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Metal prices may keep rising in 2007 |
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Investor flows that pushed metal prices to record highs this year are proving more resilient to top-of-the-cycle jitters than some had predicted and may help keep prices high well into next year. This could be good news for long-term investors who are only starting to look at commodities as a diversification option.
Spurred by a wall of passive fund money and a tightening fundamental picture, commodities such as copper and zinc reached record high prices this year.
While some attributed the rally to an unprecedented, China-driven commodity super-cycle, many analysts had predicted the bubble would burst sooner than later. They argued consumers are being priced out of the market by the rally.
The doom-sayers appeared to be vindicated amid a midyear correction when prices fell sharply in May and June on concerns over the damping impact of rising global interest rates, but most prices have since recovered.
To the surprise of many, most metal prices are still around double of where they started the year, and within striking distance of their midyear highs. In the case of nickel and zinc, chronically low stock levels continue to push prices into uncharted territory.
"Funds have weathered a number of quite icy blasts and we haven't seen much evidence of real outflows," said Citigroup's global commodity analyst Alan Heap.
The scenario has many participants concluding that both trend-following funds and buy-and-hold investors such as pension funds are in commodities for the long haul.
"It's certainly not a flash in the pan," Merrill Lynch analyst Daniel Hynes said.
The London-based Standard Bank recently estimated commodity indexes such as DJ-AIG and Goldman Sachs are now managing up to US$120 billion versus around US$85 billion at the start of the year and just US$500 million back in 1993.
These indexes offer long exposure to a basket of commodities including derivative instruments designed to overcome the conservative nature of investors like pension funds, insurance companies, private banks, high-end retail investors and balanced funds incorporating small commodity components.
Such mainstream players are following leading investors such as US endowment funds and some Dutch funds into commodity markets seeking long-term portfolio diversification because of commodities' historically negative correlation with other asset classes.
A recent, and significant, example is California's Calpers, which set aside US$500 million for investment in commodities. Being the US's biggest pension fund manager, Calpers's entry may entice Japanese institutions to do the same, according to Tetsu Emori, Executive Researcher at Mitsui Bussan Futures.
Mainstream institutions seeking portfolio diversification aren't spooked by prices stagnating in recent months, analysts say.
"These investors are willing to ride short-term weaknesses ... based on the premise that (the historical) non-correlation with other assets will come back into play," Merrill Lynch's Hynes said.
Global growth concerns and signs of accelerated supply in some markets, however, continue to fuel fears that trend-following funds will trim commodity exposure in preference for less risky bonds and US equities.
Latest global industrial production data indicate a moderation in metals demand in the first half of 2007 and the likelihood of prices moving to end-005 levels by the end of next year, some analysts say.
According to them, metals, including flagship copper, have already moved back into contango, when futures prices exceed spot prices, from their hitherto backwardation status, when spot exceed futures.
"If markets remain in contango, investors will need a consistent appreciation of commodity prices to make money," said Levi Folk, president and managing editor of The Fund Library.
Under such a scenario, some of the newer investors are likely to exit their positions, while some others such as Commodity Trading Advisors may trade their long positions for short.
However, overall investor inflows are expected to remain strong into next year. More institutions are also likely to seek out commodities as a diversifying asset class, analysts said.
In addition, global supply of most base metals remain at low levels and therefore vulnerable to surprises such as supply disruptions, a return of Chinese buying interest or stockpiling by a large investment fund.
Another anticipated driver of investor demand for commodities is the proliferation of investment vehicles – some simpler and others more sophisticated.
For example, actively managed funds, rather than passive indexes, allow investors to move along the forward pricing curve and position exposure with minimal contango costs.
The recently announced smaller-sized LME contracts for aluminium, copper and zinc and new stock exchange-traded metal contracts give retail investors simple and direct access to the sector, possibly at the expense of mining equities.
"People that understand risk and leverage will diversify into these products because you're taking the board of directors out of the equation," said Jonathan Barratt, managing director of Sydney-based Commodity Broking Services.
"Clearly, there is still great appetite among investors for exposure to metals, and the success of ETFs, commodity indices, and the general surge in volumes traded on the LME in recent years is testament to this," said Standard Bank.
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