5 commodities to drive the markets in 2012

Commodity prices dominated the headlines in 2011. There was complete drama unfolding on the commodity pricing front, from rising crude oil prices to declining base metal prices. Commodity-led stocks constitute almost 35 per cent of the total market cap of the top 50 companies (based on market cap). Naturally then, the price scenario with respect to commodities has significant influence on the
stock market as well. This is precisely why it becomes important to understand and gauge the future dynamics of the commodity prices to figure out the probable direction of the equity markets going forward.

To understand the determinants of commodity prices, we need to go back a little and understand the sea change in the way commodity prices are determined that has come about in the last decade. Two events that really impacted the way commodity prices have behaved are the financialisation of commodities and the emergence of China as a commodity- consuming behemoth. “China has consistently been the single-largest mover of commodity prices for the last few years”, says Jayant Manglik, President – Retail Distribution, Religare Securities. At the start of the decade, China consumed just 10-15 per cent of the entire global commodity produce, but this has now increased to the range of 35-45 per cent. Therefore, any change in the consumption pattern of China has a significant impact on the prices of commodities globally.

The financialisation of commodities, which implies a growing presence of financial investors in the commodity markets, can be traced back to 2001. After the dot-com bust, financial investors were in search of greener pastures, and that search led them to the  commodities market. This is evident from the swelling of assets under management (AUM) dedicated for commodities from a mere USD 10 billion in CY01 to around USD 400 billion currently. If you consider this as a percentage of the global GDP, the AUM for investing in commodities have increased from a little over 0.03 per cent to 0.65 per cent during the same period. However, this fund flow is now more determined by liquidity rather than a simple demand supply situation of a commodity.

The downward spiral in the commodities market in 2011 (except for crude, which has more to do with geopolitical issues) had a lot to do with these two factors. In fact, Sterling Smith, Market Analyst, Country Hedging, Inc. expresses liquidity as one of the key concerns going ahead. “I have concerns about the first three-six months of the year. The problems in Europe should lead to a significant short-term slowdown in the Euro zone, which will weaken the demand for physical commodities and also reduce liquidity and
speculative demand”, Smith opines. The relation of fund flow and commodity prices is exemplified by the flow of funds into commodities AUM and the performance of S&P GSCI, a benchmark for commodity prices. Between May and October 2011, commodity dedicated funds have seen an outflow in excess of USD 8.5 billion due to the volatile situation in the Euro zone. During the same period, the S&P GSC Index was down by almost 25 per cent.

The second factor, i.e. commodity consumption in China, is not helping to contain the price of commodities either. The growth in the demand for commodities in China initially relied on the huge infrastructure requirement and then the construction boom. However, recent data shows that this trend is slowing down. Manglik reiterates this view, saying, “China, which is the world’s largest consumer of metals, is showing signs of slowing down, and this fear is driving prices down”. This sentiment is shared by Amar Singh Deo, Head of Commodity Research, Aditya Birla Money. “The year 2011 witnessed a slowdown in the housing market in China following monetary
tightening measures to tame inflation, which led to a sharp fall in commodity prices, especially base metals”, explains Deo. This has resulted in the fall in the prices of some of the commodities like copper, as China is the largest copper consumer in the world – the
country accounts for 40 per cent of the global consumption, with the residential sector making for most of the consumption.

Even as the broader market grapples to come to terms with the volatility in commodity prices, here is an analysis of the five principle commodities and how they would behave over the next one year. We have covered steel, copper, crude oil, aluminum and cement
and analysed them based on various factors, with the intent of determining their probable price behaviour.[PAGE BREAK]
ALUMINIUM

A slowdown in economic growth this year has resulted in the worsening of fundamentals in the aluminium sector. Lower economic
growth in the future is expected to hurt demand for aluminium going forward. The price of aluminium on the London Metals Exchange (LME) has tumbled by 24 per cent from its recent peak in April 2011 to levels of around USD 2000-2100 per tonne. In the current
market, aluminium producers are feeling the pinch of poor prices and rising costs, which paves the way for production cuts. The domestic aluminium prices in China are also significantly higher than the LME prices, but roughly 40 per cent of the industry is losing
money on a cash cost basis.

The global aluminium output has come under intense pressure owing to poor prices and sticky production costs. The output fell to a six-month low in October 2011, according to official figures from the International Aluminium Institute (IAI), as production in China decreased sharply. The pipeline for capacity expansions outside China looks relatively dry, and is heavily dependent on expansions
in India, where the output has disappointed already. Planned expansions in China are decent, but could be hurt by poor profitability and power-related constraints amid recurring power shortage issues in China.

According to the China Electricity Council, the current power shortage could last until next spring, but may be alleviated by the recently-announced hike in power prices and the cap on coal prices from January 2012. This exerts an upward pressure on Chinese production costs without self-generated power. Although the current prices incentivise production cuts, especially in China, it is expected that the prices may remain at the current depressed levels for a while. Shutting down and restarting production is costly. High premiums provide some offset, costs can come down further and history suggests that prices must trade at current levels on the cost curve for a sustained period before any cuts are made.

Rio Tinto, the world’s largest producer of aluminium sees a credible risk in China. Continued escalation in coal prices is going to put pressure on aluminium prices going forward. China has witnessed a strong demand for the commodity, and that may keep the prices stable. Smith says, “Aluminium prices are likely to remain stable in 2012”. However, capacity is expected to expand at a slightly higher pace than the demand next year. One could expect a largely balanced aluminium market for the next couple of years.

The current aluminium prices are considered too low compared to the operating costs. The short-term outlook remains challenging, as the industry experiences higher input costs and lower LME prices, which are currently well below the industry’s marginal cost
of production. The cost curve is expected to sharpen, mainly because of the rising energy costs. The effects of events across the globe are likely to have a ripple effect on India too. The performance of companies like Hindalco and National Aluminium will be hampered
going forward.

Top Companies That Are Likely To Be Affected: Hindalco, Nalco[PAGE BREAK]
CEMENT

Cement is one of the basic commodities necessary in all aspects of community and economic development. Very vital for setting up a
strong and healthy infrastructure, the production, demand and supply of cement play a crucial role in the economic development of any country.The demand for cement is a derived one, as it depends on industrial activity, the real estate market and construction activity in general.

India’s total cement capacity stood at 286 MTPA in FY2011. During FY2010-11, the country’s cement capacity increased by 55 MTPA. The huge capacity addition coupled with low demand growth led to a decline in the utilisation levels to 73.8 per cent in FY2011.Over FY2012-13, it is estimated that another 31 MTPA of capacity will be added. Of this, around 20 MTPA capacity is expected to be added by March 2012 and 11 MTPA in FY2013. On a YTD basis, 7.5 MTPA of capacity has been added in FY2012

The all-India capacity utilisation stood at 73 per cent in FY2011. For H1FY12, the utilisation has reduced even further to 71 per cent. As mentioned earlier, the huge capacity addition that the Indian cement players have initiated since 2007 has led to a glut that has hindered capacity utilisation and also has led to price-competitiveness. After moderate growth in FY2011 and tepid growth in the
current year, the cement demand may pick up pace only in FY2013. This essentially means that demand for cement is likely to remain sluggish throughout 2012.

At present, India is passing through a phase of political inertia. This is impacting infrastructure-related growth, and hence, the demand for cement too is on the lower side. The forthcoming state elections may bring in some uptick in the infrastructure activity. But, it should also be remembered that the government has to come  up with bold steps to rejuvenate infrastructure activities that were in cold storage for a long time. We are not bullish on the prices moving upwards. The phenomenon may take place on a region-wise basis, and one has to keep a close track of the commodity and play a wait-and-watch game before taking any call on it.

Top Companies That Are Likely To Be Affected: ACC, Ambuja Cements, UltraTech Cement, Shree Cement, Madras Cements[PAGE BREAK]
COPPER

Copper - which is also known as ‘Dr Copper’ due to its widespread industrial application in construction, electrical, consumer products, etc - makes it an economic bellwether. Therefore, it is no coincidence that the worsening global economic condition is accompanied by a sharp fall in copper prices. Since March 2011, copper prices have fallen by almost 30 per cent. Shakeel Ahmed, CMD, Hindustan Copper, explains such a fall by saying, “There are actually two drivers of copper prices: one is the Chinese economy and the second is the US economy. At the current moment, the Euro zone crisis is the biggest dampener that has led to a correction in the prices of copper”. There would have been a further fall had there been no production cuts in Chile, Peru and the United States by four per cent that account for almost half of the copper ore production globally.

However, China, which accounts for around 40 per cent of the world’s copper consumption, influences copper prices in a major way. The current weakening in the copper prices has a lot to do with what is happening in China. According to the International Copper Study Group (ICSG), China’s apparent usage declined by six per cent in the first half of the year. Its refined copper imports too declined by 40 per cent. This was mainly due to a lack of seasonal restocking that Chinese buyers undertake during the spring. Instead, they turned to drawing on inventories amid historic high prices and tight credit conditions.

Going forward, the copper prices in 2012 will be determined by the inventory cycle of China and the economic data coming from the USA and Europe. According to the ICSG, the world copper usage for 2012 is expected to grow by 3.6 per cent, mainly supported by a growth of six per cent in China. However, if we want to put a range to the price of copper this year, it would be at USD 4000 at the lower
end and USD 8000 at the higher end. According to Ahmed, “My mining cost of production is USD 3000 per tonne, but since we have fixed costs of other activities, it takes it to around USD 4000 per tonne”. This is applicable to almost 90 per cent of the total producers of copper around the world.

As far as the upper range of copper prices is concerned, we believe that it will be around USD 8000 per tonne. This will result from the demand pickup in the latter half of 2012, as the US home sales data will improve further, Japan will start its comprehensive reconstruction programme after the tsunami and most notably, China’s power industry that solved its technical problems in 2011 will once again start demanding more copper. Ahmed agrees with this and adds, “I do not see it going above USD 8000 per tonne”.

Coming back to India, the country faces an imbalance between copper production and its smelting capacity. In 2010, India’s refining capacity was more than one million tonne, which requires 100 million tonnes of copper ore (assuming one per cent of copper content). Compared to that, we have mined merely 3.6 million tonnes of copper ore. Therefore, India has to import copper ore to feed its smelters. However, the demand for copper in India is just 0.6 million tonne, and the rest of the refined copper is exported. Hindustan Copper is the only company in the listed space that is vertically integrated and present in the entire value chain of copper. In addition to this, the other two major players that have major refining capacities are Sterlite and Hindalco Industries.

Top Companies That Are Likely To Be Affected: Hindustan Copper, Sterlite Industries, Nissan Copper[PAGE BREAK]
CRUDE OIL

Politics rather than economics plays a dominant role in determining the price of this commodity. The rise in the price of crude in 2011 again illustrates this point suitably enough. Brent crude oil prices have consistently remained over USD 100 per barrel since March
2011, which sadly has nothing to do with a significant increase in demand. Rather, we find that the global oil demand has continuously been revised downward. The International Energy Agency (IEA), in its recent monthly market report, lowered the global demand of crude oil by 0.2 million barrels per day (MBPD) to 90.3 MBPD, its fourth cut for the 2012 forecast. The rise in prices was more due to a disruption in supply from the Middle East and North African (MENA) countries, following political unrest there. However, we believe that in terms of supply, things will normalise by the second half of 2012. Moreover, OPEC alone is investing around USD 300 billion in the next five years, which will improve the spare capacity, leading to a softening of crude prices in 2012. Nevertheless, we cannot expect
the fall in crude prices to be as sharp as we saw in 2008, on account of an increase in the break-even cost of crude oil, which is about USD 80-90 per barrel. Therefore, in the absence of a robust demand, we expect the prices to be in the range of the break-even (USD 80-90/bbl) levels, unless there is any significant change in the equilibrium either due to demand destruction, or the breaking up of the Euro or any unforeseen political upheaval that causes supply disruptions. “Apart from the European crisis, concerns over Iran’s nuclear program will also dominate sentiments,” says Deo.

When we try to gauge the higher range of the crude prices, we find that, according to a Citi report, USD 120 per barrel is a pain point (though it is dynamic and will change with the movement of USD) when expenditure on energy would consume about nine per cent of the global GDP. Historically, this has proved to be recessionary for the world economy, and we believe that any increase in price above that will trigger more supply from the spare capacity that is currently at 2 MBPD, leading to downward pressure on crude prices. Hence, we feel that in the international markets, crude oil price will trade in the range of USD 80-120 in 2012.

Whatever happens globally, on the domestic front we cannot expect the price to be in that range, as we suffer from one extra risk point, which is the INR’s movement against the USD. The rupee has already depreciated by almost 18 per cent year till date, with most of that happening in the last four months. A depreciating rupee adversely impacts downstream companies like HPCL, BPCL, etc. and positively impacts upstream companies like ONGC. Since fuel prices are yet to be fully decontrolled, any increase in crude prices increases the under-recovery and subsidies that will impact the oil marketing companies adversely.

In the current scenario it is estimated that for every `1 depreciation against the dollar, the under-recoveries of staterun oil marketing companies increase by approximately `8400 crore and the net import bill goes up by `9000 crore. We believe that in 2012, the prices are going to be more stable than in 2011 and are likely to hover around USD 100 per barrel. However, this sector is still dominated by the state-owned companies, and the absence of any clear policy guidelines in terms of implementing the Kirit Parikh report on de-regulating the sector will make returns from this sector uncertain as the government can change its subsidy-sharing burden.

Top Companies That Are Likely To Be Affected: ONGC, Cairn India, Reliance Industries, Indian Oil Corp, Bharat Petroleum[PAGE BREAK]
STEEL

Steel was one of the worst-hit commodities last year, sandwiched between the rising cost of raw materials and falling product prices. Although steel prices (of different types) have fallen in the range of two to 20 per cent in the last six months across various geographies, raw material prices have remained at the same level and resisted wider commodity sell-offs. If we compare the prices of iron ore, which is a key raw material for steel, they are up by almost 40-45 per cent since last year, to USD 275 per tonne. This is on top
of the 27 per cent increase that we witnessed in the year 2010.

Domestically, events like the mining ban in three districts of Karnataka – Bellary, Tumkur and Chitradurga – did not help either. Bellary alone accounts for 16 per cent, or about 36 million tones, of the iron ore output in India. If we look at the cost of production of steel (including labour and other raw material costs), we find that it has increased by almost 40 per cent since last year against the drop in sales prices. All this is clearly reflected in the share prices of leading steel companies, which are trading at their 52-week lows.

We do not see any significant reversal in the situation in the next few months, as the scenarios supporting steel demand are deteriorating. Steel demand is directly correlated with economic activity or growth, and the current scenario does not paint a rosy
picture in this regard. The first concern is a much slower recovery in advanced economies since the beginning of the year, and the second is a large increase in fiscal and financial uncertainty, which has been particularly pronounced since August. Each of these developments is worrisome in isolation and in their interactions. Put together, they have resulted in a downward revision of the
world economic growth. The UN and the IMF have revised their 2012 growth projection downwards.

Other indicators too are pointing toward a deceleration in the demand for steel. Construction and auto are two sectors that are major consumers of steel, and both are showing signs of weakening.

In the US and in Europe, construction activity is weak and contracting, whereas there is some buoyancy in emerging economies owing to slightly better activity in the residential housing sector. The scenario on the auto front too is also not encouraging, with lower
sales being reported in both developed and emerging economies. Policy paralysis is adding another impediment to the demand growth for steel – lower infra spending by the government results in lower demand of steel, since infrastructure is a major consumer of
steel (almost 50 per cent).

Going forward, we believe that the steel sector will continue to face headwinds for the next six to 12 months due to lower demand and higher production, which will lead to carrying stock at higher costs. Indian companies will be impacted to a greater extent due to a depreciating rupee that definitely keeps raw material prices up. Companies will also be exposed to higher mark-to-market losses on
account of foreign borrowings.

Top Companies That Are Likely To Be Affected: SAIL, Tata Steel, JSW Steel, Jindal Steel & Power, Monnet Ispat

CONCLUSION

According to us, the year 2012 will be a year of two distinct halves, as prices are expected to remain weak in the first half and will rise from there on. For 2012, Smith says, “I see copper remaining the strongest of the group, followed by cement and crude oil. I look for weakness in steel and stability in aluminum.” One of the reasons, he holds, is that “the weakening Euro will also allow for the US dollar to rally, which in turn, will further pressure the prices of commodities”. However, any sign of a deeper recession in the US
and Europe, as well as a hard landing by China may push the commodity prices further down. We believe that some sort of quantitative easing from the Euro zone and improving US economic data will lead to a surge in commodity prices in the second half.