A sustained bull run in markets such as copper has offered tempting returns; gold is seen as a safe haven, and huge demand growth from China and India has pushed up prices in metals, energy and agricultural products. The question is whether investment in production capacity for many commodities will lead to oversupply, or whether the demand pull from rapidly growing economies will lead to scarcity and rising prices.
Growth in China and emerging markets could be the most important factor in deciding which side of this line a commodity will fall. Some analysts have advocated shorting those commodities in which China and India are investing heavily, and going long in those markets where their demand growth will outstrip their ability to increase domestic supply.
But will playing the commodity markets be as simple as tracking these investment patterns and shorting markets such as petrochemicals and aluminium, or riding price gains in markets such as copper and platinum to which their capital may not flow?
Forecast follies
Commodities can be unpredictable and often surprising. In copper's bull run up until mid-2008, for example, bullish and bearish voices were split over whether a new 'supercycle' age was being entered, or whether prices had overheated and had to retrench. The bears were continually confounded, but ultimately vindicated when prices crashed. Now, the bulls are back.
Copper on the London Metal Exchange is back at record highs, having nudged $9000 a ton - almost treble its price in early 2009. The big pull on copper is demand from China, a huge importer of the metal due to the rapid industrialisation and urbanisation in the country. China's demand for copper does not, however, set the tone for the whole industrial metals complex.
"There can be big differences between the metals, especially in terms of the speed of supply response. Inventories in many metals rose dramatically after the credit crisis, but some have tapered off, especially tin and nickel. Tin is particularly notable, as it is so dependent on one country - Indonesia - for its supply," says Daniel Wills, senior analyst at ETF Securities.
China's heavy investment in aluminium smelting capacity pushed the market towards oversupply, but the tide is turning. Aluminium began 2010 with a big surplus, but should be in deficit by the end of the year. Smelting is extremely energy-intensive, so higher energy prices curb investment. Furthermore, China's government has disincentivised such investment, partly to quell demand for power. So, despite growth in capacity, analysts are bullish on prices, which must rise to incentivise new investment.
"The [Chinese] government's main focus is on the mining side, whereas previously it was on smelting and downstream capacity. [China] is short of all mined materials, so is a net importer. Mainly it is short of copper, which is why the market is so strong. It has been investing in copper, nickel and to some extent zinc, both domestically and abroad," says Michael Widmer, a strategist with Bank of America Merrill Lynch's research team.
"But all markets are cyclical, so there is not a consistent deficit. Copper supply will come on or demand will be destroyed, so the markets will be balanced. The scrap market will become more important or people will substitute out of it. In aluminium, China could activate more production if it wanted to, though government disincentives should mean a slowdown in growth. India won't have the same impact. Its demands are much smaller and it is proactive in bringing on domestic metal supply," he adds.
India's Vedanta Resources is already the world's biggest zinc producer and it has plans to significantly increase aluminium smelting capacity, although some projects have been deferred to prevent oversupply.
"Overall, India is increasing its metals consumption, so expect production growth to follow. But it all depends on whether it wants to be self-sufficient or a net exporter," says Mr Widmer.
Energy markets diverge
For energy, investment patterns clearly carve out radically different trends. The story for oil is one of tightness, as resources struggle to keep up with rising demand. For natural gas, the outlook is very different.
"Globally, we see growing pressures on oil supply. We expect moderate growth rates for demand in the medium term, but it is enough to put pressure on the market. In fact, the spare OPEC [the Organisation of the Petroleum Exporting Countries] capacity may seem high now, but is only about 4% of the annual global oil demand. Based on our projections, we believe that the erosion of OPEC spare capacity could happen faster than generally expected," says Yingxi Yu, analyst at Barclays Capital in Singapore.
Global oil demand is about 90 million barrels per day (bpd). OPEC spare capacity is only 4 million bpd. The market is currently vulnerable to any supply-side shock, unlike natural gas, where reserves seem plentiful and inventories are at record levels.
"There is lots of supply coming on and there is an overhang from the credit crisis, as it is heavily used by industry and demand fell away. There is also a change in production technology, especially in the US where shale gas is becoming accessible, and the Middle East is boosting capacity. So, more supply is coming on at a faster rate," says Mr Wills.
Estimates of spare capacity must take into account rising demand, which inevitably throws the spotlight on China and India.
Urbanisation growth
Key to understanding Chinese and Indian patterns of demand for energy - and all commodities - is the rate of urbanisation. It took 30 years for India's urbanisation rate to move from 20% to the current level of 30%. The move to 40% could take only 20 years.
"That is still slow compared to China, but we anticipate India's demand growth is about to accelerate. It has reached a tipping point. We find that income per capita growth accelerates after a certain urbanisation ratio, and demand for most commodities will also accelerate," says Ms Yu.
Barclays Capital estimates that in the next five years, India's primary energy demand will rise by 50%, and its demand for metals by 80%. After 2030, the numbers become even more remarkable - its energy consumption rising fourfold from 2010 and levels and metals demand growing fivefold.
"If you put demand and supply together, energy is where India will have the most bullish impact. Domestic oil production growth has averaged about 0.2% per annum for the past 10 years , and even if we assume a relatively optimistic growth of 2% per annum over the next 10 years, then India's import dependence in crude oil will still increase from the current 75% to 87% by 2025," adds Ms Yu.
Admittedly, there is a different picture for refined oil products. India, a net exporter after major investment in the sector, will continue to expand refinery capacity. Its crude oil exploration, however, has had little success, despite the government's best efforts. It has done better in natural gas, with large fields such as Krishna-Godavari coming onstream.
India needs to secure its energy needs, so it has been investing in gas and nuclear power, and there is a lot of interest in securing coal assets overseas. But in other markets such as agricultural commodities, investment has been more limited.
"It is a big net importer of edible oils, for example, and there is a risk it will become a bigger importer of milk and grains. Even as the economy grows, most food is supplied domestically, but the monsoon [season] is unpredictable, the irrigation network is not secure and diets are changing," says Barclays Capital analyst Rahul Bajoria.
Opaque agriculturals
Urbanisation and economic growth in China and India are strong demand-side forces in agricultural markets, but long-term forecasting is harder for goods such as grains, sugar and cocoa, as the supply side depends on unpredictable, short-term factors such as weather patterns.
Changing rainfall patterns in Asia and the effects of climate change, including later harvests in China and India, make markets sensitive to supply shocks, as was seen last year with India's poor sugar harvest.
The market was caught short when India became a net importer instead of an exporter. There is also a question - even if there is a supply rebound - over how much will go into rebuilding inventories. How much of a buffer will be left? asks Mr Wills.
"In 2009, Latin America stepped in to meet the shortfall, but inventories were not rebuilt, so the market is still vulnerable to shocks. For agriculturals, however, supply turnaround is shorter than markets such as industrial metals. Supply response is elastic as planting patterns can change relatively quickly," he says.
Again, much will depend on how much China and India can expand domestic production. Demand growth in India and China is very rapid. India, although it is broadly self-sufficient, has water problems, but China is very reliant on imports. "[China] has at times been a modest exporter of corn, for example, but there is a massive increase in its use for animal feed and in industrial demand, so imports have gone through the roof. They have gone up 8500% in the past year," says Barclays Capital commodities analyst Sudakshina Unnikrishnan.
Striking a balance
The long-term cycle in agricultural markets, however, is broadly expected to be one of balance.
Most believe that the problem is not about the potential for additional supply on the long-term: there is enough land available in Africa and Latin America for expansion and there could be increases in yield in countries such as Russia. However, the next five to 10 years, could be see many food crises.
"Prices will push higher, which will trigger a supply response meaning production gains, rising stocks and, then, prices fall. But with consumption growing by up to 40 million tonnes per year for grains, demand would soon outstrip slowing production again. Then there will be another shortage and prices will rise again, and there will be another supply response," says Emmanuel Jayet, head of agricultural commodities research at Société Générale.
In some markets, the spectacular demand growth from China, India and, in the longer term, Africa, is compounded by supply side limitations, such as a lack of infrastructure investment and uncertain political situations in countries such as Côte d'Ivoire, and in sectors such as grains, the competing demands of the biofuels market.
In some markets, notably oil and copper, there is little buffer to withstand supply-side shocks alongside growing demand. "In the next five to 10 years, the tightest markets will be crude oil and copper, where the current misalignment between supply and demand will remain," says Ms Unnikrishnan. "For oil, non-OPEC supply is weakening, so OPEC's spare capacity will be whittled down.
If any markets are to see oversupply, then it will be commodities such as natural gas and silver, where there are no major structural constraints on supply. "The rest of the commodities are somewhere in the middle, but there are always risks," says Ms Unnikrishnan.
Even in a tight market, however, the future is not set. "Although copper will be reasonably tight, and aluminium will be less oversupplied than it is at the moment, metals are very cyclical, so if demand is there, then supply will ultimately come through," says Mr Widmer.
Most believe that a similar analysis holds for most commodities. It may be logical to try to gauge future commodity trends by tracking the capital investment flows from China and India, but it pays to keep other variables in mind.
