Danske Markets

8/6/2019 Danske Markets

1/17

www.danskeresearch.com

Investment ResearchGeneral Market Conditions

In this outlook for commodities in 2011 we discuss five themes that we believe will drive

prices this year. We discuss the essence and implications of each theme below; we also

give an account of the themes outlined as key at the start of 2010. Finally, we provide

revised price forecasts for 2011 and introduce 2012 projections, see commodity-price

forecasts. Notably, we have revised our 2011 forecasts for oil a little higher, and our

projections for next year generally reflect our mildly bullish view on most products.

Some of the issues we pointed to as essential a year ago are still highly relevant. This

apply to the prospects for (further) tightening of market balances, and the potential for thehigh correlations of commodities with other asset classes to (eventually) break down. Last

year, we also emphasised the potential for Asia to steer commodity-price developments

and the importance of the region has only grown larger since then. While both fiscal and

monetary policy tightening should be key themes in many countries for years to come,

this is already an central issue in e.g. China and will likely be crucial to commodity

markets this year as well.

Notwithstanding, new topics have surfaced in the past year. The likelihood of the

commodities super-cycle being resumed, and the potential importance of physically-

backed base-metal ETFs (exchange-traded funds) currently being introduced are

significant developments in our view. But, regulatory changes in response to physical

ETFs and to speculative flows more generally cannot be ruled out. Crucially, we expect

the re-pricing of a commodities super-cycle to be a key theme across commodities and

FX markets in 2011. This is one reason why we expect commodity currencies to perform

well this year; see alsoFX Top Trades 2011.

Commodities super-cycle intact

Source: Eviews, EcoWin, Danske Markets. Note: the series real commodity priceshere refers to the first

principal component extracted from the deflated crude oil, base metals and grains prices.

-6

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-2

0

2

4

6

1969 1979 1989 1999 2009

Common commodities factor (log real prices) "Super-cycle"

5 January 2011

Important disclosures and certifications are contained from page 16 of this report

Commodities 2011Five themes to drive the markets this year

Outlook 2011

We outline five themes for

commodities in 2011:

Theme #1: Market balances to

tighten further, shifting forward

curves towards backwardation.

Theme #2: Pricing of a restart of

a decade-long commodities

super-cycle on top of business-

cycle fluctuations.

Theme #3: Risk of commodities

decoupling from the dollar not

least if euro debt woes continue.

Theme #4: Degree and pace of

policy tightening in emerging

markets on both the monetary

and fiscal side.

Theme #5: Introduction of new

physically-backed base-metal

ETFs and regulatory responses.

We have revised our 2011

forecasts for oil a little higher and

introduce mildly bullish 2012

projections for most products.

Chief AnalystArne Lohmann Rasmussen+45 4521 [email protected]

Senior Analyst

Christin Tuxen+45 4513 [email protected]

Bloomberg: DRFX
http://danskeanalyse.danskebank.dk/abo/FXTopTrades2011/$file/FXTopTrades_2011.pdfhttp://danskeanalyse.danskebank.dk/abo/FXTopTrades2011/$file/FXTopTrades_2011.pdfhttp://danskeanalyse.danskebank.dk/abo/FXTopTrades2011/$file/FXTopTrades_2011.pdfhttp://danskeanalyse.danskebank.dk/abo/FXTopTrades2011/$file/FXTopTrades_2011.pdf


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2 | 5 January 2011 www.danskeresearch.com

Commodities 2011

Review of 2010 themes

In January 2010, we highlighted that commodity markets would likely see increasing

focus on the supply side having been driven almost solely by the business cycle in 2009.

Production constraints have clearly surfaced over the past year but economic growth hascontinued to be a key driver as well.

Theme #1: Correlations to fade

At the start of last year, we thought that the high correlations between commodity prices

and for example, EUR/USD and equities were set to fade in 2010 as focus seemed likelyto increasingly turn to individual-specific fundamentals for different products. Although a

clear co-movement of commodities and the dollar has broken down for prolonged periods

of time, the relationship between commodities and equities (risk sentiment) has remained

largely intact. The latter implies that investors remain wary of adding (further)

commodity exposure to their portfolios as the diversification benefits now look more

limited than prior to the recession. The fact that a range of commodity markets are now in

(or closer to) backwardation could lure investors going forward, however, as roll yields

turn positive.

Theme #2: No new all-time highs soon

In light of the large stock overhang in place for most raw materials at the start of 2010

and due to the risk of a negative feedback loop with growth, we predicted that new price

records were unlikely to be seen in most commodities in the near future. We did,

however, give two exceptions to this call for gold and copper indeed, these two metals

have hit new all-time highs this year on the outlook for low interest rates for an extended

period and waning mine supply, respectively.

Theme #3: OPEC still in charge

A year ago, we saw OPEC keeping production broadly unchanged during 2010 in order to

let rising demand work off booming inventories and thus help to stabilise prices. Whileoutput quotas have indeed been kept at end-2008 levels, members compliance edged

lower still until the summer. Forward-demand cover for the OECD region has been

stubbornly high as a result, hovering around a lofty 60 days. However, a firm recovery in

OECD demand and expectations of continued vigorous growth in emerging markets have

contributed to a relatively steady market with prices range trading for most of the year.

Yearly changes

Source: Bloomberg, Danske Markets.

Commodities movements in 2010

Source: EcoWin, Danske Markets.

Correlations with oil


Gold and copper


0 50 100

ICE Brent

API2 coal

Aluminium

Copper

Gold

LIFFE Wheat

% y/y


3/17


Commodities 2011

Theme #4: Flatter curves in sight

The tightening in market balances from both the demand and supply side that we outlined

as a theme for 2010 and to extend into 2011 has led forward curves for a range of

products to see clear shifts in levels and slopes alike. Curve flattening has been seen in a

range of markets but most recently so for crude oil where the Brent forward curve is nowbroadly flat after having been in contango since the onset of the financial crisis. However,

it is noteworthy that in spring, during the massive sell-off in both the energy and the

metals complex, the oil forward curve in fact shifted into a steep contango as the

Macondo oil spill simultaneously prompted fears over long-term supply. The grains

markets also saw periods of backwardation as adverse weather tightening spot markets

significantly.

Theme #5 Asia to put a solid floor under prices

Finally, we stressed that Asian appetite for commodities would continue to put a solid

floor under prices. While fears over policy tightening in China have spooked commoditymarkets every now and again, the Chinese remain key on the demand side for most

products. This is notably clear from the ever-growing attention paid to Chinas monthly

commodity import data; in 2010, the market has been taken aback by the continued

strength in copper purchases and by the surge in demand for corn and soybeans. In

contrast, Japanese growth has come in weaker than anticipated and the floor under prices

that we forecast last year has been provided chiefly by the rest of Asia with notably India

an emerging player.

And the unforeseen: weather events!

One of the things that surprised us the most in 2010 was the significant impact of adverseweather on the agricultural complex. This spurred a rally in grain prices in H2, which

took our relatively bearish call aback. Stocks-to-use ratios declined to less comfortable

levels and we expect to see the lower buffer stocks cause volatility in grains to remain

high in the near term. In the longer term, the recent experience highlights that the impact

on production conditions for a range of commodities from a changing climate with more

extreme weather events as a result is set to be a crucial factor.

Matif milling wheat forward curve


Chinese imports of copper



4/17


Commodities 2011

Theme #1: Tighter market balances

Heavy market surpluses were seen in most commodity markets in the wake of the global

recession in 2009 as demand fell well below production. In 2010, deficits began to re-

emerge first in copper and more recently in the oil market. We expect to see a morewidespread pattern of tighter market balances in 2011.

Market balances to tighten further

On the demand side of the equation, the fact that our economists now view the global

recovery as being back on track after double-dip worries in mid-2010 (see Global

Scenarios, December 2010) suggests that consumption of raw materials should continue

to prove healthy. US and German data has surprised on the upside in recent months, and

even the weak spot during the upturn Japan has been showing signs of stronger than

previously projected economic activity. Asia is still going strong, and our economists see

the apparent frontloading of policy rate hikes in China as positive in reducing thelikelihood of more aggressive tightening measures and a harder landing at a later stage,

see Theme #4.

Supply-side issues are also surfacing in key markets. Although these problems may partly

be caused by a setback in capital spending during the credit crunch, we believe capacity

constraints are for now more structural than cyclical in nature; see Theme #2. In short,

mine supply is struggling to expand in copper and nickel the announcement of mining

super taxes in both Australia and China will only add to the costs associated with

production expansion in the sector. Even in the aluminium industry where smelting

capacity is ample, costs are picking up in the form of both input (bauxite/alumina) and

energy, thus supporting output prices. Finally, oil majors are facing an increasingly

uncertain environment on the supply side as the prospects of expanding output in non-

OPEC countries are growing bleaker the Macondo oil spill is likely to increase safety

standards and insurance premia for deepwater drilling.

On balance, we think inventories are set for further draws this year. We expect the crude

oil, copper, nickel and corn/maize markets to experience deficits for 2011 as a whole.

Buffers as measured by stocks-to-consumption levels are thus set to decline significantly.

Specifically, we look for OECD forward-demand cover of oil products to decline from

currently 60 days to around 57 days; this would still be an elevated level compared with

the 52-54 days historically preferred by OPEC. As a result, we believe that OPEC will

keep production close to current levels; indeed, the cartel still seems wary of the

sustainability of the global recovery in energy demand.

Base metals weeks of consumption Grains stocks-to-use

Source: CRU, Danske Markets. Source: USDA; Danske Markets.

0

5

10

15

20

25

Copper Al umi nium

Hist avg (weeks) 2010 2011 (Danske

0

5

10

15

20

25

30

35

Wheat Corn

Hist avg (%) 2010 2011 (Danske)

Key points

We expect 2011 to give way tofurther tightening of market

balances in oil and metals

Forward curves should eventually

shift into backwardation, offering

opportunities for both consumer

hedging and investors

LME metal stocks

Source: EcoWin, Danske Markets

Crude oil forward-demand cover

Source: IEA, Danske Markets

Senior AnalystChristin Tuxen+45 4513 [email protected]

47

49

51

53

55

57

59

61

63

Jan

Feb

Mar

Apr

May

JunJul

Aug

SepOct

Nov

DecJan

mean2005-2009

days2010

Min/max 2005-2009

2009
http://danskeanalyse.danskebank.dk/abo/GlobalScenariosFixedIncomeImplications02122010/$file/GlobalScenariosFixedIncomeImplications02122010.pdfhttp://danskeanalyse.danskebank.dk/abo/GlobalScenariosFixedIncomeImplications02122010/$file/GlobalScenariosFixedIncomeImplications02122010.pdfhttp://danskeanalyse.danskebank.dk/abo/GlobalScenariosFixedIncomeImplications02122010/$file/GlobalScenariosFixedIncomeImplications02122010.pdfhttp://danskeanalyse.danskebank.dk/abo/GlobalScenariosFixedIncomeImplications02122010/$file/GlobalScenariosFixedIncomeImplications02122010.pdfhttp://danskeanalyse.danskebank.dk/abo/GlobalScenariosFixedIncomeImplications02122010/$file/GlobalScenariosFixedIncomeImplications02122010.pdfhttp://danskeanalyse.danskebank.dk/abo/GlobalScenariosFixedIncomeImplications02122010/$file/GlobalScenariosFixedIncomeImplications02122010.pdf


5/17


Commodities 2011

In base metals, the copper stocks-to-consumption ratio is currently running at a mere 2.3

weeks i.e. below the historical average of 3 weeks; we look for a drop to below 2 weeks

this year. In aluminium, the buffer is traditionally higher but the market is at present well

above normal levels with stocks available to cover almost 24 weeks of demand; we see

a small drop close to 20 weeks in 2011. For grains, stocks-to-use ratios dropped sharply

in 2010 and corn inventories are now at 16% (of annual world use) i.e. markedly

outside the 20-40% range which is usually considered a balanced market; we look for a

further decline in 2011 to 12%. Wheat is also approaching less comfortable levels but we

see a broadly balanced market this year as new plantings have increased on the back of

production shortfalls over the past season; stocks-to-use seen stable at around 30%.

Backwardation to lure investor flows

Tighter market balances will most likely affect forward curves. Last year we saw the

crude oil forward curve shift from a pronounced contango form to now being almost flat.

We expect to see the crude curve shifting into a more marked backwardation during the

course of the year. Overall, we see the oil market recovery as taking place in three stages:

off-shore/floating storage being run down (2009/10), on-shore stocks declining (2010/11),

and finally, OPEC spare capacity shrinking (2011/12). Refined oil curves are still in

contango for most products but lighter oil could see curve flattening as industrial activity

continues to add to demand. But, the refining sector is currently seeing a good deal of

capacity additions which should cap price pressure in the front end.

The historically close relationship between US days of supply and the near-term slope

broke down to some extent in 2010. There are good arguments as to why the co-

movement may be less pronounced going forward: the market is increasingly behaving in

a forward-looking manner, thus reacting more to expected future tightness and less to

present conditions. Also, the importance of the US in terms of global oil use is declining instead Asian market balances will probably prove decisive going forward.

The copper market was one of the first commodity markets to shift into backwardation

after the crisis led to a front-end sell-off in late 2008. LME 3M copper prices have

recently reached new record highs as not least construction activity is starting to gain pace

and a range of mines are struggling with e.g. labour disputes, dragging LME stocks lower.

We think the curve will remain downward-sloping throughout 2011 but developments

further out the curve will depend much on whether new mine projects are announced.

In aluminium, consumption was quick to recover after the recession but LME stocks

merely stabilised in 2010. This kept the aluminium forward curve in contango and

ensured that the widespread business of buying metal spot and selling it forward to lock

in the contango difference (minus funding and storage costs) has continued to be

profitable. Financial deals activity has not led to a marked flattening of the curve but

affect the physical market by tying up a large amount of metal. With interest rates set to

stay low for most of 2011, there is little on the funding side to destroy the party. But, as

yields could pick up towards year-end, financial deals could be unwound (or simply not

rolled over), thereby releasing a lot of aluminium. This could cause downward pressure

on prices. Physically backed base metal ETFs (exchange-traded funds) have the potential

to tighten the aluminium market significantly however, see Theme #5.

All in all, we expect further tightening of market balances in oil and metals markets this

year. For consumers, this is essential because in a backwardation market it is possible to

lock in expenses below the prevailing spot price. From an investor point of view, this isalso crucial as the roll yield obtained from traditional index/futures investment becomes

positive when the curve is downward-sloping. As a result, we expect to see investor

inflows into commodities grow further.

Brent forward curve


Crude fwd curve and US days of supply


Copper forward curve


Commodities speculative flows

Source: BarCap, Danske Markets.

01020304050607080

Inflows (bn USD)


6/17


Commodities 2011

Theme #2: Super-cycle resumed

The cyclical rebound in demand (seeTheme #1) is, in our view, only one factor set to

drive commodities higher in 2011: we believe the market will soon begin to price a re-

start of the so-called commodities super-cycle which could remain in place for decadesirrespective of the regular business cycle fluctuations. The notion of a commodities super-

cycle i.e. the idea that scarcity of raw materials combine with rising demand from

emerging economies to drive a cycle that supersedes the ordinary business cycle is in

our view about to be reignited after having been put on hold during the financial crisis.

Demand and supply factors create perfect storm

In terms of demand, activity in Asia has recovered strongly and metals consumption,

within notably the construction sector, is once again on the rise. In addition, the large-

scale Chinese infrastructure projects implemented as part of the fiscal stimuli in wake of

the recession are unlikely to mark an end to the countrys need for metals. China is set toexpand, for example, its rail network and power grid extensively going forward. During

2010, China took over the US as the worlds number one energy consumer and together

with an ongoing urbanisation process across emerging markets, this underlines structural

changes likely to support demand for raw materials going forward.

On the supply side, the metals market is increasingly focused on output problems

resulting from falling ore grades and a lack of new mine projects coming on stream. In

particular, the copper market has entered what appears to be a structural stance of deficits

as production is stalling. At the same time, costs are on the rise in the mining sector as a

result of higher mining taxes in key countries and ongoing labour disputes.

In energy markets, the oil spill in the US Gulf of Mexico has fuelled worries over futurerestrictions and/or costs associated with deepwater oil drilling. A structural decline in

North-Sea production is just one other factor behind falling non-OPEC oil production.

Notably, the world is set to become increasingly dependent on OPEC for supplies going

forward, but whether Iraqi production can be raised as quickly and cost-effectively as

planned is subject to great uncertainty. However, bright spots from a supply point of view

are advances in natural-gas extraction (e.g. horizontal drilling) and transportation (in the

form of liquefied natural gas, LNG). Indeed, the current gas glut could persist for years.

At the same time, extreme weather events resulting from a changing climate worldwide

are likely to continue to affect the agricultural sector in particular 2010 showed that

adverse weather conditions in key growing regions (e.g. droughts in Russia, flooding in

Pakistan, etc) have the potential to exert massive impact on grain prices as the sector

operates with little spare capacity.

Key points

On top of support from thebusiness cycle, commodities will

likely receive tailwinds for years

to come from a re-start of the so-

called commodities super-cycle.

We believe the market will soon

start to price a re-ignition of a

super-cycle i.e. the idea that

rising demand for raw materials

from emerging markets couple

with supply constraints to drive

prices higher for an extended

period of time.

Real commodity prices: trend intact


Non-OPEC oil supply

Source: IEA, Danske Markets.

Senior AnalystChristin Tuxen+45 4513 [email protected]

Copper market balance: deficits becoming structural

Source: WBMS, Danske Markets.

Metals cycle

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100000

200000

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2000

1999 2001 2003 2005 2007 2009

1000tonnes

Consumpti on Pr oduc ti on Ma rket ba lanc e (RHS)

Al (log r eal price)


7/17


Commodities 2011

Super-cycle intact despite crisis

In order to gauge whether the 2008/09 recession led to a break in a commodities super-

cycle we, first identify a common factor (in statistical terms, the first principal

component) among real prices for a wide range of commodities, including crude oil, base

metals and grains. All series are annual, in logs, and deflated by US consumer prices. Wethen separate the cyclical and non-cyclical component (using a band-pass filter) of the

common factor in order to disentangle the impact of a super-cycle (low frequency) from

the regular business cycle (higher frequency).

Results are similar across oil, metals and grains: in all cases the most recent trough was

observed around the start of the millennium and there are no signs of a cyclical peak

having been reached as a result of the recession. Within the grains complex (wheat, corn,

and soybeans) the common factor explains 97% of the variation in the data; for metals

(copper, aluminium, nickel, zinc, lead, and tin) the corresponding figure is 70% which is

still rather high. When all commodity prices are considered, the common factor accounts

for 68% of the variation. Hence, the apparent super-cycle component on average explains

more than 2/3 of movements seen in real commodity prices over the period from 1969 to

2009.

The difference between the common factor and its super-cycle component highlights that

the 2008/09 sell-off in commodities was merely a business-cycle phenomenon and thus

that this did not mark an end to a broader price upturn. It is also evident from the analysis

that the previous cycle peak was witnessed in the late-1970s around the first oil crisis

for a long time thereafter commodity prices fell in real terms. Our results are broadly

similar to those presented by the IMF in theWorld Economic Outlook, October 2010.

Commodities super-cycle intact

Source: Eviews, EcoWin, Danske Markets. Note: the series real commodity priceshere refers to the first

principal component extracted from the deflated crude oil, base metals and grains prices.

However, we are not uncritical of the super-cycle theory. There is a risk that world

demand for raw materials could suffer from an extended period of below-trend growth.

Also, the supply response to higher prices may be quicker this time compared with

previously due to technological advances. Moreover, in the event that some markets

tighten more than others and to the extent that technology allows, substitution effects may

kick in as well. For example, surging copper prices may lead some manufacturers to

replace the red metal with aluminium if possible, and soaring oil/coal prices may induce

power stations to shift feedstock toward natural gas instead.

Overall, evidence is in our view in favour the idea that the crisis merely posed a pause toa commodities super-cycle which is still intact. We believe that the market has not yet

priced in the likelihood of this perfect storm for commodities but will soon start to do

so. The existence of a super-cycle suggests that the balance of risks for notably metals

and energy prices could lie persistently on the upside for years to come.

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1969 1979 1989 1999 2009

Common commodities factor (log real prices) "Super-cycle"

Grains cycle

Source: Eviews, EcoWin, Danske Markets.

Business-cycle induced price

movements in real commodity prices

Source: Eviews, EcoWin, Danske Markets.

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5

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1

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1969 1984 1999

Corn (log real price)SoybeansWheatGrains super-cycle

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1969 1979 1989 1999 2009

Business cycle component
http://www.imf.org/external/pubs/ft/weo/2010/02/index.htmhttp://www.imf.org/external/pubs/ft/weo/2010/02/index.htmhttp://www.imf.org/external/pubs/ft/weo/2010/02/index.htmhttp://www.imf.org/external/pubs/ft/weo/2010/02/index.htm


8/17


Commodities 2011

Theme 3: Risk of dollar decoupling

Correlations of commodities with EUR/USD and equities remained at elevated levels for

most of 2010. Risk sentiment was a key driver in daily price movements for most of the

year but temporary decoupling of commodities from the dollar was seen. As double-dipfears were eventually sidelined on a healthy growth outlook for Asia, the US and core

EMU countries commodities continued to head higher. Meanwhile, a risk premium on

the single currency led EUR/USD lower as peripheral-debt fears remained in place.

Look for declining correlation of commodities and the dollar

In 2011 we foresee that risk appetite will continue to be a crucial factor in steering

sentiment in the commodity markets. In contrast, we expect this year to see the

correlation between commodities and the dollar fluctuate a lot and likely decline

somewhat; this highlights the risk associated with relying on a high correlation to provide

an implicit hedge of price risk for a EUR-based consumer/producer. Two scenarios basedon a declining correlation are important to consider from a hedging point of view.

Base scenario: commodities stall as EUR/USD risk premium is priced out

As our economists remain complacent that the euro debt crisis will be contained, the risk

premium attached to the euro at present should gradually start to be priced out. Indeed,

our FX strategists are looking for EUR/USD to rise from the current 1.33 to 1.50 in 12

months. In this process we could see the euro go higher without this giving broad-based

support to dollar-denominated commodity prices, as the latter recently appear to have run

ahead of the currency pair. This scenario stalling commodity prices combined with

EUR/USD appreciation - should provide attractive hedging opportunities for consumers

as it would offer relatively low commodity prices measured in euros. For producers or

hedgers of inventories, this would be an unfortunate scenario however.

Alternative scenario: commodities surge on global growth outlook but

EUR/USD drops on renewed euro debt fears

An important alternative scenario to consider is the event that debt woes continue to

weigh on the euro whereas strong US growth - not least if employment takes off

supports the dollar. If EUR/USD is dragged down further as a result, commodities could

nonetheless soar ahead on improving demand prospects. This scenario rising

commodity prices coupled with EUR/USD depreciation could be poisonous for EUR-

based consumers. On the other hand, clients looking to sell/hedge inventories would

benefit from attractive prices converted into EUR.

In order to illustrate the potential risk associated with relying on a high correlation

between oil and EUR/USD, we do as follows. We first calculate the Brent oil forward

curve in EUR per barrel at the current level of correlation along with the probability

bands implied by option pricing. We then compare this with the implicit forward curve

when the correlation between oil and EUR/USD is set to the minimum level observed

since the year 2000. If oil and EUR/USD moved one-for-one the implicit hedge for a

EUR-based client would be a perfect one as the EUR price would be constant. However,

as illustrated by the charts, the fact that the correlation is imperfect and periodically weak

implies that the implicit risk for a EUR-based consumer may be much larger than the

most recent experience would suggest. As is evident from a comparison of the two 90%

confidence ranges (see charts next page), a decline in the oil-dollar correlation would

significantly increase the sample space for commodity prices measured in euros.

Key points

We expect the correlation ofcommodities with equities (risk

appetite) to remain high, but we

highlight that hedging clients

should prepare for some degree

of dollar decoupling in 2011.

As a result, we advise against

relying on EUR/USD movements

to provide an implicit hedge

against commodity-price

fluctuations and we suggest fixing

prices in ones local currency.

Correlation of oil with EUR/USD and

equities


Commodity prices in EUR terms


Senior Analyst

Kasper Kirkegaard+45 45 13 70 [email protected]

Senior Analyst

Christin Tuxen+45 4513 78 [email protected]


9/17


Commodities 2011

Oil in EUR at current USD correlationOil in EUR at historical low USD

correlation

Source: Bloomberg, EcoWIn, Danske Markets. Source: Bloomberg, EcoWIn, Danske Markets.

Oil, dollar, risk, inventories, and speculative flows

The high correlation between commodities and the dollar may however derive from the

fact that both are likely to be driven by risk appetite, i.e. improvements in risk sentiment

have a tendency to lead both commodities and EUR/USD higher. In order to investigate

this hypothesis we conduct the following exercise. We first estimate the relationship

between EUR/USD and the oil price and then add equity returns (as a proxy for risk

appetite) and then in turn augment with US inventories and speculative positioning to see

how causal effects of the different variables on oil might change. All data series are taken

to run from the year 2000.

A bivariate model of Brent oil and EUR/USD suggests that there is both a long- and

short-term relation between the two variables and that notably EUR/USD appears to lead

oil rather than the other way around. However, when adding risk appetite as measured by

S&P 500 returns to the model, it becomes evident that movements in equity markets are

potentially more crucial in driving oil prices than the dollar. Brent oil is in the longer run

driven both by EUR/USD and equity returns and as such there is a stationary long-runrelation between the three variables which sees oil prices adjusting in an error-correcting

fashion whenever disequilibria occur. From causality tests, it is clear, however, that in the

short term equity markets drive both EUR/USD and oil prices whereas there is no clear

direct link between EUR/USD and oil once risk sentiment is controlled for.

Importantly, if we take changes in US crude oil inventories into account usually seen as

a key driver of oil-market fundamentals - the oil price is on a weekly basis largely driven

by changes in stock levels rather than by risk or the dollar. Finally, when adding

speculative positioning we find that there is a borderline significant relation between non-

commercial net long positions in oil at NYMEX and the price. However, causality tests

reveal that in the short run there is a tendency for price rises to precede increases in

investor flows. In other words, there are no clear signs from this model that speculators

have a marked direct effect on prices when other factors (risk, EUR/USD and inventories)

are controlled for. Thus, it appears that speculative flows to large extent chase price rises

rather than the other way around.

Take care when hedging commodities via the dollar

In light of the above, we advise clients against relying on a close correlation between

commodity prices and the dollar. Historically, the simple correlation is highly unstable

and the apparent co-movement seems to be driven largely by shifts in a third factor, risk

appetite. Thus, a direct relationship between EUR/USD and commodities is not given by

nature. Crucially, if global risk appetite remains intact but market sentiment towards

Euroland continues to sour, then risk would likely be supportive for commodities while

negative for the single currency. The possibility of dollar decoupling is thus a central risk

to the factor in deciding on ones hedging strategy.

Causality test (daily bivariate model)

p-value

EUR/USD --> Oil 0.09

Oil --> EUR/USD 0.62

Source: Eviews, Danske Markets. Note: a p-value

below 0.05 indicates significant effect at a 5%

probability level.

Causality tests (daily 3D model)

p-value


S&P500 --> Oil 0


S&P500 --> EUR/USD 0

Oil --> S&P500 0.28

EUR/USD --> S&P500 0.23

Source: Eviews, Danske Markets.

Causality tests (weekly 4D model)

p-value


S&P500 --> Oil 0.04

Stocks --> Oil 0.02

Spec flows --> Oil 0.46


S&P500--> EUR/USD 0.18

Stocks--> EUR/USD 0.25

Spec flows --> EUR/USD 0.07

Oil --> S&P500 0.53

EUR/USD --> S&P500 0.61

Stocks --> S&P500 0.37

Spec flows --> S&P500 0.62

Oil --> Stocks 0.75

EUR/USD --> Stocks 0.8

S&P500 --> Stocks 0.85

Spec flows --> Stocks 0.2

Oil --> Spec flows 0

EUR/USD --> Spec flows 0.09

S&P500--> Spec flows 0.46

Stocks--> Spec flows 0.13

Source: Eviews, Danske Markets.


10/17


Commodities 2011

Theme 4: Chinese policy tightening

In 2011 the developed world will see governments focusing on reducing budget deficits

and central banks preparing exits from (near) zero interest rate policies. Meanwhile, the

focal point in emerging markets will be reining in credit growth while fiscal policy couldremain relatively loose in order to accommodate structural needs for investment in e.g.

infrastructure. Although other Asian countries such as India are growing in importance,

China remains the central consumer in the developing world and we outline its 2011

policy outlook below.

Monetary policy: tightening but not aggressively so

The Peoples Bank of China (PBOC) is set to conduct a minor shift in policy from being

accommodative to being prudent in Chinese terminology this usually means neutral.

Following the Christmas Day rate hike, our economists now look for higher policy rates

to be frontloaded into H1 where growth is expected to be strong and inflationary pressuremost severe. The Chinese authorities will probably continue to use a combination of

higher reserve requirements, yuan appreciation, and constraints on credit growth in order

to curb inflationary pressure. The latter tool should be particularly effective in dealing

with the booming property market which is still a key concern. Although no target for

credit growth has been announced yet, it will probably only see a modest decline. Also,

even if China raises interest rates as expected, a real one-year deposit rate will still be

negative.

Despite higher interest rates, the impact from monetary policy on growth could actually

be positive in early 2011. This is because the considerable focus on the part of

policymakers and banks on achieving the annual targets for credit led to relatively tight

credit conditions towards the end of 2010. During Q1, banks should thus again have

ample room to expand loans. This could boost investment demand and imply a strong

start to industrial activity in the new year.

Overall, commodities are thus unlikely to be severely constrained from the monetary side

when it comes to China in 2011. On impact, news of tighter policy measures could still

spur sell-offs in particularly base metals, but in the longer term we think that measures

that limit the risk of a hard landing for the economy will eventually be perceived as

positive by the market. Recent hints that China will use a stronger CNY to rebalance the

economy are also positive for cycle-sensitive commodities as this will increase the

likelihood of longer-term growth sustainability. Gold may suffer from fading risks of a

global currency war though as safe-haven flows should wane.

Fiscal policy: softening impact from lower infrastructurespending

One of the key factors lifting China out of the financial crisis was the implementation of

massive fiscal stimuli in 2009 and 2010. The programme, which notably involves a

significant amount of spending on infrastructure, was set to run out in 2011 but it now

appears that the government will attempt to soften the negative impact. Policymakers

have maintained the phrase proactive to describe fiscal policy in Chinese terminology

this usually means expansive fiscal policy.

Key points

Policy tightening on both thefiscal and monetary side will be

vital in most countries in 2011

but Asian developments are likely

to play a key role for raw-

materials demand.

Commodities will likely be

spooked by news of excess

liquidity being withdrawn but

fiscal policy is set to remain

relatively expansive in China and

thus to give broad-based price

support.

Investment demand often strong early

in the year due to credit targets


Negative real deposit rates can feed

asset bubbles


Senior Analyst

Flemming J. Nielsen

+45 [email protected]

Senior Analyst

Christin Tuxen+45 4513 [email protected]

05 06 07 08 09 10

-2.5

0.02.5

5.0

7.5

10.0

12.5

15.0

17.5

-2

02

4

6

8

10

12% 3m/3m

% 3m/3m

99 00 01 02 03 04 05 06 07 08 09 10

-6

-4

-2

02

4

6

8-4

-2

0

2

4

6

8

10

12 %-point

Real interest rate, 2-year deposit>>


11/17


Commodities 2011

To offset the negative impact from lower infrastructure spending in 2011, the Chinese

government is planning to boost construction of social housing. This implies that the

construction of social housing may be almost doubled this year to 10m units from 5.8m in

2010. In addition, investments will be boosted to support the governments effort to

improve energy efficiency and environmental protection. On the negative side, however,

the government has simultaneously announced an abolishment of subsidies for auto

purchases from 1 January 2011. This could weigh on auto sales going forward after

strong performance in past years.

All in all, the negative impact on metals demand from infrastructure programmes running

out is set to be smaller than feared, although it could still have some negative

consequences for base metals and energy in 2011. Still, ongoing structural developments

related to the ongoing urbanisation process and adaptation of a Western lifestyle mean

that demand for raw materials should stay strong despite tighter fiscal policy; see also

Theme 2 on the existence/impact of a commodities super-cycle.

Goldilocks outlook on track but risk of hard landing has risen

Taken together, the above-mentioned factors point to an acceleration of Chinese growth

in H1, driven mainly by stronger investment demand, recovering exports and some

restocking following inventory cuts in Q2 and Q3 last year. Rate hikes are unlikely to

have much impact in the near term. We see Chinese GDP growth entering double-digit

territory in H1 and hence exceed long-run sustainable levels.

We expect inflation to accelerate again soon thereafter and to stay above 5% y/y into Q2.

In H2, we forecast that GDP growth will slow to below potential on the back of monetary

tightening. But, it should prove a soft landing as PBOC will eventually pause the

tightening cycle. Indeed, it is crucial that Chinese inflation has so far mainly been driven

by higher food prices. In the absence of negative disturbances to the supply of agricultural

commodities, inflation is poised to ease substantially in H2.

Nevertheless, there is a substantial risk that the slowdown after the summer could be

more severe than our base scenario. This would be the case if inflation increases more

than our forecast and thus forces PBOC to tighten monetary policy more aggressively.

This could be triggered by further price increases, e.g. for grains. This will in turn depend

largely on the weather at key stages in the crop-growing cycle in the relevant countries.

Chinese demand benign for commodities but keep eye on supply

The favourable mix of healthy growth and limited inflationary pressure bodes well forChinese commodities demand in 2011. But with commodity prices on the rise and

notably copper hitting all-time highs lately, China is looking to secure future access to

raw materials without having to be at the mercy of other countries. Last year, a range of

incidents were seen with China making attempts to take control of production facilities

for oil, steel and metals alike. More recently, China has cut export quotas for rare earth

materials (essential in a wide range of high- and green-tech products) considerably to

ensure own supplies going forward. Hence, also in 2011, the monthly Chinese customs

data on commodity imports should prove an important guide to the Chinese market

balance for different commodities, i.e. the extent to which domestic demand continues to

outpace own supplies for different products.

Construction activity could improve

again in early 2011


Chinese growth 2011-12


Inflation should start to ease in H2 11


Chinese oil imports


05 06 07 08 09 10

40

60

80

100

120

140

160

180

40

60

80

100

120

140

160

180

3M moving average

Construction indicator

Index

Iron ore import

Index

Projects under construction

07 08 09 10 11 12

2

4

6

8

10

12

14

16

-5

0

5

10

15

20

25

30

% q/q AR

03 04 05 06 07 08 09 10 11 12

-2

0

2

4

6

8

-2

0

2

4

6

8

Non-Food

Contribution to inflation % y/y

Forecast

% y/y

Food


12/17


Commodities 2011

Theme #5: Physical-backed ETFs tointeract with the market balance

The introduction of physically-backed Exchange Traded commodity Funds (ETFs) has

been a major issue over the last couple of months in the base metal markets. We have

already seen ETF Securities introduce physically-backed ETFs. JP Morgan has

announced it will introduce physically-backed ETFs together with iShares. Rusal, the

worlds biggest aluminium producer is also expected to introduce an aluminium ETF.

Commodity ETFs based on futures have been available for several years. However, the

new ETFs are different. They are not backed by futures, but by physical commodities.

Hence, by definition they interact with the physical market balance contrary to traditional

ETFs that by definition only interfere with the futures market. In theory, physically-

backed ETFs could be introduced in all kinds of commodities which have a reliable

market price. However, as the investor has to bear the costs to storage, insurance,

shrinkage etc, physically-backed ETFs have, or will to our knowledge, only be introducedin base metals and precious metals. Many precious metal ETFs are backed by physical

assets today as the storage costs are very low. Hence, we focus here on the base metal

market.

Physically-backed ETFs to tighten market balances further

The impact on the physical market will depend on the popularity of the new instruments

and tightness of the market. The latter can be described by the size of the inventories and

the spare capacity in the single market. In this note we assume that the introduction of

physically-backed ETFs will not affect supply in the short term, as most base metal prices

are already well above marginal costs in the industry. Therefore, we focus on theinventory situation.

Value of LME stocks are not impressive relative to potential investor flows

Warehousestock/m tonnes Price/USD

Value of stocks/bn USD

Aluminium 4,277,050 2,485 10.63

Copper 377,550 9,700 3.66

Lead 208,275 2,568 0.53

Nickel 135,672 24,750 3.36

Tin 15,275 26,850 0.41Zinc 701,425 2,448 1.72

Steel billet 56,485 575 0.03

Source: Bloomberg

Aluminium has the highest stock value well above USD10bn. However, it has to be noted

that a significant amount of aluminium is already tied up in financial deals, i.e. aluminium

sold at the forward price to take advantage of the contango structure in aluminium. The

independent researcher, CRU, estimated that last year up to 80% of the aluminium stored

in exchange-monitored warehouses was sold forward. Hence, even though aluminium

inventories look plentiful, physical ETFs could have a significant impact on aluminium

prices.

Key points

Physically-backed commodity

ETFs could be a potential game

changer for the base metal

market, as they interact with the

physical market balance contrary

to traditional ETFs which only

affect the futures market

The impact on the physical

market will depend on the

popularity of the new instrumentsand tightness of the market.

Due to the significant storage and

insurance costs related to the

physical products the market

impact should not be

exaggerated. New regulation is

also likely if the new products gain

in popularity.

Aluminium attractive for physical

investors as forward curve is in

contango

Source: Ecowin

Chief AnalystArne Lohmann Rasmussen+45 45 12 85 [email protected]


13/17


Commodities 2011

Copper is the second-largest base metal measured by the value of LME stocks. Copper

has some very strong fundamentals and is well known for its correlation with the global

business cycle and Asian growth. Hence for the investor looking for a sustained global

recovery, it is an obvious choice and we expect investors to continue buying heavily into

copper in 2011. Lead, nickel, tin and zinc are volatile metals and are not expected to

attract the same investor interest. However, the nominal values of the LME stocks are

quite small and it would only take modest investor interest in the smaller base metals to

have a significant impact on the physical market balance.

To put the value of the LME inventories into perspective, it can be noted that in the first

nine months of 2010, according to the World Gold Council, investors invested

USD12.9bn in gold ETFs and similar products. Hence if physical ETFs become popular,

they could potentially affect the base metal market strongly.

Fees for physical investors are not negligible

The advantage of physically-backed ETFs to traditional ETFs backed by an underlyingfutures position depends on the forward structure and the costs of holding physical metal.

If the forward curve is upward sloping (contango) the physical investor avoids the

negative roll yield from the futures positions. This makes aluminium particularly

interesting for physical investments. If the market is downward sloping (backwardation)

the physical investor will miss the positive roll yield from the futures position.

The physical investor has to take into account the costs of holding physical metal. ETF

Securities charge different fees for their physically-backed products. First of all a

management fee, that is little different from the fee incurred when purchasing an ETF

based on futures. But on top of that the investor will have to pay insurance and storage

fees. According to ETF Securities the insurance allowance is 0.12% p.a. and the rental fee

36 cents/tonne/day or 1.4% p.a. for copper with the current price. Hence costs are 2.16%

p.a. including a management fee of 0.69%. However, the copper investor will also have to

take account of the foregone roll yield. Currently, the cash to 12-month spread in copper

is equivalent to 2.4%. Hence, total costs are above 4.5% p.a. for copper. In aluminium

the physical investor avoids a negative roll yield above 2%, but the storage fee, according

toETF Securities, is as high as 6.54%.

The cost-benefit analysis underlines that if the curves stay unchanged going forward the

impact on the copper market might be smaller than the simple market-balance approach

indicates. The impact on the aluminium market should also not be exaggerated as the

storage costs, at least for now, are quite high relative to the saved roll yield.

Regulation to be tightened if prices get out of control

Physical ETFs would, if successful, interfere with the physical market balances. But for

now, regulatory authorities have been remarkably silent. In fact, it can be argued that

physical ETFs circumvent some of the current regulation regarding position limits in the

futures market. However, if physical ETFs actually do become popular, we are quite sure

that new regulations will emerge. In fact, physical ETFs could be used to interfere with

the futures market if one or more ETF owners were to suddenly hold a dominant share of

the physical market.

Overall, we conclude that physically-backed ETFs could be a potential game changer for

the base metal market. However, due to the fees associated with storage and insurance,

the impact should not be exaggerated not least for metals trading in backwardation.

However, the relative modest value of base metal inventories underlines that new investor

money could potentially interfere significantly with the physical market balance. One

almost certain consequence of physical ETFs is that volatility will continue to stay high or

even rise in the base metal market.

Copper to attract investors due to

strong fundamental case

Source: Ecowin

Storage costs for ETFs are high

Metal Storage fee,% p.a.

Aluminium 6.54

Copper 1.56

Lead 5.67

Nickel 0.75

Tin 0.61

Zinc 6.13Source: ETF Securities prospectus


14/17


Commodities 2011

Commodity-price forecasts

Energy, metals and grains


Oil crack spreads


2010 2011 2012 AVERAGE05/01/11 10Q4 11Q1 11Q2 11Q3 11Q4 11Q1 11Q2 11Q3 11Q4 2010 2011 2012

NYMEX WTI 88.6 85 89 91 93 95 97 99 101 103 81 92 100

ICE Brent 92.9 87 92 93 94 96 98 100 102 104 81 94 101

Aluminium 2,465 2,365 2,475 2,500 2,525 2,550 2,575 2,600 2,625 2,650 2,202 2,513 2,613

Copper 9,475 8,613 9,500 9,800 9,800 9,800 10,000 10,100 10,200 10,300 7,562 9,725 10,150

Zinc 2,422 2,333 2,400 2,405 2,410 2,415 2,420 2,425 2,430 2,435 2,188 2,408 2,428

Nickel 24,779 23,619 25,000 25,500 26,000 26,500 26,750 27,000 27,250 27,500 21,915 25,750 27,125

Steel 570 518 560 570 580 590 595 600 605 610 488 575 603

Gold 1,384 1,370 1,400 1,425 1,450 1,475 1,450 1,425 1,400 1,375 1,226 1,438 1,413

Matif Mill Wheat (/t) 251 225 250 240 230 220 220 220 220 220 171 235 220

CBOT Wheat (USd/bushel) 782 707 791 816 796 774 774 774 774 774 599 794 774

CBOT Corn (USd/bushel) 601 562 600 605 610 615 620 625 630 635 441 608 628

CBOT Soybeans (USd/bushel) 1,359 1,245 1,350 1,360 1,370 1,380 1,390 1,400 1,410 1,420 1,043 1,365 1,405

Agriculturals:

front month

Preciuos Metals:

spot (US$/oz)

Base metals:

LME 3M (US$/t)

Energy:

front month (US$/bbl)

Price forecasts AVERAGE

spot Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2010 2011 2012

ULSD 10ppm CIF NWE cargo (USD/MT) 799 766 809 822 839 859 873 888 903 917 697 832 832

ICE gasoil (USD/MT) 758 741 784 802 819 140 140 140 140 140 675 636 636

ICE Brent (USD/bbl) 93 87 92 93 94 96 98 100 102 104 81 94 94

3.5% fuel oil FOB ARA barge (USD/MT) 487 491 514 512 509 514 528 543 558 572 449 512 512

1.0% fuel oil FOB NWE cargo (USD/MT) 500 501 524 522 519 524 538 553 568 582 464 522 522

Crack spread forecasts AVERAGE

(USD/MT) spot Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2010 2011 2012

ULSD 10ppm CIF NWE cargo 120 125 135 140 150 155 155 155 155 155 100 145 145

ICE gasoil 79 100 110 120 130 140 140 140 140 140 78 -51 -51

3.5% fuel oil FOB ARA barge -192 -150 -160 -170 -180 -190 -190 -190 -190 -190 -148 -175 -175

1.0% fuel oil FOB NWE cargo -179 -140 -150 -160 -170 -180 -180 -180 -180 -180 -133 -165 -165

Brent (USD/MT) 679 641 674 682 689 704 718 733 748 762 597 687 687

2010 2011 2012

2010 2011 2012


15/17


Commodities 2011

Commodities at Danske Markets

Commodities Research:

Arne Lohmann Rasmussen Chief Analyst, Head of FX and Commodities Research +45 45 12 85 32 [email protected]

Christin Tuxen Senior Analyst, PhD +45 45 13 78 67 [email protected]

Commodities Sales:

Martin Vorgod Senior Dealer (Denmark) +45 45 14 32 86 [email protected]

Fredrik berg Vice President (Denmark/Sweden) +45 45 14 32 85 [email protected]

Michael Winther Senior Dealer (Denmark) +45 45 14 67 67 [email protected]

Antti Malava Senior Dealer (Finland) +358 (0) 105462057 [email protected]

Anders Winnss Senior Dealer (Norway) +47 23 13 91 57 [email protected]

Patrick Aran Shawcross Senior Dealer (Northern Ireland) +44 (0) 28 9089 1111 [email protected]


16/17


Commodities 2011

DisclosureThis research report has been prepared by Danske Research, a division of Danske Bank A/S ("Danske Bank").

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17/17

Commodities 2011

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