Commodities rebound, but face limits

By Dina Cover, Economist, TD Bank Financial Group

Forest product prices are projected to be among the top performers, with lumber prices expected to jump by 70% and newsprint prices to gain 50%.

As pieces of the global economic recovery fall into place and risk tolerance rises, global commodity markets are getting pulled along for the ride. Building on its 7% advance (quarter-over-quarter average basis) in the April-June period, the TD Commodity Price Index (TDCI) in U.S. dollars registered a third-quarter gain of roughly 5%. Had it not been for a slide in natural gas prices, the Q3 increase would have topped 10%.

During the summer quarter, the non-precious metals and minerals sub-index was by far the top performer, as it shot up by more than 20%. In contrast, the agricultural sector weighed on the index, falling by over 9%.

Further price gains harder to come by

Looking ahead over the next four to six quarters, gains in commodity prices will be harder to come by.

For a number of commodities, notably crude oil, nickel, zinc and precious metals, the fickle flows of investors — rather than any meaningful improvement in current supply-demand fundamentals — have been behind the recent rally. In fact, the challenge of excess stockpiles extends through most areas of the commodity complex.

The investment lure of commodities as a hedge against the U.S. dollar is likely to continue in the short run, but further scope for greenback depreciation appears limited. In fact, a respite in the U.S. dollar appears likely as 2010 progresses.

While we expect supply-demand conditions to strengthen in tandem with the global economy, the rate of economic recovery is likely to be gradual compared to past recoveries. Despite our upwardly revised growth forecast for a 3.8% rebound in world real GDP growth in 2010, the level of world output will remain quite depressed.

There is a considerable amount of excess capacity within most commodity areas. So as demand revs up, production can easily be increased. But, as demand picks up and prices begin a sustainable recovery, producers will be tempted to ramp up output in order to capitalize on the higher prices. As such, it will take a great deal of producer discipline to work down the excesses and balance the market.

Over the next few months, a scaling back in Chinese consumption appears to be an impediment to a sustained rally in forest products and base metals. In the first half of 2009, robust demand from China helped to underpin prices. However, it appears as though demand was not sufficient to keep pace with imports, leading to a rise in stockpiles and, more recently, a fall in forest product and metal imports into China. We suspect that this de-stocking trend has not yet run its course.

Natural gas prices to outperform

The TDCI is expected to end next year a healthy 15% above its September 2009 average. Still, if a continued recovery in natural gas prices is removed from the equation, the index is expected to grind ahead by only 6%. On a brighter note, momentum in commodity markets should pick up and broaden in 2011, as the world economy continues to normalize.

Natural gas prices are forecast to rise by almost 150%, outperforming all other commodities in the index. Forest product prices will be among the top performers, with lumber prices expected to jump by 70% and newsprint prices to gain 50%.

Meanwhile, precious metals prices will fare the worst, with the sub-index sinking 20% during the forecast period. Overall, we expect the TDCI to rise 35% by the end of 2011, and the index excluding energy to gain a more modest 13%. This will bring the TDCI back to levels seen in the third quarter of 2007, prior to the rapid run-up in prices seen towards the end of 2007 and early 2008.

Highlights

Strength in base metals prices drove TDCI up 5% in the third quarter, while a steep decline in natural gas prices provided some offset.
Commodity price gains will be limited over the next four to six quarters, but will pick up momentum in 2011.
Natural gas prices to outperform throughout the forecast period, skewing the headline figures.
TDCI to rise by 35% above September levels by the end of 2011, while the index excluding energy advances by only 13%.