July 22, 2013

Commodities Snapshot

A background overview of the major commodity markets.

With so much attention on commodity markets (namely Oil and Gold prices), over the past few months, it can be easy to overlook the broader Commodity space - markets such as Platinum, Copper, Coal or Natural Gas as just a few examples. All commodities are correlated, and the strength of those correlations tends to fluctuate in the same way normal prices do. Some of those correlations are caused by geographical or political factors such as China's consumption growth. Others are caused by economic factors such as the pricing of most commodities in US dollars. In the Middle-East for example, geo-political themes ebb and flow like a market in themselves – recent civil unrest in Egypt for example, has been a catalyst for oil prices to rise from $95 per barrel to over $108 today. Commodity price spikes tend to occur on fears of supply delivery or inventory shortage – the demand side is rarely to blame directly.

The charts below illustrate where the major commodities come from (production source), where they go (consumption destination) and for what they are used for (allocation).

China is both a large producer and large consumer – clearly, a fall in either aggregate Chinese demand or supply will affect the broader commodity markets given their correlations. But which commodities are worth most attention and are most at risk from severe declines if China happens to slow its production and demand? Its likely to be the commodities that have the highest levels of inventory and stored reserves while the commodities with the least will probably remain fairly reslient to broader commodity market declines and fall by less than the rest.

The major consumers of global commodities are China and the US. China is now by far a larger consumer of all commodities compared to the U.S. Its worth noting that 10-15 years ago, their positions were reversed. China has become the world's growth engine - in commodities. China consumes 80% of the world's aluminium, 85% of the world's tin and 60% of the world's zinc.

Commodity allocation shows that the majority of commodities are utilised in transport and construction. Even in the case of oil, 80% of all oil production goes into transportation. In the case of coal, over 90% of coal is used to power electric power stations - with urban populations rising across the World, demand for electricity is also expected to continue to rise. Despite being one of the most environmentally inefficient commodities, coal could be a commodity that remains resilient if Chinese demand slows significantly and rise faster than expected if China continues its >7% rate of growth.

All commodities are different, yet they are all correlated to a degree. By looking at the specific details of each commodity such as inventory size, production levels, demand location, industry allocation and so on, investors can derive good hedges against severe market volatility and potentially, as a hedge against inflation given the historic tendency for commodity prices to spike higher when widespread shortages occur.

Commissioned by Think Forex