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Commodity Outlook 2006 Breaking out of the "Comfort Zone"

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Title: Commodity Outlook 2006 Breaking out of the "Comfort Zone"


1
Commodity Outlook 2006Breaking out of the
"Comfort Zone"
Jeremy Baker, Senior Commodity Analyst, UBS
March 2006
2
  • A look back at what has been stimulating
    commodities globally

3
Drivers of a secular up trend in commodities
  • Globalisation
  • Treaties negotiated through membership of the
    World Trade Organisation.
  • Government Central Bank Policies.
  • Commodity inflation cycles were followed by
    deflation, peace dividend, cycles (19201933,
    1951-1965 1981-2001).
  • Geopolitics
  • Has the "peace dividend" evaporate with 9/11?
  • Lack of Capital Investment long lead times
  • Delayed major investment cycles, combined with a
    structurally induced shift in the demand curve
    and the long lead times will influence pricing
    and new investment opportunities.
  • Further Industrialisation Urbanisation of
    China.
  • China (a delicate giant), and S.E. Asia as a
    whole, is likely to become a longer term global
    economic power that will lead to massive raw
    material and processed goods consumption.

4
China's economy between Canada and Italy...
USD GDP rank as of 2003 2004
Sources IMF, UBS WMR
5
..but 2 in terms of Purchasing Power Parity
(PPP)
USD PPP GDP rank as of 2003 2004
PPP A theory stating that over the long term
the exchange rate between two currencies adjusts
according to currencies' relative purchasing
power.
Sources Maddison, IMD, UBS WMR
6
Reuters CRB (CCI) Futures Index - Real and Nominal
Have investors missed the cycle, or is it still
gaining steam?
Adjusting for US inflation (CPI), commodities
have been in a long-term downtrend.
Sources CRB, Bloomberg, UBS WMR
7
London Metal Exchange Real metal prices since
1969
Adjusted for inflation, metal prices are not
excessive
Sources LME, UBS WMR
8
  • Energy

9
Energy Are we approaching the end?
10
Fear and tight supply continues to dominate energy
"It is not that oil prices must come down due to
demand slackening, it is that prices have to go
up in order to get demand to slacken."
  • Oil price drivers split between HARD SOFT
    issues
  • HARD ISSUES
  • Demand growth - remains firm despite high oil
    prices
  • Limited OPEC spare capacity - greater risk of
    supply shock
  • Lack of non-OPEC growth - low cost oil exploited,
    new marginal barrel costlier
  • Reserves getting harder to replace - 2004 oil
    replacement rate at only 70
  • Strained refining capacity - more stringent
    environmental regulations
  • SOFT ISSUES - or better known as "Fear Factor"
  • Geopolitics (Saudi Arabia, Iraq, Nuclear
    stand-off in Iran, Nigerian strike action,
    Venezuela and investment anxiety in Russia).
  • Another extreme Hurricane Season in the Gulf of
    Mexico?

11
World oil demand comes from developing economies
Global oil consumption in 2005 was 83.5 million
barrels/day
  • 1990 the industry increased its reserves by 140
  • 2004 that replacement rate halved to only 70

Sources IEA, UBS WMR
12
Reserves are located in "sensitive" regions
OPEC share of global production will likely
continue to increase in the coming years.
Sources BP Statistical Review 2005, UBS WMR
13
OPEC "Spare Capacity" at critical levels
Spare Capacity is currently 2 million
barrels/day (mb/d)
  • Did OPEC "free" supply make up for loss of
    Non-OPEC supply growth in the 1980's and 1990's?
  • Massive investment is needed to replace lost
    supply volumes.

average 7.4 mb/d
average 2.6 mb/d
Sources OPEC, UBS WMR
14
  • Base Precious Metals

15
Base Metals inventories have been a key driver
of prices
Sources LME, Datastream, UBS WMR
16
Exploration success declined, supply growth
limited
Mining exploration success and expenditure from
1980
  • Long lead times involved from initial deposit
    discovery, feasibility studies and final
    production makes mining companies hesitant to
    commit large sums of capital to new "Greenfield"
    projects.

Sources BHP Billiton, MEG, UBS WMR
17
Company cashflows redirected to Acquisitions
The dichotomy between "old" "new" economies in
the late 1990's meant that exploration budgets
took a back-seat to MA activity.
Sources Metal Economics Group, UBS WMR
18
India and China a comparison
China's demand in base metals outpaces India
()
Sources Brooke Hunt, UBS WMR
19
  • Precious Metals and a growing theme

20
2006 A Precious year ?
Perceptions of risk increase interest in Gold.
  • Gold
  • Gold has regained significant investor status
    driven primarily on concerns about

Economic growth, Inflation
expectations,
Geopolitics, and Currency
concerns.
  • Platinum Group Metals and Silver
  • Platinum Positive impact due to tougher
    environmental regulations pushing demand for
    auto-catalysts.
  • Platinum beset with supply constraints and growth
    opportunities.
  • Palladium Jewellery demand (Asia) remains firm,
    switching from Platinum.
  • Silver driven by gold, copper and ETF
    speculation.

21
A growing theme
Agriculture Driven by China and Energy
Alternatives?
  • Agriculture
  • Agriculture commodities present a long-term
    opportunity.
  • China is likely to become a key importer of
    certain agricultural commodities.
  • Rural Chinese population highly dependent on
    self-production of food.
  • Yet, urbanisation is already having an affect on
    changing food patterns.
  • Other issues high energy prices influencing
    sentiment towards corn sugar used in Ethanol
    production.
  • Agriculture underperformed other commodity
    complexes in 2005.

Rural agricultural employment trend
Rural agricultural employment is declining due to
migration to urban regions.
Source Chinese National Bureau of Statistics,
UBS WMR
22
Characteristics of commodities
Commodity futures still an unknown asset class
despite being traded in the US for over 100 years
and elsewhere even longer!
  • Commodity Returns over the business cycle Over
    a long period (1959 2004) the average monthly
    annualized returns of the SP 500 and the
    equally-weighed commodity futures total return
    are very similar.
  • Correlation to other asset classes Over all
    horizons the equally weighted Commodity Futures
    total return is negatively correlated with the
    return of the SP 500 and long-term bonds. This
    suggests that Commodity Futures are effective in
    diversifying equity and bond portfolios.
  • Inflation Commodity Futures have an opposite
    exposure to inflation expectations compared with
    Stocks and Bonds. The correlation of Commodity
    Futures with inflation expectations is positive
    over all time horizons.
  • Source Facts and Fantasies about Commodity
    Futures, National Bureau of Economic Research,
    June 2004

23
Performance since 1991
Commodities, global equities, global bonds and
money market(Total Return Indices, 01/91
08/05)
Source Bloomberg (all data in USD)
Past returns are no guarantee for future returns
24
Commodity Conclusion
Booming commodity prices, but dont forget
  • After a strong year in 2005 for commodities,
    driven primarily by the energy complex, 2006 is
    likely to be a more challenging year as fears
    about sustainable economic growth could rise.
  • On a longer-term horizon, investors betting
    purely on commodity price increases due to rising
    demand from China should be aware of downside
    risks for individual commodities even in the
    context of a long-term secular trend.
  • We believe that commodities offer an attractive
    investment opportunity for investors due to the
    diversification benefits.
  • The historical negative bias towards commodities
    is unjustified as over a long-period, commodity
    futures have delivered a similar performance to
    that of global equities.
  • A longer-term driver in the consumption of
    commodities will come from continued expansion of
    Emerging Asian markets, which will be driven the
    desire for stability, employment and wealth.

25
Disclaimer
26
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