Long-term behaviour of commodity markets

Light at the end of the tunnel – or is it a train speeding this way? The year 2009 started with the sharpest economic contraction seen in over 60 years. This was not limited to just Germany, but effected all 26 of the other EU member states. And most banks are also looking less than healthy these days. The current situation can best be described as “financial markets without direction and trust”.

The news from every industry – from automotive to retail to manufacturing – is earthshaking. The reduction of inventories due to weak demand, in combination with declines in new orders, is impacting not only the real economy but commodities producers as well. On the supply side, the first half of 2009 looked much the same:

• Producers like OPEC cut output by a cumulative 4.3 million barrels/day
• Various mining projects were put on hold indefinitely
• “Green” projects saw investment dry up unexpectedly

All signs of one thing: the supply and demand structure is trying to regain balance. Only a few countries (like China) are strategically taking advantage of low commodities price to strengthen their reserves. The morning after a party is always rough – so are we still heading towards a hangover?

Anyone who has not looked at commodities prices for the past 6 months would be dumbfounded by what they would see today. The oil price has risen by 70%, copper by 40%. Analysts have an array of good arguments as to why this is – from a weak dollar to fear of inflation to “reactivation of demand”. There is almost no escape for financial managers from the plethora of differing opinions. Is there a transparent solution for the appraisal of commodity markets, without forecasts and opinions?

A short look at the differences between the debt market and commodity market will help us answer this question. In many cases, price developments on the commodity markets are interpreted via the better-known money or forex markets. This is not the proper way to understand them. Commodity markets have a different way of behaving:

• Unlike interest rates and currencies, commodities are “consumer goods", and their prices are accordingly affected by shifts in supply and demand.
• Short-term interest rates are strongly influenced by the central bank. There is no central bank for commodity markets.
• Debt market instruments are relatively standardised, both in USD and EUR. Commodity contracts can have very different features from the standpoint of quality and quantity, whether for coal, crude oil or industrial metals. (the term “crude oil” alone requires explanation: it includes various petroleum products such as light crude, bitumen, heavy crude oil, tar sands etc.)

The separation of sourcing management and price hedging forms the foundation of successful risk management. Procurement secures the necessary goods on the spot market and the Finance department ensures long-term prices via “paper contracts”, such as commodity swaps or options. A conventional supply contract is often used as the basis for this process. Simultaneous fixing of price and volume at a specific point in time, terms of up to one year, lack of customisation and the impossibility of realising an intrinsic value on these contracts represent to most prominent weaknesses of this solution.

The value of so-called commodity swaps (see EduResearch, February 2009) is determined by the long end of the curve. The contract terms, and thus the potential hedging periods, range from 10 years for crude oil to 7 years for Aluminium. The long forward prices have another advantage: they indirectly show the market prices at which producers can maintain the offer. As a rule of thumb, “long prices” are a function of marginal research and development (R&D) plus a reasonable mark-up. Short-term price determinants such as weather conditions in the Gulf of Mexico and political relations between Russia and Ukraine have little impact on long-term pricing. The long price is therefore determined by very different, fundamental factors such as long-term supply and the capital cost for new projects:

• Costs for exploration in accordance with the motto “deeper – further – colder”, since the level of quality and volume cannot be maintained long term;
• Personnel costs (e.g. for engineers) and input costs (steel prices in the oil industry or energy for aluminium production or transport costs);
• Costs for new technologies, in order to (hopefully) render production less expensive and cleaner or to allow deeper drilling in the future;
• Royalties/taxes for the use of wells or mines;
• Political access for production – the majority of oil production is in non-Western countries.

An oil price of USD40/barrel is no problem for “old” wells. New sources that are not fully in production, such a s tar sands in Canada or deep-sea oil off the coast of Brazil require higher market prices given the big difference in R&D costs.

There is an old Texan saying in the oil industry: “The price of oil on the world market is 3-4 times R&D costs”. This rule applies as much today as it did in the past.

R&D costs and the oil price

Source:DOE/Deutsche Bank Global Markets Research (March 2009)

The oil producing countries have very different rates of R&D spending. OPEC is among the lowest cost producers, followed by the old countries like Norway, Great Britain, Russia and the US. At the expensive end of the spectrum are countries like Brazil and Canada. Within a country, costs can also vary based on the difference between conventional and more modern sources of oil.

Marginal R&D costs (last unit produced)

Source:DOE/Deutsche Bank Global Markets Research (March 2009)

The long prices are based on the higher cost ratio. If the global market price falls below the profit threshold, then a “cash negative” volume of the crude oil additionally produced must be withdrawn from the market and production cuts implemented, or the well becomes unprofitable. Similar logic can be observed in the metals market. Production of aluminium has been reduced in many regions because the LME price is lower than the cost of production. The price deterioration is closely related to the recession in the automobile and construction industries. Moreover, aluminium warehouse shelves are filled to capacity.

Connection between aluminium production volumes and costs

Source:Deutsche Bank Global Markets Research (March 2009)

What lessons can be gleaned from this for practical use?

• Commodity swap prices provide the best fundamental estimate of medium to long-term prices levels;
• Long-term swap prices are less volatile than short-term spot prices;
• From the producers’ standpoint, oil prices above USD50/barrel contribute more to long-term supply security than lower prices (assuming demand remains constant globally).

Although insights into market dynamics have improved, the activities of many companies have failed to keep pace when it comes to hedging of market risks. In many cases, companies still wait and hope that prices will come down and/or are so confused by the copious offering of forecasts that they cannot decide what steps to take.

One solution would be a standardised approach to hedging with commodity swaps. Standardised hedging offers two clear advantages:
independence from subjective opinions and smoothing of results. For implementation, a guideline is issued and applied in a disciplined manner by the Finance department and Treasury. The core process may look something like this:

• Every quarter, 25% of the hedging volume is hedged for the next calendar year (see below: “Practical Example – 25% per quarter oil price hedging (in USD)”;
• At the beginning of the new calendar year, prices are hedged 100%;
• Short-term opportunities can be exploited separately using purchased options;
• Variations:
  • Hedging for periods of longer than 1 year
  • Adjustment of hedging to accord with order levels
  • Conclusion of commodity collars instead of swaps.

Practical Example – 25% per quarter oil price hedging (in USD)

The above description can make the hedging level of roughly USD 109 for 2009 seem high.
But, this compares to an average hedging level of roughly USD 71 for 2008, which was established in 2007.

The best derivatives strategy against changes in the oil price is to purchase options. But, this strategy is often seen as the most expensive and seldom systematically implemented in practice. The standardised strategy smoothes price increases, while leaving open price opportunities in falling markets. A subsequent purchase of options for reduction of price differences between the