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Commodity Outlook 2006
Breaking out of the "Comfort Zone"
Jeremy Baker, Senior Commodity Analyst, UBS
March 2006
A look back at what has been stimulating
commodities globally
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 (1920–
1933, 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.
2
China's economy: between Canada and Italy...
USD GDP rank as of 2003 & 2004
… but how will China develop over the next 5 to 10 years?
14'000
12'000
10'000
8'000
6'000
4'000
2'000
2003
US
Japan
Germany
UK
France
Italy
China
Canada
Spain
Mexiko
Korea
India
Brazil
Russia
Indones.
0
2004
Sources: IMF, UBS WMR
3
..but #2 in terms of Purchasing Power Parity (PPP)*
USD PPP GDP rank as of 2003 & 2004
12' 000
10' 000
8' 000
6' 000
4' 000
2' 000
2003
US
China
Japan
India
Germany
France
UK
Italy
Brazil
Russia
Korea
Mexiko
Canada
Indones.
Spain
0
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
4
Reuters CRB (CCI) Futures Index - Real and Nominal
Have investors missed the cycle, or is it still gaining steam?
1000
900
Nominal Reuters CRB (CCI) Futures Index
Real Reuters CRB (CCI) Futures Index (Real Dec 89 = 100 (US CPI at 4.6% ))
800
Real Reuters CRB (CCI) Futures Index (Real Jan 05 = 100 (US CPI at 3% ))
700
Adjusting for US inflation (CPI),
commodities have been in a long-term
downtrend.
600
500
400
300
200
100
0
Dec-69
Dec-74
Dec-79
Dec-84
Dec-89
Dec-94
Dec-99
Dec-04
Sources: CRB, Bloomberg, UBS WMR
5
London Metal Exchange: Real metal prices since 1969
Adjusted for inflation, metal prices are not excessive
300
Monthly average spot price
250
200
150
100
50
Ju
l-6
O 9
ct
-7
Ja 1
nAp 74
r-7
Ju 6
l-7
O 8
ct
-8
Ja 0
nAp 83
r-8
Ju 5
l-8
O 7
ct
-8
Ja 9
nAp 92
r-9
Ju 4
l-9
O 6
ct
-9
Ja 8
nAp 01
r-0
Ju 3
l-0
5
Real base metal price index (USD Current)
350
Sources: LME, UBS WMR
6
Energy
Energy – Are we approaching the end?
March
1999
October
2003
April
2005
September
2005
Source: The Economist
8
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?
9
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%
120
~ 107 m b/d
~ 91 m b/d
100
80
39
75 m b/d
30
60
23
11
8
5
40
20
47
53
57
2010
2020
0
2000
OECD
Transition Economies
Developing Economies
Sources: IEA, UBS WMR
10
Reserves are located in "sensitive" regions
Percentage of crude oil reserves (2004)
Nigeria - 3%
USA - 2%
China - 1%
Libya - 3%
Saudia Arabia 22%
Russia - 6%
Venezuela 6%
UAE - 8%
OPEC share of global
production will likely
continue to increase in
the coming years.
Iran - 11%
Percentage of natural gas reserves (2004)
Saudia Arabia 4%
USA - 3%
Kuwait - 8%
Iraq - 10%
Nigeria - 3%
Algeria - 3%
Iran - 15%
Russia - 27%
Qatar - 14%
Venezuela 2%
UAE - 3%
Sources: BP Statistical Review 2005, UBS WMR
11
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.
12
Million barrels/ day
10
8
6
average 7.4 mb/d
4
2
average 2.6 mb/d
19
8
19 0
8
19 1
8
19 2
8
19 3
8
19 4
8
19 5
8
19 6
8
19 7
8
19 8
8
19 9
9
19 0
9
19 1
9
19 2
9
19 3
9
19 4
9
19 5
9
19 6
9
19 7
9
19 8
9
20 9
0
20 0
0
20 1
0
20 2
0
20 3
0
20 4
05
0
Spare Capacity OPEC-10 (mbpd)
Sources: OPEC, UBS WMR
12
Base & Precious Metals
Base Metals – inventories have been a key driver of
prices
USD/M T
1'000'000
MT
USD/M T
MT
1'500'000
2'600
5'000
900'000
1'300'000
2'400
4'500
800'000
4'000
700'000
2'200
1'100'000
3'500
600'000
2'000
900'000
500'000
1'800
3'000
700'000
400'000
2'500
1'600
300'000
2'000
200'000
1'500
1'000
Jan-00
Oct-00
Jul-01
Apr-02
Jan-03
Copper LME Inventories (RHS)
2'500
Oct-03
Jul-04
Apr-05
500'000
1'400
100'000
1'200
0
1'000
Jan-06
Jan-00
Copper LME Cash Price (LHS)
USD/M T
300'000
100'000
Oct-00
Jul-01
Apr-02
Jan-03
Aluminium LME Inventories (RHS)
19'000
MT
2'300
700'000
2'100
Oct-03
Jul-04
Apr-05
Jan-06
Aluminium LME Cash Price (LHS)
USD/M T
MT
17'000
38'500
15'000
33'500
600'000
1'900
43'500
13'000
28'500
500'000
1'700
1'500
11'000
23'500
9'000
18'500
7'000
13'500
200'000
5'000
8'500
100'000
3'000
400'000
1'300
300'000
1'100
900
700
Jan-00
Oct-00
Jul-01
Apr-02
Jan-03
Zinc LME Inventories (RHS)
Oct-03
Jul-04
Apr-05
Zinc LME Cash Price (LHS)
Jan-06
Jan-00
3'500
Oct-00
Jul-01
Apr-02
Jan-03
Nickel LME Inventories (RHS)
Oct-03
Jul-04
Apr-05
Jan-06
Nickel LME Cash Price (LHS)
Sources: LME, Datastream, UBS WMR
14
Exploration success declined, supply growth limited
Mining exploration success and expenditure from 1980
16
Number of major deposit discoveries
6.0
Number of world class discoveries
Exploration Expense (USD Bn)
14
5.0
12
4.0
10
8
3.0
6
2.0
4
1.0
2
0
0.0
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
 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
15
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 M&A activity.
8
7
USD Billions
Acquisitions
Exploration
6
5
4
3
2
1
0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Sources: Metal Economics Group, UBS WMR
16
India and China – a comparison
China's demand in base metals outpaces India
(%) 30
China – Average annual growth rate 2000 – 2005
India - Average annual growth rate 2000 – 2005
25
20
15
10
5
0
Aluminium
Copper
Nickel
Zinc
Sources: Brooke Hunt, UBS WMR
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Precious Metals and a growing theme
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.
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A growing theme…
Agriculture: Driven by China and Energy Alternatives?
 Agriculture:
Rural agricultural employment trend
– Agriculture commodities present a
Rural agricultural employment is declining due to
migration to urban regions.
long-term opportunity.
– China is likely to become a key
60%
importer of certain agricultural
commodities.
50%
– Rural Chinese population highly
40%
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
30%
Rural (Agricultural) employment as % of
total employment
20%
10%
0%
1990
Agriculture output as % of GDP
1993
1996
1999
2002
Source: Chinese National Bureau of Statistics, UBS WMR
commodity complexes in 2005.
20
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 S&P 500 and the equallyweighed 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
S&P 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
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Performance since 1991
Commodities, global equities, global bonds and money market
(Total Return Indices, 01/91 – 08/05)
2nd Gulf War
Russia crisis
9/11
Asia crisis
1st Gulf War
Return p.a.
8.3%
6.5%
7.3%
Past returns are no guarantee for future returns
5.0%
Source: Bloomberg (all data in USD)
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Commodity Conclusion
Booming commodity prices, but don’t 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 longperiod, 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.
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