Friday, January 15, 2016 12:53 PM / ARM Research
Attention is still focused on the commodity section of ARM’s core strategy document – the Nigeria Strategy Report. In today’s piece, however, we review developments in the soft commodities market over H2 15 and present our outlook for H1 16.
After staging a brief resistance in the first half of the year, soft commodity prices returned to the bearish cycle that begun in 2010. Post the 5.4% rally in H1 2015 on expectation of stronger consumption, the S&P GSCI declined massively from Q3 15 onwards, ending FY 15 with returns of -25.5%. Though supply gluts continue to narrow, they still linger across coarse grain markets like wheat, corn, and barley.
Global wheat harvest for the 2014/15 season grew by 10 million metric tons or 1.4% from the prior year to 725.3 million MT. In the same period, wheat consumption also grew, albeit at a slower pace than output. Barley prices showed more resilience in the latter part of 2015, after posting 2014/15 season returns of -3.5% YoY (-2%: H1 15), with prices down just 0.55% in FY 15 at $134.67/MT. As for Sugar, prices staged a comeback in the first half of the 2015/16 season as they increased 18.3% in Q4 15 to 15.24 cents/lb after a 21.6% inventory-driven decline in the first three quarters of 2015, bringing the 2015 decline in price movement to -7.2% YoY. Whilst CPO prices declined 14.9% YoY in FY 15, Cocoa prices trended upwards in 2015, bucking the trend in commodity prices.
Overall, our outlook for commodity prices in the near term remains broadly bearish but as legacy supply gluts continue to shrink, we could see some recoveries in the medium term. A large part of the decline in commodity prices has hinged on bearish sentiment regarding the global economy, underpinned chiefly by weakening emerging market economies especially China, and we expect this sentiment to continue into the first half of 2016.
After staging a brief resistance in the first half of the year, soft commodity prices returned to the bearish cycle that begun in 2010. Post the 5.4% rally in H1 2015 on expectation of stronger consumption, the SP GSCI declined massively from Q3 15 onwards, ending FY 15 with returns of -25.5%. Though supply gluts continue to narrow, they still linger across coarse grain markets like wheat, corn, and barley. Furthermore, other exogenous factors have weighed on prices. One such is the strength of the dollar, in which most commodities are priced and traded, and which, according to the Bloomberg Dollar Index, has appreciated 9% YTD against other currencies. Another factor is sluggish global economic growth (driven chiefly by weakness in China) which has placed considerable pressure on commodity market sentiment. Overall, the SP GSCI Agriculture sub-index posted -19.27% returns in FY 2015. However, among our coverage the picture is, with the exception of wheat, becoming more optimistic strong signs of recovery materializing as from September 2015 buoyed by the technical support from El Nino.
Figure 1: SP GSCI Agriculture Index
Lingering oversupply in wheat market worsens on strengthening dollar
From data reported by the United States Department of Agriculture (USDA), global wheat harvest for the 2014/15 season grew by 10 million metric tons or 1.4% from the prior year to 725.3 million MT — 500,000 MT more than the agency had projected earlier in the year.
The increase was driven mostly by strong output form the world's top four producers; specifically Russia (+13% YoY)—who overtook the US as the fourth largest global producer, the EU (+8% YoY), China (+4% YoY) and India (+3% YoY). These increases offset declines in other major markets like the US (5% YoY) and Canada (-22% YoY) where long-term price depression continues to encourage the substitution of soybean (in US) and barley or canola (in Canada) for wheat as cash crop. The USDA attributes the jump in EU and Russian output to bumper harvests resulting from favourable weather in planting regions. In China and India however, the increases continue to reflect response to high levels of domestic price support.
Figure 2: CBOT Wheat Prices (USD/Bushel)
In the same period, wheat consumption also grew, albeit at a slower pace than output. The numbers recorded by the USDA for the 2014/15 season fell 3.7 million MT short of the projections it made at the start of 2015 with consumption growing 8.4 million MT or 1.2% YoY. The net increase was tempered by sharper than expected declines in US, Brazil, and Canadian consumption primarily resulting from reduced demand for biofuels as a result of the downdraft in oil prices.
Unsurprisingly, in FY 15, global inventories climbed for the second consecutive year (9.4% YoY to 212 million MT) and wheat prices declined 24.1%. Also adding pressure to prices was the rapid appreciation of the dollar which rose 9% according to the Bloomberg Dollar Index (BDI) over the 2014/15 season.
In its latest projections, the USDA expects wheat production to grow 9.5 million MT (1.3% YoY) in the 2015/16 season; a slower rate than the prior year. The estimates come on the heels of increased acreage in Canada and an expected change in policy in Argentina which should see caps on wheat production removed under the new administration. Contributing to the projected slowdown is expectations of reduced US and Russian output. On the other hand, consumption is projected to accelerate as increases in Africa and Far East Asia offset reduced demand for biodiesel and feeding wheat in the EU. Consequently, inventories are projected to grow 100 bps slower that the previous year's at 8.4% growth YoY to 299 million MT. Nonetheless, the global wheat market is expected to remain oversupplied and this underpins our expectation for wheat prices to remain bearish over FY16.
El Nino cautiously tips the scale towards bullish Barley fundamentals
After posting 2014/15 season returns of -3.5% (-2%: H1 15), Barley prices have shown more resilience in the latter part of 2015 with prices down just 0.55% in FY 15 at $134.67/MT. The negative trend over the 2014/15 season was driven primarily by prolonged high levels of market inventories. The USDA reported a 2.3% drop in global barley output from the prior season to 141 million MT driven by sharp cuts in output from major producers: Canada (-30.5% YoY), Australia (12.6% YoY), the US (-16.2% YoY), Turkey (-45.2% YoY), and Argentina (38.9% YoY); caused by a combination of lower acreage in some regions and poor weather in others. These declines more than offset the contributions caused by favorable growing weather in other major producing regions: EU (+1.3% YoY), Russia (+30.1% YoY), and Ukraine (+25% YoY). Similarly, the USDA reports that consumption also fell but by a much smaller margin of 0.1% YoY, as large increases in China (+81% YoY) and Russia (+11% YoY) offset aforementioned declines. As a result, the season ended with a minuscule increase in inventories by 202,000 MT to 23.9 million MT.
Figure 3: Global Barley Output, Consumption and Inventories (RHS)
For the 2015/16 season, both the International Grains Council (IGC) and the USDA forecasts increases in both output and consumption. The USDA projects a more bullish market for prices in 2015/16 with consumption growth (+3.2% YoY) expected to be greater than output’s (+2.8% YoY), with ending inventories down 2% YoY. The growth is seen driven by recoveries in output in Canada, Argentina, and Turkey, which are expected to offset moderations in the EU, Russia and Ukraine. On the other hand, the IGC expects higher output than consumption, and for inventories to grow. On the whole, we are more inclined to agree with the USDA's projections, which accounts for the impact of El Nino activity reminiscent of last year even as the IGC itself reports increasing substitution of barley for wheat feed in the Middle East and EU. Consequently, we expect moderate increases in Barley prices over the season with more risk to the upside depending on the length and intensity of El Nino.
Sugar recovers as El Nino casts doubt on global output
Sugar prices staged a comeback in the first half of the 2015/16 season. Specifically, prices increased 18.3% in Q4 15 to 15.24 cents/lb after a 21.6% inventory-driven decline in the first three quarters of 2015, bringing the YTD decline in price movement to -7.2%. The recovery in prices is in line with our earlier forecasts though, admittedly, it has come surprisingly early as demand-supply dynamics changed. For the 2014/15 season, the USDA reported 0.3% decline in global sugar supply as a result of dry weather in Brazil, US, and China (which jointly account for 31% of global supply) while also reporting a 2.6% rise in global consumption – thus marking the first time in over 5 years where demand surpassed supply. Inventories dropped by 0.7% to close the season at 43.5 million MT.
Figure 4: ICE Sugar prices (cents/lb)
Going forward, the USDA forecasts global production to decline 1.7% to 172 million MT, mostly driven by declines in four of the top five producing regions (Brazil, India, EU, and China). Reports of overactive El Nino weather patterns from the National Oceanic and Atmospheric Agency (NOAA) has increasingly lent support to expectations of a drier than usual monsoon season in India, and droughts in China. In Brazil, the declines in output were driven by the conversion of more sugar crop to ethanol instead of traditional consumable sugar and the continuation of this trend adds to the bullish sentiment surrounding sugar.
Overall, reports of the European Environmental Agency (EEA) citing a reduction in planted acreage of beet sugar reinforces expectations for lower output for the 2015/16 season.
On the demand side, the USDA projects a 1.2% increase in global consumption, driven chiefly by a 3% increase in India (the world's largest consumer), a 31% increase in Iranian consumption on the back of oncoming sanction lifting, and minor increases in other regions which altogether offset the decrease in the only major regional consumer Brazil. Given the prevailing demand supply dynamic, the substance of our outlook for sugar prices in the second part of the 2015/16 season remains unchanged; we expect the uptrend to continue as inventories fall in
Fortunes changing for CPO as price support policies look to materialize
As reported by the Malaysian Derivatives Exchange (MDE), CPO prices declined 14.9% in FY 15. In H1 15, the downward trend in prices over the previous season reversed, driven by positive sentiment built on expectations of positive impact of oncoming regulations on demand, and stalling inventories. However, the bearish trend resumed as the 2015/16 season commenced with recoveries in Indonesian and Malaysian crop yields.
For the 2014/15 season, supply grew 3.6% to 61.4 million MT while consumption rose only 1.1% to 58.5 million MT. In Indonesia, which accounts for over 50% of global CPO output, 2014/15 output surged 8.2% YoY to 33 million MT, driven by good weather and on streaming of output from plantations planted in 2011. This increase more than compensated for 1.4% and 10% declines in output from the next two largest producers Malaysia and Thailand. In Malaysia, flooding in key regions and El Nino related dryness over the course of the season led to declines in yields. El Nino was also the key factor cited for drier than average weather which frustrated yields in Thailand too.
Consumption grew for the fifth consecutive year by 1.1% or 623,000 MT; still, this was a slower growth pace than supply. The growth was driven chiefly by 7.1% YoY increase in India, where rising income levels and economic growth continues to broaden demand for CPO. The growth in India helped it supplant Indonesia as the world’s largest CPO consumer, with the 15.5% YoY drop in the latter’s consumption caused by major reform of the government's biofuels subsidy regime. The 2014/15 season ended with inventories up 9.5% from the previous year to 8.3 million MT.
Good growing conditions in South-East Asia for H1 15 have prompted expectations of greater output for the 2015/16 season. The USDA projects CPO output to grow 1.9% YoY by the end of the season to 62.6 million MT; with Malaysian and Thai output expected to post comebacks. Increases from the early season are expected to compensate for the impact of El Nino activity on harvests in the latter part of the season – CPO is harvested all year long. On the demand side, global consumption for the season is expected to grow 7.1% YoY, driven by surges in Indonesia, Malaysia and the US as regulation favoring increased use of biofuels translates to higher demand. Consequently, the USDA expects global consumption to surpass output for the first time in a decade and projects ending inventories to fall 19% to 6.7 million MT. Hence, outlook for the 2015/16 season prices is cautiously optimistic; we expect stability in the early part of 2016, tested by a strengthening dollar, with some latent recovery possible at the end of the season.
Harmattan fears buoy Cocoa prices
Bucking the trend in commodity prices, Cocoa prices have trended upwards in 2015. Prices from the Intercontinental Exchange (ICE) indicate that Cocoa prices increased 13.1% in FY 15 to $3211/MT. In the Cocoa market, demand and supply tend to be evenly matched given its small size relative to other commodity markets. Hence, prices are largely driven by monthly production and grinding reports.
Figure 6: Cocoa Prices
For most of the 2014/15 season, high demand hoisted prices progressively higher. Prices surged in the early part of the season as harsh harmattan towards the end of 2014 threatened harvests in the world's two largest producers (Ivory Coast and Ghana). As the season progressed however, this assessment of the markets turned out to be half true. Ghanaian yields experienced strong declines, due to harmattan, intermittent power failures and poor water supplies leading to a 22.4% YoY decline in output to 696,000 MT for the season. On the other hand, output in Ivory Coast stayed flat (+0.2% YoY) at 1.75 million MT as the impact of harmattan partly offset the strength of the early season. Overall, global output declined 4.9% to 4.2 million MT compared to a smaller decline of 4% in consumption, leading to a demand surplus of 22,000 MT for the season.
Our outlook for the 2015/16 season is moderately bullish for Cocoa prices given the re-emergence of last year's harmattan fears and the threat of El Nino to cocoa producing regions in South-East Asia. However, the ICCO reports declining orders from Cocoa processors in the wake of slow global economic growth which could temper the net upside price effect we expect.
Global macroeconomic headwinds reinforce cautiously bearish outlook in the mid term
Overall, our outlook for commodity prices in the near term remains broadly bearish but as legacy supply gluts continue to shrink, we could see some recoveries in the medium term. Closely looking at influences on the broader pattern, a large part of the decline in commodity prices has hinged on bearish sentiment regarding the global economy, underpinned chiefly by weakening emerging market economies especially China – where the Peoples’ government attempts to transition from export to consumption-led growth. We expect this sentiment to continue into the first half of 2016 as the 32% YTD downdraft in oil prices appears to have reduced the momentum in demand for cleaner fuels, removing a potential boost to soft commodities that serve as biofuels. Furthermore, given the trajectory of the dollar and its strong negative correlation to commodity prices, the shift by the US Fed in favour of tightening suggests more headwinds for commodity markets. However, the move by some key stake holders like Indonesia and Malaysia to support their domestic prices could be an important development for commodities, potentially resulting in some price recovery for certain commodities as early as H2 16.
In terms of the domestic impact, we expect lower input costs for some FCMGs. For Nestlé and Cadbury however, expectations of strong cocoa and sugar prices foretell no such benefit. Nonetheless, given the diversification of Nestlé’s product portfolio, we might see some cost savings in other segments of the business. For palm oil producers, we are cautiously bullish on CPO prices in the midterm, with current forex restrictions likely to accentuate near-term benefits for domestic players.
It is worth noting that even as the fundamentals of some of the commodities in our coverage look increasingly bullish, we remain cautious. On the whole, the prospect for any benefit or otherwise to corporate earnings is secondary to our expectations from the Nigerian economy in 2016 (especially currency) which we believe will exert greater influence on aggregate demand and input costs, which will impact these companies’ revenues. On that note, our bearish outlook for the economy given the weak outlook for oil price is hardly good news for corporations.