DSIJ Mindshare

Commodity Shining

If there is one factor that plays a very critical role in shaping the future course of the economy, it is the behaviour of essential commodities. At the start of the calendar year, we had looked at how five essential commodities were expected to behave during the course of the year, depending on a host of factors that drive their demand and supply and in turn, the prices. After all, commodity-based stocks have a weightage of around 35 per cent in the overall market capitalisation of the Nifty.

Over the past nine months, the prices of commodities have remained fairly volatile. With so much happening on the macro-economic scene, not just on the domestic but also on the global front, we decided to revisit the whole paradigm of how these vital commodities are likely to behave going forward. These commodities actually have a bearing on the future course of  the economy, or so to say, are affected the most due to macro-economic happenings.

Why are we relooking at commodities within a span of nine months? As we pointed out, at the start of CY12, commodity stocks constituted about 35 per cent of the Nifty. Even as we write this story, the weightage of commodity-based stocks has increased to 40 per cent of the Nifty. As always, it makes us feel proud about being bang on target when we predicted the price movement of these commodities at the beginning of the year and how true that has turned out to be.

At that point, we had said, “We believe that the year 2012 will be a year of two distinct halves, as prices are expected to remain weak in the first half and will rise from there on”. In light of this assertion, let’s take a look at how the S&P GSCI Index, a benchmark for commodity prices, has behaved. The index has seen a good amount of volatility on a YTD basis, and has returned almost 7.64 per cent. After reaching a high of 715.52 in February 2012, it has witnessed a sharp move southwards to levels of 559, declining almost 28 per cent from its peak. As we predicted, these low levels were achieved in the month of June 2012. After hitting a low, the index has seen a steady northbound move to reach 694.12, witnessing a gain of 24.19 per cent.[PAGE BREAK]

Since the beginning of this year (2012), there have been many roadblocks on the macro-economic front. The Euro zone crisis and the worries on the US economic growth front were the principal factors that were hurting the sentiment.

However, as the year progresses, there have been several developments. The liquidity pumped in by the ECB and the announcement of QE3 are morale boosters for the global economy. The announcement of recent liquidity infusion measures is sure to increase the risk-taking ability of investors.

The Federal Reserve announced that it will increase its assets of long-term securities with open-ended purchases of USD 40 billion of mortgage debt each month in order to accelerate economic growth and reduce unemployment. This will see investors moving back towards riskier assets and will help base metal prices to trade higher. Nitin Nachnani, Research Analyst, Geojit Comtrade, says, “Weakness in the US dollar index will also help further upside in metal prices, as a weaker dollar makes dollar-denominated commodities look cheaper for the holders of other currencies”.

Speaking of commodities, we can hardly ignore the China factor. At the beginning of the year, the world’s largest consumer of metals was facing headwinds, which in turn, led to a drop in several commodity prices. After entering the second half of the year, we are witnessing several steps being taken by larger economies to boost the growth prospects of their respective countries. In September 2012, the National Development and Reform Commission, a nodal planning agency in China, has approved 25 urban rail projects, 13 highway construction projects, seven waterway projects and nine waste water treatment plants at an estimated total project cost of about USD 158 billion. According to Naveen Mathur, Associate Director – Commodities & Currencies, Angel Broking, “The implementation of such projects would boost demand for the metals in the country, and in turn, would enhance the imports”.

We believe that most of the bad news that was hovering around the global economy has been priced in, and going forward, the situation will only improve. This view of ours is seconded by Vivek Gupta, Head of Research at CapitalVia Global Research. According to Gupta, “Most of the bad news and effects of the slowdown have been already discounted in the markets, and we can already see the financial markets steadying and rising in spite of the surrounding news flows”.

As predicted earlier, we are still of the belief that the second half of the calendar year will be a better one. So, to help you get a better grip of the situation, here is an in-depth analysis of how the five vital commodities are likely to shape up going forward.[PAGE BREAK]

Aluminium: Bright Future

Aluminium as a commodity has seen some improvement in its prices. After hitting a low of USD 1667 per tonne in CY2009, the prices of aluminium witnessed some uptick, and it closed CY2011 at USD 2100 per tonne.

In the current calendar year, however, this commodity has not moved much and it is currently trading at USD 2082 per tonne on the LME. On an YTD basis, the commodity is up by four per cent from USD 2100 per tonne at the end of CY11.

In the four years after the commencement of a global slowdown, aluminium production and consumption gap hit a high of 2465 million tonnes in 2008. This gap has diminished over the next three years, which lends a positive outlook to the commodity. Consumption has gone up, and the gap has reduced to 995 million tonnes at the end of CY11. For 2011, the total smelter production stands at 45475 million tonnes and the refined consumption stands at 44480 million tonnes worldwide. This shows that there has been some improvement in the sentiment for this commodity.


However, earlier this year we had asked investors to maintain caution while playing this commodity, and we have been proved right as the prices have remained volatile on a YTD basis.

So, what next? There have been positive developments on the global and domestic macro-economic fronts, with the ECB and the US Federal Reserve taking several steps in that direction. With the infusion of liquidity, it is certain that there will be a rise in the prices of base metals.


In an elaborate presentation (available in public domain), British-Australian multinational metals and mining corporation Rio Tinto has opined that the environment is indeed challenging in the short term. However, the company is positive about the long-term prospects. There is a concern over the supply of bauxite though. This supply constraint will have a cascading effect on the prices, which may head northward.

China is the largest consumer of base metals, and any positive step that the country takes will have a positive impact on the prices of these metals. According to Nachnani, “China’s metal demand has witnessed a fall in the current year due to a slowdown in global growth, but demand is expected to increase in the fourth quarter, which is usually a peak period for consumption, and this will help prices to rise further”. It has recently announced 60 infrastructure projects worth more than USD 150 billion, and this news has already boosted the prices of metals. News that the country plans to construct highways, ports and airport runways this year has helped improve the sentiment in commodities, and aluminium is surely going to be one of the beneficiaries.[PAGE BREAK]

Cement: Measured Optimism

Cement is a commodity that has come to the forefront over the last couple of months after remaining subdued for a long time. This is exemplified by the outperformance of cement companies’ stocks on the bourses. The demand for cement is a derived demand, as it depends on industrial activity, real estate and construction activity. With the thrust on infrastructural development, there is expected to be more demand for the commodity going forward.

On the domestic front, the cement prices per bag across India have witnessed a rise of Rs 50 in Q1FY13 on a YoY basis, and stand at Rs 312 per bag. During the same period, the EBITDA margins of cement companies have witnessed a fall of 150 basis points to 18.7 per cent. The aggregate capacity utilisation has been at a level of 77 per cent for FY12 as against 83.6 per cent during FY10. From the capacity utilisation figures, it can be extrapolated that the ROCE was southward-bound. This is clear from the aggregate ROCE of the sector, which stood at 12.7 per cent for FY12 as against 16.7 per cent during FY10. Both the ROCE and the capacity utilisation levels are nowhere near where they were during the peak this commodity had achieved in FY09.

On the capacity front, India has added a capacity of 26 million tonnes during FY12. In FY13, there is expected to be a further increase of around eight million tonnes. Companies like Ambuja Cements, Birla Industries, Century Textiles, JK Lakshmi Cement, Madras Cements and Mysore Cements are in line to add capacities in the current fiscal.

However, cement majors have slowed their capacity addition in view of the lower utilisation levels, and it is expected that around 60 million tonnes will be added till FY15. While most players have exhausted their brownfield capacity addition potential, the economic feasibility of greenfield capacity is limited looking at the current profitability. The addition of capacities up to FY15 will mean excess supply. Companies may not be able to increase volumes by resorting to disruption in pricing discipline. The ROCE is not expected to reach the peak levels of around 94 per cent that it saw during FY07.

After a fairly long period of remaining politically dormant, things have started moving at a rapid pace on the economic reforms front. This is a major sentiment booster, though will take some time to gather speed. We believe that the government will soon expedite its project implementation plan, and this will be a major game changer for the commodity as demand from the infrastructure sector will be on the higher side. Cement prices are likely to move up on a region-wise basis. However, one has to track the commodity closely and play a wait-and-watch game before taking any call on it, rather than flowing with the tide that has engulfed the sector as a whole.[PAGE BREAK]

Copper: On The Up-Move

The red metal is considered to be one of the most important barometers of an economy due to its extensive use in construction, electrical, consumer products and various other sectors. The demand for copper and its prices broadly indicate how the economy is performing. The prices of copper have increased by 4.1 per cent in the international market and 11.1 per cent in the domestic market YTD. Essentially, there are three factors that are currently driving copper prices - the US economy, China’s commodity demand and the EU sovereign debt crisis.

With the US economy struggling, the Chinese economy witnessing its worst growth rate in the last three years and the Euro zone which still doesn’t have any credible solutions to its sovereign debt crisis, why should the prices of copper be at such elevated levels? Realistically speaking, this is because the situation is not as alarming as it looks to be in all these cases, at least not as much as to impact copper prices significantly. Let’s understand this a little more in detail.

In the US, copper consumption is expected to recover due to the firmness in the automotive sector. This will be further supported by the recent quantitative easing (QE3) initiative. In case of China, which still accounts for 40 per cent of total copper consumption around the world, its recent announcement on infrastructure spending has assured the world that demand will not drop in this region.

As regards the Euro zone, the situation seems to be gravitating towards a more sustainable monetary union, with the German constitutional court backing the European Stability Mechanism (ESM), which would be the Euro zone’s permanent rescue fund, removing the last big hurdle to its launch. Therefore, we do not foresee the demand destruction that was witnessed during 2008.

In addition to these factors, the demand-supply equation is also tilted towards demand. According to preliminary International Copper Study Group (ICSG) data for 2012, the worldwide demand for refined copper is expected to exceed the production of refined copper by about 240000 metric tonnes as supply will continue to lag behind the demand growth. According to Mathur, “LME stocks of copper at warehouses have declined 38 per cent since the beginning of January 2012”, which is at the lowest level since October 2008. According to a report by global securities and investment banking group Jefferies, the stock-to-consumption ratio of copper, which is currently at 0.6, will remain below 1 till the end of 2013. All this is definitely going to give support to the prices of copper.

There are not many listed players in copper production in India except for Hindustan Copper (which is present in the entire value chain of the metal), Sterlite Industries and Hindalco. Therefore, the current demand-supply situation augurs well for these companies. Nevertheless, user industries like construction, electricals, etc. will definitely feel the pinch of the heightened copper prices.[PAGE BREAK]

Crude: Will Cool Off

After hitting an 18-month low in June 2012, the prices of crude have once again started going up and the commodity is now trading in three digits. There is a multitude of factors that have led to such a rise in the prices of this essential commodity, which is currently trading at its four-month high.

The current rise in the prices of crude oil may be traced back to the US intensifying the embargo on Iranian crude oil in July 2012, when crude was trading near USD 100/bbl. According to some analysts, such sanctions led to the reduction of Iranian crude oil entering the international crude oil market by 1-1.5 million barrels a day. Then, there was the seasonal tightening of oil markets and the continuing production outages in northern America. Most recently, Hurricane Isaac led to the suspension of 13 million barrels of crude oil production from August 25 through September 10 in the Gulf of Mexico.

The prices have also gone up due to liquidity infusion by the two major central banks of the world, the European Central Bank (ECB) and the US Federal Reserve. As these banks are adding liquidity into the asset markets and this money will need to go somewhere, some part of it will definitely find a place with commodities like crude oil, lifting its prices. Furthermore, the bond purchase programme by the Fed will make the US dollar cheaper as compared to other commodities, which will also made crude expensive. The US dollar index, which measures the performance of the US dollar against a basket of currencies, is already down by more than three per cent from the start of September 2012 and by six per cent from the month of July.

Going forward, we may see the prices of crude cooling down, as the current fundamentals (i.e., the demand and supply situation), which will determine the long-term prices, have not improved and supply growth is still outstripping demand growth. According to the US Energy Information Administration (EIA), with non-OPEC liquid fuels production growing by 1.2 million bbl/day compared with world consumption growth of 1.0 million bbl/day, crude prices are likely to soften. Such a low demand may be attributed to the deceleration in growth of the world’s second largest economy, China. Moreover, the Euro zone still has to come out of the woods – most of the economies in the region are still contracting, which is impacting the demand for crude.

Even domestically, we can see the crude oil prices coming down. In addition to the aforementioned factors, an appreciating rupee is favouring the softening of crude prices. The rupee has already gone up by almost four per cent from the start of August 2012. This will impact downstream companies like HPCL and BPCL positively. The current rise in diesel prices and limiting the subsidised LPG to six cylinders a year will definitely help oil marketing companies to limit their under-recoveries.[PAGE BREAK]

Steel: Gradual Recovery

When we had discussed the prospects of steel as a commodity in DSIJ Vol. 27, Issue No. 2 (dated 15th January, 2012), we had categorically stated that the sector will continue to face headwinds for the next six to 12 months due to lower demand and higher production, which will lead to carrying stocks at higher costs. This is exactly what has happened. Globally, steel prices have witnessed a decline of around 20 per cent since then on account of a contraction of demand in developed as well as emerging economies.

On the demand contraction front, crude steel consumption on the global front has witnessed a marginal improvement of just one per cent from January to July 2012. The production stood at 896.94 million tonnes as compared to 888.39 million tonnes during the corresponding period in 2011. The marginal growth of one per cent is much slower as compared to the 3.30 per cent growth expected for CY12. If we look at the factors that have resulted in demand contraction and ultimately in a price decline, these are similar to what we had mentioned in the previous story. The global slowdown and its impact on overall industrial production and user industries like automobiles, construction, capital goods and consumer durables stands out as the primary reason for this demand contraction. The demand mainly contracted on account of a slowdown in the GDP growth of China, which is the largest manufacturer globally. Further, the European worries only worsened, thereby impacting the overall demand.

While this was the scenario on the global front, the scenario was not very different on the domestic front either. However, all this was about the past, and investors would be more interested in knowing what lies ahead. A lot has changed over the past one month. While on the domestic front, the reforms process has started, on the global front, a few positive factors like the third round of quantitative easing and bond buying in the Euro zone have turned the tide.

Further, the high raw material prices (iron ore), which were earlier impacting the steel sector, have seen a bit of a decline. Since January 2012, the prices of iron ore have declined to USD 108 per tonne in August 2012 from the previous levels of USD 150 per tonne.

Will these developments change the scenario for the steel sector? Well, steel demand is directly correlated with economic activity or growth, and the current scenario hints at some improvement. The first concern was the much slower recovery in advanced economies since the beginning of the year. With the US going ahead with QE3 and hurdles in the easing of the Euro zone crisis cleared, this issue has been addressed for now. Further, China, which has witnessed some slowdown, is expected to come out with policy reforms, though no immediate improvement is expected on that front.

Overall, the recovery process is expected to be gradual. Some improvement will be seen in the US in user industries like Automobiles and Capital Goods. Further, the construction sector is also expected to pick up pace. Hence, going forward, expect gradual improvement in the scenario for steel. On the domestic front, also expect some steady improvement in the scenario.

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