Monday 09, January 2017 by William Mullally

Metals and soft commodities 2017's early risers

By Ole Hansen, Head of Commodity Strategy, Saxo Bank

A holiday shortened first week of January saw plenty of action across the commodity space. A busy year awaits where Donald Trump, China and Opec will have a major impact on the performance of a sector which returned to profit in 2016 for the first time since 2010. 

The failure of the dollar and bond yields to continue their post-US election ascent brought some relief to precious metals. However it was the metal minnows of platinum and palladium that stole attention among the metals. Strong gains was seen on the back of an improved outlook for demand from the automobile industry. 

Soft commodities raced higher on supply concerns while the star performer of 2016, natural gas, slumped on warmer weather thereby pulling the energy sector down on the week.

Among the other drivers receiving attention was concern about the ongoing capital outflows from China. The Chinese government tried to stem this capital flight by reducing liquidity in the offshore version of its currency, thereby pushing the overnight funding of short positions above 80 per cent. 

Trump-day is approaching and with that the market is likely to adopt a cautionary approach considering the risk of a protectionist president and the inflationary impact of his promised policies.

Annual index rebalance to attract buying of agriculture commodities 

The two major commodity indices – the S&P GSCI index and the Bloomberg Commodity index which we tend to use when measuring performance – will go through the annual process of rebalancing holdings from January 9 to 13. During this time the index weightings are adjusted in order to align existing positions according to the individual performances during the previous year. 

These two indices have, according to data from Morgan Stanley, a large investor following that currently sits at around $115 billion ($55bn GSCI / $60bn BCOM).

Generally, the exercise involves buying/increasing the exposure of commodities which suffered losses during the previous year at the expense of selling/reducing commodities experiencing gains. In addition, the overall target weight of an individual commodity or sector can also be adjusted, while old contracts can be removed or new added.

According to the latest calculations, the agriculture sector, with the noticeable exception of sugar, will see increased buying during this period. This is especially the case for corn, wheat, soybeans and live cattle. 

Apart from sugar, selling will be seen in Brent crude oil and natural gas while gold will be bought. These transactions are well-flagged and known to the market in advance but may still create some movement. This depending on the available liquidity i.e. the amount of buying/selling relative to the number of outstanding contracts, the so-called open interest. 

Hedge funds exposure heavily skewed towards energy sector

Large investors such as hedge funds and money managers ended 2016 holding a net-long commodity exposure of 1.7 million futures lots. This compares with just 0.1 million at the end of 2015. The energy sector represents 70 per cent of this exposure with record bets having been placed on Opec successfully implementing production cuts to ensure higher crude oil prices. 

Natural gas also saw strong speculative demand during a very cold December. This helps to explain why a milder January outlook caused a heavy correction this week. 

Gold rose to a four-week high following a continuation of the recovery seen since mid-December when it hit a low point of $1,123/oz. Gold has a strong correlation with the Japanese yen and US real yields. Following the initial selloff in US bonds in the aftermath of the US presidential election, we saw a big jump in US 10-year real yields from 0.11 per cent to 0.70 per cent . During the past three weeks, however, it has dropped back to 0.37 per cent thereby removing some of the pressure on gold. 

The rapid yen weakness following November 8 Presidential election also helped remove support for gold but after hitting a high on January 3, USDJPY has since retraced to hit a three-week low. 

The wave of long-liquidation hitting gold, especially following November 8 continued right up until the end of 2016. Following seven consecutive weeks of selling, hedge funds held a net-long of just 41,247 lots in the week ending December 27. This was the lowest since February and down 85 per cent since the July peak. 

Holdings in exchange-traded products backed by gold remain elevated but are showing signs of stabilising following non-stop selling since November 8. At this early stage of the year we are unlikely to have seen much in terms of real money buying but several event risks have helped stir up some attention. 

Physical demand from China and India remains robust. In China demand is being driven by yuan-devaluation worries combined with Chinese New-Year demand. In India, the cash crunch following the removal of high denomination currency notes has triggered safe-haven demand. 

In addition to this we are seeing signs of a Trump hedge being played out in gold. As we approach his inauguration on January 20 concerns about protectionist and inflationary policies will come increasingly to the fore. 

Gold has established some support at $1,162/oz. and continued support from a weaker dollar and bond yields has the potential of seeing a retest of key resistance between $1,195 and $1,205.

Platinum and palladium were the star performers of the week with both rising strongly. Booming car sales and strong US and Chinese manufacturing data and the end of heavy investor selling during December gave palladium the perfect start to January with platinum enjoying being caught up in the slipstream of its advance. The month-long downtrend in platinum was broken and this helped reduce the discount to gold to just $210, the lowest since last August.

Bullish oil momentum but beware of correction risk

The expected kick-off of Opec supply cuts helped carry WTI and Brent crude higher on the first trading day of the year before a sudden drop of more than 5 per cent ensured a range-bound market for the remainder of the first trading week. 

The focus during the coming weeks will be squarely on the commitment of Opec and non-Opec producers to cut output. News that GCC members from Kuwait, Oman, Abu Dhabi to Saudi Arabia had started to cut production helped keep the market supported. This happened despite news of rising production from Libya and raised concerns that Iraq could be struggling to deliver the promised production cut.

The US weekly inventory report was perceived as bearish with a larger than expected inventory drop being driven by refiners reducing stock for end of year tax reasons. A huge jump in product stocks and a near record level of inventory at Cushing, the delivery point for WIT crude oil futures, further added to the downside.

The biggest risk to oil markets during the coming weeks and one that could yield a major correction is the record speculative position currently held by hedge funds. The combined long position in Brent and WTI crude oil reached more than 900 million barrels in the week ending December 27. The sudden 5.5 per cent sell-off last Tuesday for no apparent reason was a clear sign of this current danger stemming from a very one-sided market positioning.

Any change in the current positive outlook carries the risk of longs being reduced. This could come either from emerging signs of cheating and/or a continued increase in production from troubled countries such as Nigeria and Libya that are exempt from cutting. 

We view upside potential on Brent crude oil beyond $60/barrel as limited at this stage. The forward curve on Brent crude is currently seeing the highest price during September. This is happening on the assumption that the production cuts will only last six months and that US production is likely to pick up speed into H2 of 2017.

Brent is currently trading within an uptrend which is targeting $65. An already very long position combined with the risk of cheating and rising production from countries such as Libya, Nigeria and the US is however likely to cap the upside towards $60. 

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