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NSR H2 2017 (3) - Supply Glut Underpins Broadly Bearish Trends Across Soft Commodities

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Wednesday, July 19, 2017   02.09PM / ARM Research

We continue discussions on the commodity section of “The Nigeria Strategy Report” by reviewing developments in the global soft commodities market over H1 17 and delineate our outlook for the second half of the year.

In contrast to the gains recorded over H2 16 (+2.6% YoY), a broad oversupply picture across most agricultural commodities drove price declines over H1 17 with the S&P GSCI Agricultural Index recording a decline of 2% over the period, largely driven by surplus in Rubber, Crude Palm Oil (CPO), Raw Sugar and Cocoa which underpinned the bearish sentiments across these commodities. However, a rapidly shrinking surplus picture in the wheat market spurred a rally in prices.

Our outlook for CPO, sugar and cocoa are bearish buoyed by elevated inventory levels, prevailing surplus in the market and favorable weather conditions. Although lower barley production and tighter supplies support a rally in prices further out, we remain cautious given the existing elevated inventory levels.

For wheat, the global supply-demand picture guides to a rapidly shrinking surplus which should drive prices higher. Rounding up our coverage commodities is rubber where the market is expected to return to a bullish state given weak production outlook alongside export quota limits by major rubber producing countries. Overall, we hold a guardedly pessimistic outlook for commodity prices over H2.


Soft commodities choke on oversupply

In contrast to the gains recorded over H2 16 (+2.6% YoY), a broad oversupply picture across most agricultural commodities drove price declines over H1 17 with the S&P GSCI Agricultural Index recording a decline of 2% over the period, largely driven by surplus in Rubber, Crude Palm Oil (CPO), Raw Sugar and Cocoa which underpinned bearish sentiments, save for wheat where a rapidly shrinking surplus picture in the market spurred a rally in prices.

Figure 1: S&P GSCI Agriculture Index


Sugar’s sweetness to fade further as narrower deficit turns to surplus 
Similar to the second half of 2016, sugar prices maintained a downtrend in H1 17 (-32% YTD) underpinned by the weaker Brazilian Real which boosted exports. The increased supply from Brazil helped further narrow the deficit in the global market to 1.1 MT (2015/2016: 4.7MT deficit). In the 2016/2017 season, data from USDA revealed a 4% YoY increase in global sugar production to 170.8MT, largely reflecting higher yields from Brazil (+13% YoY), EU (+16% YoY), Russia (+17% YoY), Pakistan (+13% YoY) and China (+5% YoY) which combined to offset the impact of lower production in India (-20% YoY). 

Specifically, the upsurge in Brazil’s output is to meet rising demand from millers’ which, given attractive pricing, have increasingly switched from ethanol to sugar. Elsewhere, the surge in EU production reflected the anticipated liberalization of sugar markets across the region after a decade of tight output quotas and export limitations. Higher output in Russia was buoyed by import taxes implemented in 2014 which encouraged firms to continually invest in making sugar beet refining more efficient.  

In Pakistan, elevated sugar production can be attributed to the combination of improved yields as well as high import tariffs which supported domestic demand for locally produced sugar. Elsewhere in China, favourable government legislation, which took the form of the imposition of additional layer of tariff (i.e. 45pps to 95%) on sugar importation more than the set quota (1.95MT) enforced by World Trade Organization rules1, provided a boost for domestic sugar production in the country. 

On the flip side, growth in global sugar consumption was modest (+1% YoY to 171.9MT) reflecting lower consumption in India (-4.10% YoY) and China (-1.27% YoY) which offset higher consumption in US (+3% YoY), Russia (+7.14% YoY) and Indonesia (+16% YoY). 

In India, falling sugar demand was a side-effect of the economic slowdown due to its demonetization policy in Nov 2016 as aggregate demand from notable sugar consumers slowed. Elsewhere, China’s lower demand is attributed to consumers switching from sugar to other substitutes (majorly fructose from corn) as corn prices was relatively low compared to domestic sugar prices which is still higher than its 3-year average. 

Figure 2: SB Sugar prices (USD/lb)

 

Going into the 2017/2018 season, we forecast a transition to a surplus market which we expect to keep sugar prices on the downtrend. For sake of context, the USDA expects global sugar production to rise 5% YoY to 179.6MT driven by stronger output from India (+18% YoY to 25.8MT), EU (+13% YoY to 18.6 MT), Thailand (+12% YoY to 11.2MT) and China (+11% YoY to 10.5MT).  

In India and Thailand, the increase in output should be bolstered by favourable weather conditions, which should drive improved yields and expansion in areas cultivated. Elsewhere, like prior season, accommodative policy environments should keep sugar production in China and EU elevated. For the latter, the expected common agricultural policy reforms—which will, among other things, lift restrictions on production and exports imposed on sugarcane growers, — will be key to enabling output. 

On the demand side, USDA’s projected decline in sugar consumption (-0.2% YoY to 171.6MT) aligns with our view. Subsisting weak demand in India (-0.3% YoY to 18.65MT), Indonesia (-1.9% YoY to 6.4MT) and Russia (-1.6% YoY to 6.2MT) looks set to keep the overall demand picture subdued.

In India, the demonetization impact, though waning, should continue to hamper off-take of sugar from the Public Distribution System (PDS) and bulk consumers.2 In addition, the government’s plan to pull back ~INR45 billion ($687.2  million) of sugar subsidy, from state governments distributing sugar through the PDS, has negative connotation for sugar demand in the country. In addition, increasing health awareness on dangers of excessive sugar consumption in Indonesia should lower demand while higher domestic sugar prices in Russia is expected to drive the marginal decline in Russia’s demand. Overall, the sugar market is expected to transition to a surplus of 8.1MT (vs. deficit of 1.1 MT deficit) in the 2017/2018 season.
 

Figure 3: Global Sugar Production, Consumption, and Inventories 


Unparalleled deficit picture underpins bullish stance on Barley prices
 
Despite posting its first deficit in three years (-0.7MT), Barley prices have declined over 25% YTD. In our view, the decline in prices is a fallout of subdued demand from major consumers that have accumulated excess inventory of high quality barley following elevated supply in the market over the past two seasons. In the review season, global barley production declined marginally (-1% YoY to 147MT) following weaker output from EU (-3% YoY to 60MT), Turkey (-36% YoY to 4.8MT), and Argentina (-33% YoY to 3.3MT). 

According to USDA, contraction in EU’s output was largely driven by France and Belgium where excessive rain in May/June and low temperatures at the crucial flowering period led to poor harvests while in Turkey, severe droughts also had negative impact on barley production. The decline in Argentina’s output reflect a tilt in production towards the relatively better priced wheat in the review period. On the consumption side, global barley demand also tracked lower (-1% to 147.04 MT) underpinned by Turkey (-20.3% YoY to 5.5MT) and Morocco (-28.4% YoY to 2.4 MT). For both countries, the drop-in consumption was linked to a rise in domestic prices that trailed the drought-induced reduction in production levels. 

Figure 4: Global Barley prices (USD/tonne) 

 

Going into the 2017/2018 season, sizable supply contractions in Australia (-38% YoY to 8MT), Canada (-14% YoY to 7.6MT) and Ukraine (- 25% YoY to 7.4MT) are expected to leave barley output subdued (-7% YoY to 137MT). Indeed, USDA expects that ongoing hot and dry weather condition should drive Australia’s Barley production lower in the 2017/2018 season. Elsewhere, a return to more normalized yield in Canada following bumper harvest in the past season is likely to restrain growth in Canadian’s Barley output just as less attractive pricing discourages production in Ukraine. On the demand side, global barley consumption is forecast to decline 2.4% YoY with sizable demand down-leg in China (-13% YoY to 6.9MT) and US (-12% YoY to 4.1MT). China’s lower demand is attributed to changing consumption preferences toward domestic corn, which is priced more affordably, for feed use in the near-to-medium-term. In the US, lower barley consumption is linked to slower sales of domestic beer which should weaken demand for malting barley. Despite this, due to severe supply contractions, the global barley market is expected to post an unprecedented deficit of 7.2MT which creates scope for a bullish price outlook over the 2017/2018 season. 

Figure 5: Global Barley Production, Consumption, and Inventories



Imbalances in global wheat production to sustain price uptrend
 
Following sustained deceleration in the 2015/2016 season (-18% YoY), wheat prices have rallied 8% YTD on the back of increased demand which narrowed the surplus in the global market (-48% YoY to 12.93MT) - the first time in three years. Providing further breakdowns, global wheat consumption expanded to 740.2 MT (+4% YoY) driven by higher demand from China (+6% YoY to 118.5 MT), India (+10% YoY to 97.5MT) and Russia (+8% YoY to 40MT). Rising demand in China and Russia reflects higher wheat consumption for feed and residual use. In India, strong demand is buoyed by the sale of wheat at subsidized prices through the public distribution system (PDS), and smaller quantities to local millers through the Open Market Sales Scheme (OMSS) alongside the continued importation of wheat from major trading partners at competitive prices relative to local produce. 

On the supply side, USDA noted a 2% YoY rise in global wheat production to 753.1MT after the sizable jumps in output in Russia (+19% YoY to 72.5MT), US (+12% YoY to 62.9MT), Australia (+45% YoY to 35MT) and Argentina (+42% YoY to 16MT) due to favorable weather conditions. These gains were enough to offset the impact of drought which drove production declines in Morocco (-66% YoY) and Turkey (-12% YoY). 

Figure 6: CBOT Wheat Prices (USD/Bushel) 


Going into 2017/2018 season, USDA projects a contraction in global wheat supply (-2% YoY to 737.8MT) due to lower output from Russia (-8% YoY to 67MT), Canada (-11% YoY to 28.4MT) and Australia (- 29% YoY to 25MT). Downbeat outlook on Canada’s output reflect expected delay in cultivation activities as higher winter precipitation lead to a soggy spring in major producing states. Meanwhile, in Australia, below average rainfall projected by the Bureau of Meteorology (BOM) should lower yields across most of Australia’s winter and summer cropping regions. The forecasted decline in Russia stems from lower planting area over the period. 

On the other side, USDA forecasts a contraction in global consumption (-1% YoY to 734.9MT) in the 2017/2018 season largely driven by China (-2.1% YoY to 116MT) and Canada (-14% YoY to 8.8 MT). In China, elevated prices of domestic wheat are projected to lower household demand for wheat-based staple foods such as noodles and steam breads and encumber industrial wheat consumption for liquor, ethanol, maltose and soy sauce. In sum, the global supply-demand picture reveals tighter wheat supplies of 2.94MT (2016/17: 12.93MT) which raises scope for a further increase in wheat prices over 2017. Similar to prior years, bearish sentiment trailing elevated inventory levels (+1% YoY to 258.3MT) should temper scope of price appreciation. Nonetheless, the shrinking surplus picture supports scope for modest price upswing in 2017. 

Figure 7: Global Wheat Production, Consumption, and Inventories 

 

CPO prices turn bearish on rising surplus levels 
In contrast to the uphill climb over H2 16 (+34%), crude palm oil (CPO) prices have declined 18% since the onset of the year, on the back of rising production which swung the market from a deficit of 1.1MT in the past crop cycle to a surplus of 1.3MT in the current cycle. The surplus in CPO markets largely stemmed from an expansion in global CPO production to 62.9MT (+7% YoY) on the back of favorable weather conditions in major producing countries following the receding impact of El-Nino which drove higher output levels (Indonesia: +6% YoY to 34MT, Thailand: +10% YoY to 19.5 MT). 

On the demand side, CPO consumption increased at a slower pace (+3% YoY to 61.6 MT) as weaker demand from the US (-4.1% YoY to 1.2 MT) and Russia (-0.1% YoY to 0.9MT) offset gains in both Egypt (+17.4% to 1.4MT) and Pakistan (+6.4% to 3.0MT).  

The decrease in US consumption reflects expectations of bumper Soy (a close substitute) harvests to drive more attractive pricing for Soy relative to imported palm oil. For Russia, decline in CPO consumption is a fallout of the weak Ruble and increased domestic production of vegetable oils. In addition, an anti-palm oil campaign, launched in the Russian media in 2015 and throughout 2016, also impacted demand for palm oil negatively. Elsewhere, the increase in palm oil consumption in Egypt can be attributed to higher imports in the wake of improved FX liquidity. In addition, higher CPO demand in Egypt is supported by its price competitiveness relative to alternatives3. CPO is the dominant vegetable oil imported and sold in Pakistan and consumption of the commodity has expanded as lower income consumers moving up the economic ladder increase the amount of vegetable oil4 in their cooking.

Figure 8: MDE CPO Prices (USD/tonne)  


Going into the 2017/2018 season, USDA forecasts an expansion in global CPO production by 6.2% YoY to 66.8MT. This is largely to be driven by Indonesia (+6% YoY to 36MT) and Malaysia (+8% YoY to 21MT). On the back of favorable weather conditions and expected plantation recovery in the ebb of the El-Nino crisis. On the consumption leg, we also forecast an increase of 2.5% YoY to 63MT driven by India (+4% YoY to 9.6MT) and Malaysia (+7.9% YoY to 3.4MT). We believe higher consumption in India will be underpinned by the expected economic recovery as effects of demonetization starts to wane. 

On the other hand, USDA forecasts that the bearish turn in prices should drive stronger demand in Malaysia. Overall, the global CPO market is projected to have a bigger surplus of 3.7 MT (+189% YoY) in the 2017/2018 season which poses downside risks to prices. 

Figure 9: Global CPO Production, Consumption, and Inventories



Oversupply picture drives bearish sentiments for rubber prices 
In sharp contrast to the strong rally in prices over 2016 (YoY: +72%), Rubber’s price performance over H1 2017 was negative (-31% YTD), reflecting the impact of Thailand’s5 decision to auction off 0.1MT of rubber acquired at weaker prices. Further supporting the price downtrend was the excess inventory/production of rubber, coupled with weak global demand, which led to the significant reversal in the rally in rubber prices. Global demand for rubber remained muted as key players such as China, India and Japan adopted a cautious stance on purchases in anticipation of a further slide in prices. Furthermore, China’s slowing automotive sector has further impacted negatively impacted on demand.  

Figure 10: Rubber prices (USD/kg) 


Looking ahead, the Association of Natural Rubber Producing Countries6 have revised its forecasts of global rubber production lower due to the downswing in prices which is expected to result in a delay in the frequency of harvesting and slow the reopening of rubber tapping at the end of the wintering-off season. That said, bearish sentiment surrounding muted demand from major consumers should moderate the bullish optimism on prices. 

Positive production prospects for cocoa harvests underpin bearish price

In line with bearish trend over H2 16 where cocoa prices slid 19%, prices have maintained a downward slide (-4.7% YTD) amid sustained sell-offs by investors, following reports of excessive cocoa supply in the on-going crop season. According to data from the International Cocoa Organization (ICCO), Cote D’ Ivoire’s7 cocoa supply of 1.5MT was 16% higher YoY with bumper prospects for the ongoing mid-crop over the past five months of the year, On the same hand, the Ghana Cocoa Board reported year to date cocoa sales of 0.76MT (+13% YoY) with the board revising its production forecasts for the year higher to 0.85MT (prior: 0.8MT). 

On the demand angle, data from ICCO shows muted demand across the European and American markets. Over the year, the demand from major cocoa producers in European markets marginally increased by 0.7% YoY to 0.34MT while grindings in the North American region climbed higher by 1.2% YoY to 0.12MT. In contrast, cocoa grindings in Asian markets surged 19.2% YoY to 0.18MT as depressed cocoa prices boosted demand for the commodity.

Figure 11: ICE Cocoa prices (USD/tonne)

 

Over the rest of the year, the ICCO expects favourable weather conditions to prevail across major producing countries in Africa and Asia. This is in sharp contrast to the prior year when strong harmattan winds from the Sahara alongside the impact of El-Nino dampened production levels. Consequently, the organization revised global production levels higher for the current season to 4.7MT (+18.1% YoY). On the flipside, demand is projected to increase at a slower rate (+ 3.2% YoY) to 4.3MT buoyed by the Food and Beverage and personal care industries. Overall, the global cocoa market is expected to remain in surplus of 0.4MT (prior forecast: +0.3MT) which underpins our outlook for cocoa prices to remain on a downward trend over the rest of the 2016/2017 season.  

Trends in the global commodity price guide to a mixed outlook across our coverage universe 
Our outlook for CPO, sugar and cocoa are bearish buoyed by elevated inventory levels, prevailing surplus in the market and favorable weather conditions. Although lower barley production and tighter supplies support a rally in prices further out, we remain cautious given the existing elevated inventory levels. For wheat, the global supply-demand picture guides to a rapidly shrinking surplus which should drive prices higher. Rounding up our coverage commodities is rubber where the market is expected to return to a bullish state given weak production outlook alongside export quota limits by major rubber producing countries. Overall, we hold a guardedly pessimistic outlook for commodity prices over H2  

From ARM’s H2 2017 Nigeria Strategy Report

1.       Nigeria Strategy Report H2 2017 (2) - Crude Oil: US Shale Challenges Anticipated Market Re-balancing
2.      After Bullish Run, Portfolio Flows to EM Look Set To Moderate - Nigeria Strategy Report H2 2017   

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