Threadneedle: 2010 outlook for commodities
David Donora, Head of Commodities at Threadneedle, comments on Chinese demand to support commodity prices: "Many commentators have been surprised at the broad strength of commodity prices in 2009. Moves in excess of 100% in oil and copper, around 60% in platinum and nearly 30% in gold (moving the price of bullion convincingly through $1,000 per ounce) have seemed counter-intuitive at a time when much of the world is in recession and industrial demand has been lacklustre.
"However, there is a simple explanation - or rather, a simple combination of factors that have pushed commodity prices higher - and we believe that these factors are likely to remain in place over the next few months.
"With a few notable exceptions, monetary authorities in the major economies have been engaged in a process of "beggar thy neighbour" in which the creation of money and the consequent debasing of domestic currencies have been seen as key tools in reviving economies. With all the traditional safe haven currencies weakening simultaneously, investors have sought alternative stores of value, and gold has been a key beneficiary.
"The most glaring example of the "beggar thy neighbour" theme, of course, is China. It is widely accepted that China's currency is undervalued and that, at some point, the Chinese authorities will bow to pressure from the US and EU to revalue the renminbi. The forwards market is currently pricing a revaluation of around 3% in the next 12 months. We believe that an adjustment in the region of 20% would be required to balance China's competitive advantage in world trade. This is unlikely to happen in the short term; a gradual widening of the exchange rate band versus the US dollar seems a more likely approach.
Diversification makes sense for China
"If the renminbi is to be revalued significantly, it makes sense for the Chinese authorities to diversify their foreign reserves away from US dollars in advance. China is currently estimated to be holding $2.2trn in foreign reserves and it will not wish to see these reserves devalued. At the same time, the ongoing modernisation of the country, with its attendant long-term infrastructure projects, is creating enormous demand for a wide range of raw materials. China is self-sufficient in a number of downstream commodities including thermal coal, aluminium and steel, but it has a major structural deficit in copper, oil, gas, iron ore, platinum and a host of other materials that it needs. It makes sense for China to spend its dollars on these hard assets while the dollar still has reserve currency status.
A two-pronged approach
"The twin requirements to secure long-term commodity supplies and diversify its foreign exchange reserves have driven an acceleration of the land grab of commodity assets by China over the past year that shows little sign of abating. The approach has been two-pronged: strategic reserves of hard commodities have been built and, in a nice Marxist twist, the means of production have also been pursued via a series of bids for part or all of commodity-producing companies.
"Early Chinese attempts at acquiring assets were typically unsuccessful, for a number of reasons. These included the overly bureaucratic nature of management structures and government organisations, a lack of M&A experience at the upper management level and a negative world view of Chinese labour practices in the mining industry.
"Many of these attempted transactions involved assets in North America and, while Chinese entities did meet with some success, this was typically limited to smaller projects in the Canadian oil sands. Since their early failures, China's acquisition approach has been adapted. For example, the emphasis has switched from attempting to buy entire companies in the developed world to establishing more easily digestible stakes. This approach is much easier from a regulatory and political point of view; it brings greater diversification and flexibility but can still allow for the inclusion of clauses guaranteeing preferential supply.
"There has also been a greater focus on regions where Chinese influence has been more welcome (Africa, South America, Middle East and other Asia). Areas where China has been able to trade cheap financing of infrastructure construction and other projects for stakes in hard assets have also been targeted - such the Democratic Republic of the Congo and Zambian copper belt. Finally, the Chinese have learned the value of partnering with local firms, other Chinese producers and industry leaders when trying to acquire higher profile assets that are more sensitive in nature - something especially evident in a number of deals in the oil and gas space in 2009.
Increasing success in M&A
"This revised approach, together with the scarcity of capital that accompanied the global financial crisis, has seen Chinese bids for western assets increasingly welcomed. Moreover, the deleveraging that is set to remain a feature in the developed world and the enormous capital firepower available to Chinese entities should see this more positive relationship continue over the next couple of years. Certainly, appetite remains strong from the Chinese side. Earlier this year the Chairman of the Chinese National Petroleum Corporation stated that the company produced less than 8% of its oil overseas and that foreign acquisitions and ventures must be increased as "we want overseas production to contribute half, matching domestic output by 2020".
"Looking to the future, there seems little doubt that demand from emerging economies will continue to support a wide range of commodities in the long-term. For example, annual copper consumption per capita typically runs at between 8 and 16kg in the developed world but is still below 4kg in China, below 2kg in Brazil and below 0.5kg in India. These figures are all set to rise - indeed, China's consumption has already moved from 0.5kg to its current level of just under 4kg since the early 1990s. So the long-term fundamentals are positive.
"The short-term picture also looks positive, with continued abundant liquidity and widespread currency weakness likely to underpin demand for hard assets, while China's asset acquisitions support share prices among commodity producers. However, as quantitative easing comes to an end, the medium-term picture is less clear and depends largely on how developed governments navigate the end-game of their stimulative policies.
Three possible paths
"At this stage there seem to be three possible paths. The first is the "cold turkey" option in which stimulus is withdrawn and economies have to endure a long period of sub-trend growth while previous excesses unwind. The second involves further quantitative easing and continued destruction of domestic currencies. The third, which is the hope of authorities in the US, Europe and Japan, is that current stimulus succeeds in creating a sustainable recovery that softens the blow as policies normalise.
"We don't yet know which path the global economy will follow. The tension between our positive short and long-term views and the uncertainty surrounding the medium-term outlook provides opportunities for seasoned commodity investors to make money."