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Market Overview
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by Andrew McHattie
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This may be a good time to be looking at commodities. Global equity markets are extremely unsettled and volatile, property is particularly weak, and lower interest rates are making fixed interest returns look anaemic. Yet many commodity prices have continued to surge ahead, driven by enduring macroeconomic demand from Asia and by microeconomic supply constraints. Whether or not you agree with the argument that the urbanisation of Asia is one of most significant shifts in global economics over the last century, causing a fundamental upwards shift in commodity prices, there is little doubt there is plenty of movement in commodity prices. It is worth spending some time examining the range of commodities and the range of SG instruments which enable you to invest in a variety of ways. Notably, commodity prices lack very much significant correlation with equity prices: the powerful recent rises have occurred against a negative macroeconomic backdrop. Commodities can be a useful diversifier.
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We’ll start with the most important commodity in market terms. Oil is still on the boil. The price has remained strong in spite of the jittery US economy and fears of recession that might have led to forecasts of reduced demand. For the moment, the focus is very much on supply. There have been reports of OPEC cutting its production quotas at its meeting in Vienna on March 5th – a move which would not be unusual. This is a frequent seasonal occurrence as winter ends in the northern hemisphere. Traders have seen this as a reason to mark prices higher though, particularly when coupled with trickles of news about refinery supply interruptions. Frequent reports of supply issues in places as far-flung as the Shetland Islands, Venezuela, and Nigeria, have conspired to keep the market price of oil high. The prevailing view in the markets seems to be that OPEC is content to keep it that way. The price of crude oil has barely retreated from its highs in the hinterland of US$100 per barrel, up by more than 50% in the last twelve months.
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At the time of writing (February 2008) the price per barrel of Brent crude oil is around US$96. SG has a range of call and put warrants on Brent crude, expiring in June and November this year. The leverage on these products means they can deliver substantial profits from comparatively small movements in the oil price. The SM47 Brent crude US$90 Nov 08 calls, for example, rose from 42p to 60p in the second week of February in response to a rise in the oil price from around US$87 per barrel to US$94 per barrel. With good timing, these warrants could be very useful in a portfolio. If that degree of volatility is too great, you could alternatively consider the SG02 Brent oil tracker, which closely tracks the price of one barrel of brent crude oil with no exchange rate risk for sterling investors.
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Moving on to gold, often a favourite with investors worried about economies and equity markets, it has of course been another strong market. The gold price is up by more than a third over the last year, to US$922/oz at the time of writing. A number of technical analysts view gold as well supported at US$860 and US$900, and they say that any sustained break over US$935 could be the start of a rally to take the price over US$1000 per ounce. Ironically enough, the surge in commodity prices (including gold) is likely to feed through into the inflation statistics in major economic nations, which may in turn trigger more demand for gold which has traditionally been used as a hedge against inflation. Consumer demand is also supportive on an ongoing basis. According to data from the World Gold Council, gold demand in China grew by 26% in 2007 from a year earlier to 326.1 tonnes, boosted by booming jewellery consumption. Chinese jewellery demand reached 302.2 tonnes in 2007, making China the world's second-largest retail jewellery market after India.
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As with oil, the supply situation is also part of the story. Last year, China was the only major gold-producing country to increase its production. Elsewhere it was falling, and that includes lower output from some key South African mines. Add a weak dollar and a diminishing risk appetite into the mix, and the reasons for buying gold multiply. A fortnight ago, a research note from Citigroup in the US said that a test of the US$1000/oz level is possible this year. Analyst John Hill argued that this is an extremely hospitable macro environment and that the ongoing investment-driven demand phase will continue for gold, particularly as the broader investor base is not yet fully involved. Merrill Lynch has also raised its gold price forecast, again citing broadening investor demand, a weak US dollar, record oil prices and ongoing geopolitical tension. Merrill analysts Michael Jalonen and Jeffrey Schok said they expect gold to average US$925/oz this year and US$1,000/oz in 2009. They said that notwithstanding the possibility of short-term strength in the dollar, higher gold prices should be supported by positive supply-demand fundamentals including stagnant mine production and robust jewellery demand in emerging markets.
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SG has more than a dozen covered warrants on gold from which to choose, with differing levels of leverage and intrinsic value to suit different investors. As an example, the SK72 Gold US$800 Dec 08 call warrants, which have a fairly close relationship with the underlying asset (the delta is the indicator measuring this) rose from a low of 36p in November to a high of 86p in January, illustrating the potential returns. Gearing is also available from the SG43 Gold Index Protected Accelerator product which offers 170% uncapped upside participation coupled with some capital protection. For more conservative investors, there is the SG04 Gold tracker, which has the added benefit of removing the exchange rate risk for sterling investors, or the Lyxor Gold Bullion Securities (ticker code GBSS). These securities are traded on the London Stock Exchange, and investors actually become the beneficial owners of the gold which backs each security.
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Many investors rarely look beyond these ‘big two’ commodities. Gold and oil do hog the headlines, but of late there have been two particular areas of strength elsewhere. The first has been the industrial metals. Aluminium prices have surged ahead to nine-month highs after a power crisis halted mine output in South Africa, and China, the world's largest aluminium producer, was assaulted by severe snow storms that have damaged the infrastructure and caused power shortages that have hampered mine production. The spike in prices triggered some excellent returns from call warrants, most notably the SP23 Aluminium US$2650 Jun 08 call warrants, which have soared from 46p at launch in January to 160p just over a month later. Longer-dated calls are also available.
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Similarly, the same issues in South Africa and China have boosted copper prices through the US$8000 per tonne mark, helped by a fall in stocks. Copper prices are finding support from expectations that Chinese demand will leap after severe winter weather damaged numerous power stations and electricity supply networks. Data shows that futures investors have turned positive on the commodity. The SP30 Copper US$8000 Jun 08 call warrants rose from 17.4p to 31p during just one week in February, and have risen higher since. If that sounds remarkable, platinum prices have been squeezed even more acutely by the power crisis in South Africa, which accounts for more than 80% of world platinum output. In January, Eskom, the state-owned power utility in South Africa, cut supplies to homes and businesses across the country in response to an electricity shortage. Rationing has been introduced in some areas and the shortages are expected to last at least until 2013. This has led some analysis to argue that the rally in metals prices can continue. The SP36 Platinum US$1800 Jun 08 call warrants have risen by almost 600% in one month as the platinum price has leapt from around US$1600 per ounce to US$2150 an ounce.
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In addition to the warrants and trackers available on individual commodities, there is of course a large number of warrants available on individual mining stocks, including Antofagasta, Anglo American, BHP Billiton, and Rio Tinto. Each of these shares has started 2008 in good form, helped by the metals price rises and by corporate activity. The copper mining company Antofagasta has been particularly strong, with its shares rising from a low of 578p in January to 827p within a month. The SM78 Antofagasta 800 Jun 08 call warrants rose from 32p to 130p during the same period.
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Besides the boost in industrial metals prices, the other prominent story has been the rise in agricultural commodity prices. You will probably know that food prices have been rising, hoisted in particular by wheat prices, which have more than doubled over the last year. Supply has been restricted by droughts and rain-damaged crops in Australia, France, and the US at the same time as demand has soared from Asian consumers. The use of crops for biofuels does not help the supply and demand balance either. The US Department of Agriculture predicted in February that wheat stockpiles will drop by 40% to the lowest levels since 1948. Unless something changes, the trend towards higher prices looks set to continue. In the UK, The Grocer magazine has reported on a looming pasta crisis because the price of durum wheat is two and a half times higher than June last year as supplies have tightened, forcing some suppliers to cease pasta production because they are unable to pass on the soaring cost of raw materials to customers. Other soft commodities are rising in price too.
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SG has five call warrants and two put warrants available on the GS Agriculture Index, which has been rising steadily from around 75 in November to 95 in the middle of February. There have been some large increases in warrant prices. The SM63 GS Agriculture Index 90 Dec 08 call warrants, for example, moved up from 17.5p in November to a peak of 67.5p in February.
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For investors with less certainty about the price prospects for a specific commodity, there are some interesting general alternatives. One is the Lyxor ETF (exchange traded fund) on the Reuters/Jefferies CRB Index. This index comprises a full range of commodities, with a high (23%) weighting to oil, then 6% each in aluminium, copper, natural gas, gold, corn, soybeans, and live cattle, 5% in heating oil, unleaded gas, sugar, cotton, cocoa, and coffee, and 1% in nickel, silver, what, lean hogs, and in orange juice. The ETF is designed to track the performance of this index, thereby providing a simple, broad exposure to commodities, traded in sterling, on the London Stock Exchange. The ticker code for this ETF is LCTY. As you might expect, it has performed well since its launch in June of last year, rising from 1500p to 1940p in mid-February.
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If you like the idea of an ETF and you have been impressed with the rise in agricultural prices, the Lyxor CRB Non-Energy ETF with the ticker code LCNE may be of interest. This ETF is designed to closely track the Reuters/Jefferies CRB Non-Energy Index, which strips out the oil and gas elements. This means the index has a higher weighting in the ‘hot’ areas of industrial metals and soft commodities. The 15 constituents are weighted as follows: 9.84% each in corn, soybeans, aluminium, copper, live cattle, and gold; 8.2% each in sugar, cotton, cocoa, and coffee; 1.64% in wheat, nickel, lean hogs, and silver; and 1.6% in orange juice. Since launch last June this ETF has risen from 1135p to 1430p in mid-February.
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