Gold, Oil and Copper
Could See the Biggest Gains
By Frank Holmes,
CEO and Chief Investment Officer
U.S. Global Investors
Commodities don’t all perform in the same way. In any given year, a particular commodity will go gangbusters and outperform the group. However, that commodity will typically come back to Earth and underperform the following year or the year after that. This is why active management is important when investing in commodities. Active managers can benefit from rotating from winners to laggards or by investing in the companies which produce, farm or mine commodities most effectively.
After two straight years of tremendous gains for many commodities, the first six months of 2011 haven’t been as kind. As of the end of June, only two commodities (silver and coal) saw double-digit increases, and only six of the 14 commodities we track – less than half – were in positive territory.
Silver was the leader, rising more than 12 percent, followed closely by coal (up 11.95 percent). Other commodities increasing in value included gold (5.6 percent), crude oil (3.83 percent), lead (2.16 percent) and aluminum (1.73 percent).
Looking Forward to
The Second Half of 2011
We think commodity price movements will fare better during the second half of the year. Goldman Sachs wrote in a report recently that it expects global economic growth to be “generally supportive of rising commodity demand” and “this demand growth will be sufficient to tighten key commodity markets over the next six to 12 months.” We believe gold, oil and copper are some of the commodities which could see the biggest gains.
Gold Prices
Headed Higher
As BCA Research puts it, “[gold] prices have benefited from a ‘perfect storm’ in recent months: falling real interest rates, a weak dollar, fears of a U.S. recession and/or debt default, and European stress.” Those factors, which I affectionately refer to as the Fear Trade, are what sent gold prices flirting with the $1,600 an ounce level. There was also the release of Federal Reserve meeting minutes that showed QE3 is possible, though not yet probable given Chairman Bernanke’s recent testimony. By the way, if you haven’t already seen Bernanke’s exchange with Congressman Ron Paul on gold, go to YouTube and check it out for a good chuckle. Washington’s reluctance to present a solution to the debt ceiling issue also contributed heavily to gold’s performance.
Paul was bringing attention to the threat of currency debasement, a major reason investors all over the world are turning to gold. According to U.K. research firm Capital Daily, the U.S. monetary base has increased more than 200 percent since September 2008. Meanwhile, gold prices have risen only about 70 percent over the same time period. Capital Daily says “if the two had been directly related, gold should already have risen to around $2,800 [an ounce].” That’s obviously a lofty expectation but illustrates that gold prices haven’t appreciated nearly as much as currencies, such as the U.S. dollar, have been debased.
In fact, don’t believe what you read about record high gold prices. Yes, gold hit a high in nominal terms, but the price is more than 30 percent below the 1980 peak of $2,400 an ounce if you adjust for inflation.
Gold is about to get even more attractive because we are heading into the fall and winter gift-giving season. This is the time of year when gold jewelers typically do their biggest business. The kickoff is the Muslim holy month of Ramadan, which started August 1st and ends with generous gift-giving in early September.
The key to this seasonal strength over the past few years has been demand from China and India. The rise in gold prices has been closely tied to the rise in gold demand from China and India. Back when the average per capita income in China and India was well below $1,000 a year, gold prices hovered just above $200 an ounce. As average incomes have approached $3,000 a year over the past decade, gold prices have followed. With the long-term outlook for wages in both these economies rather rosy, gold demand should continue to feel the trickle-down effect.
Those investors looking for more of a technical indicator can take a look at the ratio of gold and oil. Capital Daily says that the ratio of the price for one ounce of gold to one barrel of oil (Brent crude) is currently 13.5. Since 1970, the average has been around 16. Gold prices would need to rise to $1,870 an ounce in order to reach historical ratio levels with $117 per barrel Brent crude oil, according to Capital Daily.
Based on seasonal demand strength and sovereign debt fears of the U.S. and several European countries, we think gold prices could be headed higher.
Oil Outlook Remains Strong
This year has been eventful for the oil patch. Natural disasters, revolutions, terrorist attacks and political maneuvering kept oil bouncing around $100 per barrel and 3.8 percent higher on the year at the end of June. Despite the volatility and large number of external forces affecting oil prices, the International Energy Agency (IEA) said in its most recent Oil Market Report that “the bull run evident since autumn 2010 therefore looks in large part to be justified by supply and demand fundamentals.”
Oil industry analyst PIRA estimates incremental demand will outpace supply by 1.1 million barrels per day on a year-over-year basis during the third quarter of 2011. The U.S. Energy Information Administration (EIA) says long-term supply/demand drivers indicate the market will remain tight for the foreseeable future as growing demand from emerging economies for liquid fuels and slowing non-OPEC supply growth “maintain upward pressure on oil prices.” The IEA forecasts oil prices to average $98 per barrel this year and $103 per barrel in 2012.
The IEA forecasts the world will use 91 million barrels of oil per day in 2012, an increase of 1.5 million barrels per day. The IEA also revised its 2011 oil demand projections upward by 0.2 million barrels per day. Projecting outward to 2016, the IEA’s baseline scenario assumes a healthy 4.5 percent global GDP growth and an average oil price of $103 per barrel. With these assumptions, annual oil demand growth should average 1.2 millions barrels per day through 2016.
Emerging markets are almost entirely the source of this increased demand, with China accounting for 41 percent of demand growth over that time period, the IEA forecast says. The chart illustrates how developing (non-OECD) country oil demand has dramatically increased since the mid-1990s while developed world (OECD) demand has decreased. Through two financial bubbles and a global financial crisis, non-OECD demand has stair-stepped its way to nearly doubling in less than 20 years.
How is this possible? Many non-OECD markets have favorable demographics, rapidly urbanizing populations and industrializing economies that have returned many developing economies’ GDP growth rates to pre-crisis levels.
Rising incomes have also outpaced rising oil prices and sustained emerging market demand despite a general reduction in subsidies, the IEA says. Rising wealth has also established a new global middle class that the World Bank estimates will be more than 1 billion strong by 2030. In fact, the World Bank was cited in a National Geographic article earlier this year forecasting that for the first time ever, more people in the world will be classified as middle class than poor in 2022. Today, roughly 70 percent of the world’s population is classified as poor.
Major emerging market countries, such as China, India and Saudi Arabia, have reached the important GDP per capita range ($3,000-$20,000) where oil demand historically “takes-off.”
China carries the biggest stick among emerging markets when it comes to oil demand. Strict tightening measures from Beijing and rising inflation slowed the country’s oil demand growth to its lowest level since 2009 in June. However, China’s oil demand is still expected to grow 7 percent this year, which is in line with the country’s five-year average demand growth rate, according to Deutsche Bank. The summer months have historically been weak periods for oil demand in China but Deutsche Bank estimates growth rates will recover during the fourth quarter.
Chinese auto sales growth has slowed but still registered 10.9 percent year-over-year growth in June. In an interview with Maria Bartiromo for USA Today, Ford CEO Alan Mulally called China’s car market a “very exciting development.” The company is projecting China’s auto sales will reach 32 million by 2020 – 28 percent of the entire global market. Ford isn’t the only U.S. auto manufacturer tapping into China’s booming auto market; General Motors’ Buick brand is one of the most popular in the country. According to the Brookings Institute, General Motors sold 10 cars in the U.S. for every one car sold in China in 2004. Today, that figure is nearly 1-to-1.
In the developed world, the outlook for oil demand is less bullish. OPEC says the “austerity measures, combined with high levels of both debt and unemployment, are likely to dent the fragile recovery in major OECD countries.”
While demand growth in OECD countries is underwhelming, consumption rates have recovered from recession lows at a much faster rate than many expected. You can see that OECD demand contributed heavily to the recovery in global oil demand from early 2009 to late 2010. In fact, the developed world contributes little to global oil demand growth but still consumes more than half of the world’s total demand.
Despite China’s rise, OPEC says the fate of the U.S. economy is the most influencing factor for oil over the next 12 months. Oil demand in the U.S. was revised upward in May and the U.S. economy is forecasted to see 2.5 percent GDP growth in 2011.
PIRA says the U.S. economy is signaling strength in the second half of the year. It cites business capital expenditures as improving, which generally leads to employment gains and increased household consumption. It also expects a 20 percent hike in auto manufacturing output from the second quarter and an increase in consumer spending.
A big determinant of U.S. demand and consumer spending is gasoline prices, which the EIA forecasts to average $3.56 a gallon in 2011 – up from $2.78 in 2010. U.S. consumers have already shown to be sensitive to higher prices with total motor gasoline consumption down more than 2 percent on a year-over-year basis during the second quarter. While OPEC expects U.S. gasoline consumption to return to normal rates, OPEC calls it oil’s “wild card” for 2012. Gasoline consumption could be negatively impacted by economic turbulence, such as a dip in employment.
Copper slightly disappointed investors, ending the first half of the year with a decline of 3.50 percent. Worries about global inflation and, more specifically, the potential slowing of China’s economy weighed on copper’s price. The red metal rose 5 percent quickly in the new year, but similar to zinc, lead, palladium and platinum prices, declined sharply at the beginning of May.
Since the end of June, copper has been slowly inching its way up, with the past three weeks having produced positive results. Part of this rise is due to reduced supply issues. Chile, the world’s largest copper producer, has been plagued by power outages, strikes, accidents and heavy rains. Reuters recently reported that a “once in a half century winter storm” caused more than 12 mines to slow or stop operations after the open pit roads became too slippery in the South American country that mines about one-fifth of the world’s copper.
The election of Ollanta Humala in Peru – the second-largest producer of copper – has also been a drag on copper prices as investors debate the probability of Humala electing a mining-friendly cabinet. As I discussed in “Is Peru’s Humala Jekyll or Hyde for Mining?,” investors have worried the president-elect could retract policies that encourage mining investment.
The announcement came this week that Humala will appoint Luis Miguel Castilla, Peru’s former deputy finance minister, as the new finance minister. Carlos Herrera will lead the mines and energy ministry. However, according to the Financial Times, it is still not clear whether Humala will increase the corporate tax rate paid by miners and enforce tighter state controls. The actions of this leader will have an influence on the direction of copper prices for the remainder of the year.
In terms of demand, copper is a necessary ingredient for numerous building projects. Electrical power cables, electrical equipment, automobile radiators, cooling and refrigeration tubing, heat exchangers and water pipes all require copper. With all the construction and infrastructure building in China over the past several years, it’s not surprising that this country is the No. 1 world consumer of copper. It’s estimated that China accounted for nearly 40 percent of global copper consumption last year.
Because of this large demand, similar to our outlook for oil, copper prices hinge on China’s ongoing development. While some have begun to wonder about the health of the country’s continuing growth and development, Macquarie Research believes that “real demand in the country remains robust.”
Take developer activity, for example, which Macquarie says has been a huge driver of construction growth in 2011. The media has focused its attention on ghost cities and lagging sales of property in China. Yet Macquarie thinks it’s important to consider the property sales across all different sizes of cities. In its Commodities Comment, subtitled “Chinese social house – another reason to buy copper and iron ore,” Macquarie acknowledges a weakness in property transactions in China’s larger cities. This was due to the government restricting investment demand to slow growth. However, these larger cities account for only 20 percent of the total market, says Macquarie.
Conversely, many smaller cities, such as Anquing, Guizhou, Luzhou, Mudanjiang, and Shijiazhuang, have had double-digit year-over-year growth in unit sales so far this year. In the case of Hohhot, the capital city of Inner Mongolia, sales growth has tripled. Government investment has led to urban space increasing from 80 square kilometers in 2000 to 150 square kilometers last year, according to the city’s government website. Hohhot, which means “green city” in Mongolian, has grown to more than 2 million people and has become a hub for agriculture and manufacturing.
Most importantly, Macquarie says the tremendous sales activity in these smaller cities indicates “there has been enough cash to keep construction activity going.”
In addition, China’s social housing project should drive incremental demand for copper. Macquarie indicated that China is “aiming for 10 million social housing units, up from 5.8 million in 2010.” The country has built only 3.4 million units so far this year, but based on China’s habit of exceeding its objectives, Macquarie thinks the target will be met.
Even if the naysayers think China’s growth will slow because of the government’s monetary policy restrictions, there’s consensus among research experts that the country’s inventory of copper is getting low. Goldman Sachs’ discussion of the copper market indicated that in the second half of 2011, the “winding down of destocking will lead to a stronger Chinese pull on global supply.” China seems to have no choice but to go back to the market for copper, if only to replenish its supply.
Tom Kendall, Credit Suisse’s vice president for commodities research, agrees. In a Mineweb interview on copper’s fundamentals and expectations of further growth, Kendall stated he has seen a “very sizeable drawdown” in Chinese copper inventories this year. He goes on to say, “some point in time, they will get to a point at which they have run down inventory levels to an uncomfortably low level and then there is no alternative to coming back to the international market.”
Editor’s Note: Frank Holmes is CEO and Chief Investment Officer of U.S. Global Investors, an investment management firm specializing in gold, natural resources, emerging markets and global infrastructure opportunities around the world. The company, headquartered in San Antonio, TX, manages 13 no-load mutual funds in the U.S. Global Investors fund family, as well as funds for international clients, and is publicly traded on the Nasdaq under the symbol GROW. For more information on the company and its products, call 1-800-US-FUNDS or visit the website at www.usfunds.com.
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