Don't Be Fooled By Tanking Commodities, Bullish Upside Remains

A farmer in Batavia, Illinois plants corn in h...

Commodities have been behaving differently, but upside remains - AFP via @daylife

Commodities have been taking a beating the last couple of days, with the S&P GSCI index (which tracks the price of 24 commodities) falling almost 8% this week on continued weakness from silver, copper, and nickel to crude oil and gold.

As commodities continue to tank, underlying fundamentals suggest it?€™s not time to short the raw materials, and that substantial upside potential remains, according to Barclays. This market is different, though, in that there is ?€œgreater dynamism in time spreads and a broader range of performance both within and between commodity sectors.?€

The commodities complex seems to have broken down, with the GSCI down almost 8% for the week, hitting a nine month low. Gold was trading around $1,633 an ounce in New York while WTI oil contracts fell below $80 a barrel.

The main factor appears to be a new wave of portfolio repositioning as investors digest the latest Fed statement where the group headed by Ben Bernanke noted substantial downside risks remain for the economic outlook. With Greece teetering on default and emerging markets like Brazil and China slowing, markets seem to be bracing themselves for a continued drop in commodity demand, strong enough to ease supply pressures. (Read Operation Twist Set To Fail As Bernanke Insists On Flattening The Yield Curve).

Analysts at Barclays have a different opinion, though. ?€œFresh peaks still lie ahead?€ for commodity demand, they explain, noting that while it may be slowing down, demand is still coming off exceptionally high levels. Commodity demand is slowing, but not fast enough to ease pressures in the supply side, particularly in crude oil, grains, and some industrial metals like copper, they explain. From the report:

Global steel demand hit an all-time high, beating its previous best set in Q2 10 by4%. Global copper demand set a fresh all-time quarterly peak of over 5mt, beating its previous best by 3%. Crude oil demand softened relative to Q1, as is the seasonal norm, but still set an all-time high for the second quarter of 87 mb/d, beating the previous all-time Q2 peak set in 2010 by 1%. Meanwhile, our readings on global oil demand (and those of the IEA) suggest that Q3 will be the strongest quarter for oil demand ever recorded, at almost 90m bpd.

Risk is higher in the highly volatile energy and food markets, where geopolitical and weather related factors, added to shortages of spare capacity and low inventory levels, will keep investors on the edge of their seats.

While demand in the U.S. and other advanced economies appears to be slowing, China looks strong as ever. CPI growth has slowed and trade data has strengthened since august, with imports accelerating. China is also reaching the end of a period of destocking in copper, crude oil, sugar, soybeans and corn. ?€œTight credit conditions, volatile commodity prices and uncertainty over future demand growth means that many Chinese raw materials consumers were aggressively cutting inventory levels to save on working capital earlier this year. However, that process can only last for so long,?€ they explain.

On the supply side, ?€œmany of the problems that hampered production growth in the second half of the last decade, especially labor shortages, the declining quality of energy and metals reserves, infrastructure bottlenecks and equipment shortages, are becoming endemic once again.?€

Active commodity index strategies have outperformed - Barclays

Output will disappoint in several sectors. In crude oil, non-OPEC production has ?€œground to a halt?€, while cost floors have been approached (for example, Saudi Arabia needs the cost of a barrel of oil to sell at $90 to $100, according to Barclays). Copper production is set to be ?€œone of the weakest [?€?] since the mid-1990s.?€ Corn and soybean harvest are also expected to come in at record lows.

What?€™s the appropriate investing strategy?

Active commodity index strategies have been the year?€™s best performers, they explain. With the outright level of commodity price appreciation substantially below 2010 and curve shapes being much more dynamic (regular moves into and out of backwardation across a wide range of markets), strategies that ?€œaim to exploit the curve shape or that are based on selective long only exposure to smaller sub-sets of commodities where fundamentals are particularly strong?€ are set to succeed. (Read Gold, Acting Like A Commodity, Plummets In The Face of A Rising Dollar).