Is This Proof That Commodity Prices are Set to Fall?

Since I took over writing Money Morning every Wednesday I have focused on giving you an insight into my technical approach to trading markets.

But today I’d like to start by having a squiz at some interesting developments in the commodity markets.

I’ve noticed a distinct rise in articles referring to speculative commodity stockpiling in China and elsewhere.

An ANZ commodity research report from this week focused on something called ‘contango financing’ in the aluminium market. In a moment I’ll explain why you should take notice of this obscure term, and what it means for commodity markets…

According to the report:

‘The aluminium market is facing a supply shock in 2014 when prices could drop by 20% or more in a very short period. We expect around 70% of on-warrant and off-warrant stocks, or about 8 million tonnes of metal tied up in financing deals, to come to the market around the middle of 2014. The trigger will be rising interest rates, which will make contango financing unprofitable.

‘Contango financing – buying cash metal at a discount, selling forward at a premium, then using the difference to cover the cost of storage, interest and make a profit – has increased significantly since the global financial crisis. Low interest rates have caused investors to seek yields in alternative investment structures and financing metal remains a relatively low risk opportunity. However, margins can rapidly shrink as costs, primarily interest and warehouse rents, go up.

‘The metal locked away in these deals could amount to around 8 million tonnes or 15%-20% of global supply.’

This is scary stuff.

Then I read a Bloomberg article on Mike Shedlock’s economic blog, Mish’s Global Economic Trend Analysis. The article notes:

‘cotton stockpiles in China, the world’s biggest importer, are set to climb to about 9 million metric tons this season, enough to cover the country’s deficit for the next six years, according to Allenderg Cotton Co.

‘Inventories are rising as the government boosts purchases to support domestic prices and lift farmer incomes, Joe Nicosia, chief executive officer of the worlds largest cotton trader, said at a conference in Hong Kong today.’

A China Daily article from the same website focuses on the problems ahead for the Steel industry:

‘China’s steel industry is a big cause for concern in the fourth quarter due to shrinking demand and heavy losses, according to an industry official. The fears were outlined by Huang Libin, an official from the Ministry of Industry and Information Technology, in an interview with China National Radio.

‘The steel sector’s performance has been bad since the beginning of the year,” Huang said. “Their revenues are falling and demand remains weak.” The entire steel sector is now operating at a loss and struggling with problems of oversupply and a broader economic slowdown, he said. MIIT data show that 45 percent of the country’s steel companies suffered losses in the first nine months of 2012.’

It seems quite clear to me that we’re seeing distortions in many hard and soft commodity markets. Some are due to central bank meddling in interest rates, which is forcing investors to look for ingenious ways to make a buck (contango financing) and some are due to government interference (Chinese subsidies for cotton).

But the end result is the same: inventories going through the roof while growth comes off the boil.

A Leg Down Coming in Commodities

I find it hard to believe that we’re not close to another serious leg down in commodities.

I think the catalyst for such a fall will be any signs that Chinese macroeconomic data is shifting back to the downside.

So economic data such as this Thursday’s release of the HSBC flash PMI will be worth keeping a close eye on.

Murray Dawes
Slipstream Trader

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