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Receding Weather Shocks Hand baton to Fundamentals

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Tuesday, August 02, 2016 12.14 PM / ARM Research

We continue with the commodity section of ARM’s core strategy document – the “Nigeria Strategy Report H2 2016”; with the review of developments in the soft commodity market over H1 16 and the outlook on same for H2 16.

In the aftermath of the third strongest El-Nino on record , which resulted in unusual weather patterns across various key agriculture producing regions, the S&P GSCI Agriculture index posted a 17% gain over the first half of 2016 (H1 15:  -19%). In addition to weather shocks, a softening US dollar and fluid demand-supply imbalance across regions and crops helped underpin the positive return on the index. Across our soft commodities coverage, adverse impact of the weather shocks on farm production was primarily responsible for price increases across raw sugar, rubber, barley, corn and palm oil while subsisting over-supply concerns weighed on wheat and cocoa prices.

Figure 1: S&P GSCI - commodities and agriculture indices


Coming closer home, whilst declining commodity prices should ordinarily have cascaded to significant input cost moderation for some listed companies, recent move to a flexible exchange rate regime and the consequent NGN depreciation should more than offset effect of input cost trends.  This is the case for FMCGs like flour millers. On other fronts, higher raw sugar prices and the weak naira outlook also point to gross margin pressures for sugar refiners. Similar bearish sentiments on margins apply for cocoa and barley consumers (Brewers and chocolate drink producers like Nestle and Cadbury) where price outlook is bullish. On a positive note, bullish CPO price outlook combines with CBN FX proscription for CPO imports (amid deficit in CPO supply-demand) to boost revenue outlook for listed palm producers.

El Nino tide lifts soft commodity prices
In the aftermath of the third strongest El-Nino on record , which resulted in unusual weather patterns across various key agriculture producing regions, the S&P GSCI Agriculture index posted a 17% gain over the first half of 2016 (H1 15: -19%). In addition to weather shocks, a softening US dollar and fluid demand-supply imbalance across regions and crops helped underpin the positive return on the index. Across our soft commodities coverage, adverse impact of the weather shocks on farm production was primarily responsible for price increases across raw sugar, rubber, barley, corn and palm oil while subsisting over-supply concerns weighed on wheat and cocoa prices.

Figure 1: S&P GSCI - commodities and agriculture indices


Parched planting conditions spurs rally in raw sugar price
In line with our expectations in our last update for an expansion in global sugar deficit, raw sugar prices extended the uptick recorded at the start of 2015/16 planting season, when they climbed 18% in Q4 15, by rising a further 36.5% YTD to 20.04 cents/lb. Over the 2015/16 season in line with USDA projections (+1.2% YoY), sugar consumption rose slightly by 1% YoY to 172 million MT. However, declines of 7% YoY in production overshot forecast for a 1.7% decline. This surprise was driven by record El Nino activity, which caused prolonged dryness in major planting regions in South Asia. Toward the end of the 2015/16 season, the International Sugar Organization’s (ISO) voiced concerns that fall-out from the El Nino on Indian production, amid rising global consumption, would exacerbate the expected deficit across global sugar markets, and in February 2016 the organization raised estimates of supply shortfall by more than double to 5.02million MT, from prior forecast in Q4 15. The upward adjustment and implications for global sugar stockpiles, which closed the 2014/15 season at five year lows of 37.7million MT, underpinned the price gains over H1 2016.

Figure 2: Raw Sugar prices


Going into the second half of 2016, the USDA expects combination of a weaker Brazilian real and lower sugar-to-ethanol conversion to result in a 6.5% YoY increase in sugar output to 37.1million MT. Assisted by a 15.5% YoY expansion in European beet and sugar output to 16.5million MT, the increase should offset impact of drier weather, on account of the El Nino, on Indian output (+8% YoY to 225.5million MT), leading to an aggregate 2.7% YoY rise in global sugar production to a record 169million MT. On the consumption side, the USDA cites rising consumption of homemade jams, preserves and production of home-made alcohol in Russia, increased demand in India and China as providing scope for a 1.1% YoY increment global demand to 173million MT. Though the deficit is smaller, we expect momentum in prices to remain intact over the rest of 2016.

Figure 3: Annual raw sugar production, consumption and price trends


Government intervention in South East Asia buoys rubber prices
Despite being mired in a significant supply glut, rubber prices have been among the best performers in H1 16 having ended the period 33% up. Prior to H1 16, declining imports from China (40% of global demand) had pushed rubber into a prolonged bear market with prices sliding nearly 70% over the last five years.

Indeed, coming into 2016, global supply was expected to climb 3.8% YoY to 13 million MT and with continued slowdown in China, where rubber imports declined 10% YoY in 2015, the outlook was for an expansion in global rubber inventories by 411,000 MT to 3.7million MT. Nonetheless, on the heels of intervention by Thailand and Indonesia, rubber prices swung higher defying the fundamental oversupply picture. Starting in January, both countries began shoring domestic prices with the Thai government authorizing the purchase of 200,000 MT at a 43% premium to export prices, while the Indonesian government authorized 500,000vMT.

Further steps were taken in February, when Thailand, Indonesia and number three exporter, Malaysia, acted under the aegis of the International Tripartite Rubber Council to compress rubber exports by 615,000 MT in the six months to August.

Figure 4: Rubber Prices ($/kg)


Going forward, due to a longer dry season, a fall-out of the El Nino weather patterns, the Association of Natural Rubber Producing Countries (ANRPC) forecasts that lower yields across major growing regions would drive flat (+0.3% YoY) trends in global rubber output. On the demand side, subdued economic activity in China, where rubber stockpiles are at 13-year highs and subdued Japanese and European automobile production point to weak consumption demand in the second half of 2016. Thus, barring any agreements to extend the export curbs which should terminate in August, the drag from slack rubber demand should apply downward pressure on prices in the second half of 2016.

Demand picture raises scope for more Barley price resilience
Barley prices staged a comeback in H1 16 by closing at $134.5/MT (YTD: +3.9%) compared with a 10.3% decline seen in H2 15. Price declines in the second half of 2015 reflected market estimates that suggested a return to oversupply in the 2015/16 season, versus forecasts of undersupply made early on in the season. According to data from the USDA (and corroborated by the IGC), for the 2015/16 season, global Barley supply stood at 147.9 million MT; representing a 4.7% increase on the prior year. In a reversal from the prior season, supply outstripped global consumption which grew at a slower pace of 3.1% YoY. Consequently, inventories ended the season 1.9 million MT higher. The USDA cited favourable planting conditions as the chief reasons for the unexpected bumper harvest, as output increases from the EU (1% YoY), Canada (+16% YoY) and Australia (+9% YoY) more than offset declines from Russia (-15%) and Ukraine (-7%).

Figure 5: Global Barley Output, Consumption and Inventories


For the 2016/17 season, consumption is again forecasted to outstrip supply, which explains the rebound in prices in the late part of the 2015/16 season. Citing abundant rainfall and favourable growing conditions which boost yield prospects for Spain, the USDA raised EU barley production forecast for 2016/17 by 2.3 million MT, as abundant rainfall and favourable growing conditions boost yield prospects for Spain, while the agency also raised its estimate for Ukraine’s barley production by 0.9 million MT as the impact of fall dryness seems to have been less than expected. Nevertheless, improvements in large growing regions are expected to be insufficient to offset declines from the rest of the world. Consequently, global production for 2016/17 is forecasted to decline by 2% to 144.9 million MT. On the other hand, consumption is expected to stay flat at 146.4 million MT as higher demand for Barley for feed purpose in the EU, Iran, and Saudi Arabia offset major declines in China, where demand is shifting towards grains with greater domestic availability.

El Nino shocks spur modest gains in CPO price
In contrast to the sharp declining trend in 2015, crude palm oil (CPO) prices have shown resilience in H1 16 by climbing 8%. Similar to raw sugar, concerns over the impact of the El Nino on production levels arose after CPO inventories in Malaysia declined for six consecutive months to a two year low of 1.66million MT in May 2016. Further stoking price upside was the reintroduction in April 2016 of the 5% duty on CPO exports in Malaysia which was soon followed by a similar levy on Indonesia’s CPO exports in May. In addition, Indonesia’s B30 biodiesel program, which mandates 30% CPO inclusion in diesel production, was viewed as positive for market fundamentals. However, towards the end of H1 16, prices began a retracement as supply glut projections were raised for the 2016/17 season, and concerns rose over the likelihood of success of the B30 program.

Contrary to its forecast at the end of 2015, for the 2015/16 season, the USDA reports that global CPO supply shrunk 1.2% YoY (vs +1.9% forecast) to 60.9 million MT while consumption jumped 6% (vs +7.1% YoY forecast). The decline in production was driven a 5.7% contraction in Malaysian output even as Indonesian output stayed flat, both of which offset modest gains from the rest of the world. Analysts had expected the latter part of the 2015/16 season to compensate for lower yields caused by El Nino and flooding in the earlier part of the year.

However, sustained dryness in the two biggest markets caused by prolonged El Nino activity prevented recovery in output. On the consumption side, the growth was driven by rising demand in India, the world’s largest consumer, in line with higher demand for edible oil blends. Also pushing consumption higher was a 21.6% jump in Indonesian consumption in response to the B30 program. These increases offset declines in China and Europe where a preference for alternative oilseeds and rising activism over environmental impact of CPO cultivation put a lid on palm oil use.

For the 2016/17 season we maintain a cautious outlook for CPO prices, leaning to the upside. On the one hand, consumption prospects are greatly improved on the back of the B30 mandate, but recent price action demonstrates concerns over the long term success of the program given the technical difficulties involved with its high biodiesel requirement. Furthermore, India has replaced China as the world’s fastest growing economy and seems poised to continue being the biggest consumer of CPO, we expect growth in consumer power within the country to continue supporting consumption growth in CPO. On the other hand, depreciation in the price of other oilseeds like Soybean (which serves as a substitute for CPO) also suggests muted expectations for CPO price performance.

Figure 6: Trends in CPO prices


In line with these expectations, the USDA forecast a 7.5% increase in global output for the season to 65.6 million MT. This growth is forecasted as driven by 12% and 6% YoY improvements in Malaysian and Indonesian output respectively, on the back of less severe weather conditions compared to the prior year. On the demand side, consumption is expected to pick up 4.1% to 64.6 million MT, which would represent the second consecutive demand lags supply. The USDA expects strong growth in India (+7.1% YoY), Indonesia (+3.7% YoY), and China (+1.8% YoY) to offset impact of declines in Malaysian consumption.

Surplus across wheat market continues to weigh on prices
In line with our over-supply induced bearish outlook, wheat prices have declined 7% YTD as excellent weather across major planting areas in US resulted in upward adjustments to harvest estimates from the world’s largest exporter. In contrast to bullish bets across other commodities in our coverage, Bloomberg reports show that net-short positions on wheat futures continued to increase over the period, providing more fire-power to price downside. Going forward, whilst the USDA forecasts lower wheat production in the EU (-2.2% YoY) and China (-0.1% YoY) – the two largest growers of wheat, the agency notes that increased acreage in Russia (+6.5% YoY) and improving conditions in India (+1.7% YoY) and the United States (10.25 YoY) should have an offsetting impact which should see global output stay flat (+0.5% YoY) at 739 million MT. On the demand side, global wheat consumption continues to rise with the USDA forecasting a 3.1% YoY rise in consumption in 2016/17 to 730 million MT. Despite consumption growing at a faster rate than supply, the market still remains over supplied, though the gap continues to narrow. Consequently global wheat inventories remain close to record levels, and are projected to rise 4% YoY to 254 million MT. Consequently we expect wheat price to remain bearish for the remainder of the season.

Figure 7: Wheat prices


Lower Ivorian production to underpin global cocoa deficit
In addition to wheat, Cocoa prices bucked the positive trend which made it the best performing commodity in 2015 with 10% YTD contraction. Despite a difficult start to the 2015/16 Cocoa season which began in October with a prolonged Harmattan season in Ivory Coast, improved rains in March and a recovery in cocoa production in Ghana, from five-year lows, dragged prices lower . Despite the weather-linked improvement in H1 16, cocoa bean arrivals at the main ports in Ivory Coast are 8% lower YoY at 1.31million MT according to the ICCO.

Furthermore, the ICCO reports that the heavy rainfall provides a second layer of headaches as farmers are unable to dry Cocoa beans leading to a high rejection rate at the export ports due to the higher acid content of the beans. On the demand side, Cocoa grinding activity remains weak thus far in 2016, as overcapacity and slack global chocolate consumption continues to drive moderation in processing capacity. Largely reflecting the slack demand growth, top processor and largest maker of bulk chocolate Barry Callebaut AG reports that global chocolate sales slid 2% YoY even as the company mothballed several factories in Thailand and Malaysia.

Figure 8: Cocoa price ($/MT)


In framing our Cocoa price outlook for the rest of 2016, we note that recent regulatory changes on bean export sizes in Ivory Coast which reject smaller beans for shipping should lower Ivorian cocoa exports. Consequently, the ICCO estimates that Ivorian Cocoa production for the 2015/16 season should decline 3% YoY to 1.65million MT. Due to adverse weather in South America, the agency estimates that Brazilian production should contract 22% YoY to 180,000 MT while similar concerns mute harvest outlook in Indonesia, Cameroon and Nigeria. Overall, the ICCO forecasts a 3.4% YoY contraction in global cocoa production to 4.04million MT in the current crop year. Despite slack consumption growth, the ICCO expects the supply cutbacks to result in a global cocoa shortfall of 140,000 MT which points to a bullish price outlook in the second half of 2016.

NGN depreciation more a concern, than soft commodity price trends, for naira equities
Coming closer home, whilst declining commodity prices should ordinarily have cascaded to significant input cost moderation for some listed companies, recent move to a flexible exchange rate regime and the consequent NGN depreciation should more than offset effect of input cost trends. This is the case for FMCGs like flour millers. On other fronts, higher raw sugar prices and the weak naira outlook also point to gross margin pressures for sugar refiners. Similar bearish sentiments on margins apply for cocoa and barley consumers (Brewers and chocolate drink producers like Nestle and Cadbury) where price outlook is bullish. On a positive note, bullish CPO price outlook combines with CBN FX proscription for CPO imports (amid deficit in CPO supply-demand) to boost revenue outlook for listed palm producers.

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