steel companies like Tata Steel, JSW Steel, SAIL, etc. will remain under pressure and this is reflected in their stock prices, anywhere down by 30-50 per cent in the last one year. Integrated players such as SAIL are going to hurt more due to a sharper fall in raw material prices (iron ore and coking coal) compared to ferrous prices.

Non-Ferrous Metals: The fate of non-ferrous metal is not different from ferrous metal and prices of metals such as aluminium, copper, lead and zinc have also fallen considerably. However, their demand will not decline as has been the case with ferrous metal because it comes from the consumption-linked sector. Companies like NALCO, Hindalco, Vedanta, and Hindustan Copper will get impacted adversely. Zinc industry players are likely to benefit from improved fundamentals. Domestic realisations and operating profitability in FY16 are likely to improve due to an increase in metal demand amidst a global supply deficit.

Agro Commodities

Agro commodities too are witnessing the same trend as other commodity prices. After peaking in January 2011 they are witnessing a continuous fall reflected in the movement of the Commodity Food and Beverage Price Index by IMF. In the last one year alone it has declined by 18 per cent. This fall is primarily going to help FMCG companies and those engaged in such segments as beverages, textiles and tyres.
[PAGE BREAK]

“THE OUTLOOK FOR COMMODITIES IS LIKELY TO REMAIN WEAK”

An interview with Dhananjay Sinha, Head of Research, Economist & Strategist, Emkay Global Financial Services Limited

Commodity prices have plunged in the last few months. How do you see the prices of different commodities to behave during the rest of CY15?

The decline in commodity prices has been happening since early 2011 and recently got accentuated due to lagged correction in global crude prices. The decline in commodity prices has occurred across soft and industrial commodities and is now being exhibited in the oil sector. The key factor behind the correction has been the sub-normal global growth post 2008. The recent concerns emanate from the weakening growth scenario in China and other emerging countries. In advanced economies which are net importers, the demand has been weak and in case of global crude, the supply/demand ratio has got a further boost following the recent US-Iran agreement, which has lifted the embargo on oil supplies from Iran.Overall, given these factors, we believe that the outlook for commodities is likely to remain weak. We do not expect any significant bounce-back. In fact, we expect commodity prices to linger around at the current lows.

We believe the decline in commodity prices can be an important risk factor for the emerging market countries, especially for those that are exporters of commodities. Decline in prices has marred their growth prospects, thereby necessitating sharp currency depreciation. We have seen this phenomenon in countries like Russia, Brazil, Venezuela, Indonesia, Malaysia, etc. While currency depreciation would partly compensate for decline in realisation from commodity prices, which is denominated in US dollar, currency volatility can expose these countries to financial market and economic instability if they are exposed to large foreign portfolio investments. So the combination of decline in commodity prices and currency depreciation can be a double-edged sword for EMs.

How is it going to impact the overall performance of India Inc.? Will it even lead to slowing down of the economy?

The common understanding is that the decline in commodity prices, especially crude, will infuse additional impetus to the Indian economy and corporate earnings. The line of argument is familiar: Lower crude prices hasten disinflationary pressure, lower imports, reduce oil subsidy and lower fiscal deficit and rates, thereby boosting earnings and ratings. The underlying assumption behind this argument is the inverse correlation between commodity prices and India’s GDP growth and earnings. However, our study has indicated that the empirical data is quite contrary. The correlation between crude price (YoY) and India’s real GDP growth and corporate earnings is predominantly positive, implying that growth in GDP and corporate profits rise/fall with rising/declining crude prices.

Historical data since mid-1990s indicate a positive correlation (+0.4) between growth in operating profit and crude price. Hence, these correlations do not support the commonly held perception.This is clearly borne out from a review of corporate performance since mid-FY15 when decline in commodity prices hastranslated into contraction in sales and profits of Indian corporates. The depressing impact it has had on tax collections of the government has induced spending cuts and hikes in indirect taxes, both of which have decelerated India’s growth performance. The fact that the Indian currency has remained resilient, depreciating only modestly, has not helped improve growth performance.

Which are the sectors that will be losers and gainers of this precipitous fall in the commodity prices?

Given the strong correlation between raw material costs and commodity prices (both crude and metals), it will be logical to expect margins of companies to expand on the back of softening in commodity prices. However, given the decline in pace of sales growth, which indicates weak demand condition, the benefit of lower commodity prices will be limited to sectors and companies that can demonstrate strong pricing and market power.While sectors like automobiles, FMCG, oil and gas, power and metals benefit from decline in commodity prices, pharmaceutical and real estate are less impacted by any change. Automotive and automotive ancillary have benefited the most. Consumer durables seem to have a low correlation. Decline in transportation cost on the back of fall in crude prices can benefit cement companies. For most sectors, decline in commodity prices impacts the raw material/sales ratio with a lag of two quarters. The immediate impact is weak due to a lagging raw material inventory cycle.

Do you prefer any particular strategy to play commodities in 2015?

Softening commodity prices can potentially expand the margins of companies. However, the benefit of lower commodity prices will be limited to sectors and companies that demonstrate strong pricing power. Based on the above theme, we will remain underweight on metals and mining sector. With respect to FMCG, decline in realisation for farm sector commodities will keep the rural theme vulnerable, thereby prompting us to remain overweight on the urban theme. The automotive sector is a clear beneficiary due to quick transmission of decline in commodity prices on earnings. As argued above, we continue to expect the Indian rupee to depreciate and hence maintain overweight on IT and pharmaceutical sector. We have been overweight on oil and gas, especially PSU OMCs. Depressed commodity prices have the potential to aggravate asset quality issues as servicing of past loans become difficult with price deflation, including commodities and other assets. Hence, we have been underweight on PSU banks. We are also underweight on the real estate sector.