With manufacturing on the upswing, raw materials are eating into margins, leading companies to new levels of hedging and renewed cost-containment efforts.
The comeback of the commodities markets, which took many by surprise, is a welcome sign of renewed economic life. The surge in raw materials, mainly metals and energy, coincides with the first synchronized global recovery in the nine years since the financial crisis. Manufacturing has been gaining strength in all major regions, sparking fresh demand for raw materials at a time when supplies are tight and production more rational. This follows a six-year period of massive readjustment that included mine closures, restructurings and consolidation. Now, corporate leaders in businesses that profit from mining, energy or basic materials are growing decidedly more upbeat, displaying the confidence that comes with an uptick in new orders, higher-than-expected earnings, widening margins and improving cash flow as price hikes are pushed through.
“The market has never been more fascinating than it is now, especially for commodities,” says Robert Ryan, senior vice president for commodity and energy strategy at Montreal-based BCA Research. Current conditions call for broad exposure to the asset class, he says, and he is particularly bullish on the oil market.
Yet for every gleeful raw-materials seller, there’s a buyer whose margins are squeezed if it can’t pass on the added costs. Executives in both supply-chain and finance roles are studying the issue from their respective vantage points.
“Corporates are looking at their commodity strategies and factoring in higher prices, determining how long-term their contracts should be and whether they should hedge,” says Deborah Stanton, executive director of CAPS Research, a global supply-management research company affiliated with the Institute for Supply Management. “They’re looking at how they can get leverage and negotiate agreements with an approach that will achieve pricing levels they need. If they are already locked in on pricing, they may want to extend the current agreement and negotiate better terms.”
It’s especially tricky due to changing market dynamics. Citi Research looked at the once-reliable inverse relationship between the US dollar and commodities. “This relationship broke down in late 2016, and the breakdown looks here to stay,” Citi analysts commented in mid-March, noting that in the fourth quarter of 2016 the Goldman Sachs Commodity Index rose 9% while the US dollar also rose, about 7% against other major currencies. It was, they commented, “the first quarter in more than a decade to see such a sizable divergence” from the prior trend.
Going forward, forecasts for commodities as an asset class are uniformly rosy, calling for outperformance in generally, with the outlook for the energy industry especially positive—even in the wake of oil’s recent selloff. The World Bank predicts strong gains for energy and industrial commodities this year. In December, Goldman Sachs, Wall Street’s biggest commodities dealer, recommended overweighting raw materials for the first time in four years, noting the cyclically stronger environment. Citigroup’s global commodity team, led by Edward Morse, sees 2016’s momentum carrying into 2017 and 2018 accompanied by higher returns.
“There is little doubt that for most individual commodities the bottom has been reached,” says Morse. “Prices are likely to continue rising, albeit in fits and starts, accelerating over the two- to three-year future horizon.”
Despite the buoyant prospects overall, industry analysts caution that gains likely won’t be across the board and volatility will escalate. China’s ability to manage its growth while delicately balancing shifts in its domestic policies will have important consequences. Rising interest rates in the US and a stronger dollar, combined with the potential for new tax and trade policies, also create potential for price shocks.
“I don’t think we would’ve had this rally if the underlying fundamentals weren’t already improving,” says Ed Yardeni, president and chief investment strategist at the eponymous Yardeni Research. Yet, against the backdrop of a strengthening global and US economy, Yardeni too expresses some worries, namely that Trump’s gloomy characterization of a US in desperate straits and his promotion of a “guns and butter” stimulus plan might be adding to the inflation threat.
The February purchasing managers’ report issued by the Institute for Supply Management showed manufacturing posted a gain for the sixth consecutive month. Raw materials prices remained high for the 12th month in a row. Companies responding to the survey noted strong sales and orders and maintained a positive view of business conditions, tempered by a “watchful eye” toward commodities and the “potential for inflation.”
International Paper Group (IPG) illustrates the two sides of the rising commodities coin. At an industrial conference in February, IPG’s new CFO, Glenn Landau, acknowledged that current good economic conditions are a positive for the company, although not without downsides. “Input-cost headwinds in the quarter have increased. OCC [old corrugated containers, a raw material for the paper industry] costs went up in February, and that alone, while a positive medium-term for our business, will impact the first quarter by an additional incremental $15 million,” he said. Such factors led IPG to push through some price hikes.
The industrial giant isn’t resting on those price increases, however. “We’re also executing a host of other cost-type initiatives that will allow us to impact any other inflation across the business,” Landau said. “So, we are expecting margin and earnings growth in IPG this year for sure.”
CAPS Research’s Stanton, who has served in the past as chief procurement officer for MasterCard, Honeywell, Temple-Inland and Whirlpool, says it’s critical to seek out savings in production. “Companies will have to think of other ways of driving efficiencies, because they can’t rely solely on resorting to price increases,” she says. “Innovation and applying advanced technologies—think of the automobile market and self-driving cars—allow companies to exact a premium for a product that can help in offsetting cost pressures.”
Eivind Kallevik, CFO at Norway’s Norsk Hydro, the world’s fifth-leading aluminum producer, points out that a 10% rise in the London Metal Exchange price of aluminum increases Norsk Hydro’s underlying cash flow by NKr3 billion ($354 million) a year, while a 10% increase in the Platt’s alumina price boosts cash flow by NKr340 million annually. He sees a “fairly balanced market for primary aluminum in 2017, with oversupply in China and undersupply in the world outside China.” Norsk Hydro, he notes, generally doesn’t hedge its currency or commodity positions but does have long-term energy contracts in place for a “large majority of its energy needs,” as energy represents the biggest cost in aluminum production.
CRUDE CUTS AND SOFT LANDINGS
The roots of the current liftoff in commodities can be traced to nine months before the US election, when the price of a barrel of West Texas Intermediate crude oil was slightly more than $26, the lowest since 2003. In mid-February, major oil producers, their economies on the brink, agreed to production cuts. Little more than a year later, oil is around $50 a barrel.
In addition, China dodged a widely feared hard landing, mainly by setting aside economic reforms and reverting to its “same-old, same-old” approach of extending credit to reflate its economy. That played a major role in the recovery of the industrial metals markets: China accounts for two-thirds of the world demand for base metals and 50% for steel. In contrast, the US only represents about 8% of worldwide demand for base metals and 7% for steel.
China wants to play a bigger role in commodities. “It’s important for China to establish international commodity pricing centers, as we can have a bigger influence on determining how much they are worth,” Fang Xinghai, vice chairman of the China Securities Regulatory Commission (CSRC), said recently. “However, our futures markets are far from being international enough to qualify as these pricing centers. We need to put our focus on opening up commodity futures trade and introducing foreign investors to our market.”
Fang spoke of growing demand from multinationals whose China-based operations want to trade in the domestic futures markets in order to hedge the cost of their raw materials inputs. Earlier this month, Dalian Commodity Exchange, one of four futures markets in China, announced that one of its priorities is to woo overseas investors. New players could alter the dynamics of futures trading in China, which, according to Haitong Securities, is dominated by retail investors, who contributed 67%of the total turnover of RMB177 trillion ($25.7 trillion) in 2016. “China needs to improve the regulatory environment and squeeze out excessive speculation, while attracting more industrial capital into the market, especially overseas industrial companies, ” Fang said. “Price discovery in China will be efficient if domestic markets are linked to global markets.”
These factors—OPEC’s efforts in the oil markets, China’s soft landing, fresh business optimism from Trump’s win—have has set the stage for a commodities comeback of epic proportions, following the worst price rout in more than a generation. For the first time in six years, most members of the asset class delivered positive returns in 2016. The S&P GSCI index rose 11% in 2016 after losing half its value in the two years prior—its first year of double-digit growth since 2009. Canada’s Raw Materials Price Index rose 17% in 2016, with higher crude energy and metal ores playing a large role. Indeed, the surge is mainly in the raw materials of manufacturing; agricultural commodities have been more mixed. This year, most observers see crude oil prices trading in a range between $45 and $65 a barrel, for an average about 30% above 2016’s average price.
Industrial metals should still shine in 2017, with prices projected to rise by 11% as supply tightens for most markets. Zinc, which is used in galvanized steel, could see price gains of 27% this year as it continues to benefit from mine closures and production cuts. Lead, used primarily in batteries but also in construction products, is projected to rise 18%, as supplies have been limited by mine closures. Copper, tin and nickel should also see double-digit gains. The outlook is more bearish for iron ore, which doubled in price from 2015 to 2016, on higher China inventories, record export levels and new capacity. Yet, proving how disruptive actions in Beijing can be, iron ore and steel futures soared recently (March 13) in China after a government official reiterated the goal to cut excess capacity in the steel sector.
The MSCI Emerging Markets index, tracking 23 countries including Brazil, China, Russia, India and Indonesia, has gained nearly 9% since the start of 2017, reflecting the ebullience surrounding commodities. The countries in this sector have withstood numerous shocks in the past few years, from deflationary commodity prices to massive depreciation in their currencies to protectionist trade policies. Manufacturing economies are showing surpluses in their current accounts, and commodity-exporting countries have made progress in reducing their deficits, notes Franklin Templeton’s emerging market team.
Not surprisingly, emerging market exchange-traded funds, which often act as a proxy for the commodity markets, have attracted more inflows year-to-date through March 13 than any other, with BlackRock iShares MSCI Emerging Markets ETF (IEMG) leading the pack with nearly $4.7 billion in asset flows since the start of the year—with $2.5 billion in February alone. It’s the best performance since 2010.
With the economies of Brazil and Russia stabilizing and improving, and China forecasting 6.5% growth, emerging market economies are on track to deliver 4.5% growth, outpacing the developed world, according to forecasts from the International Monetary Fund.
No one’s enjoying this comeback more than the commodity producers. “We are positioned to take advantage of the stronger alumina prices through our 3-4 million metric ton annual long position and our increasing share of sales on the Platts Index, which is 65% in 2017,” says Norsk Hydro’s Kallevik. “We are also well positioned to benefit from an increasing aluminum price by selling almost three million metric tons of mostly value-added products per year. We will also ramp up our automotive line in Rolled Products during 2017, which will give a stronger position in high-growing automotive markets.”
The rise in commodity prices may have been overshadowed by other investment developments last year, but in 2017 look for them to be center stage.
