Key points

• Optimism has returned to commodity markets on the back on improved sentiment indicators and strong growth numbers out of China
• However, this can't last indefinitely, as the current fundamental picture is still quite weak. The market is rallying on expectations of a tighter market balance later this year and in 2010
• We expect the global recovery to continue and see further upside for prices in Q4. But short-term risk of correction in prices.

Commodity markets have been very impressive over the past three months. Prices have recovered strongly. Oil has topped USD70/bbl, copper is trading above USD5,000/t and even aluminium is up close to 30% from the bottom.

As we wrote in the previous edition of this publication, there is little doubt that the market is now pricing in an expectation that the global economy will recover from the current recession. We think the market is right in this presumption. Last week our Economics research team released new economic forecasts. Our economists argue that lean global inventories and record stimuli provide a powerful cocktail for growth. It continues to expect global leading indicators to improve and argues that the global recovery in 2009 is likely to be stronger than expected by consensus. The global recession is expected to end in Q3 09.

If this quite upbeat scenario materialises, it will - everything else being equal - be a very positive factor for commodity prices. That said, it could also already be reflected in the current pricing in many financial markets including commodity markets.

There is little doubt that the fundamental picture has improved in many commodity markets. In oil OPEC has shown strong commitment to reduce the current stock overhang, while in metals China has continued to vacuum the global market for base metals, and the numbers coming out of China are surprisingly strong. All in all it seems that commodity demand is not just stabilising but actually picking up - albeit a much lower level than before the crisis.

However, we have to acknowledge that the market in many aspects seems to be ahead of current fundamentals. Global oil stocks are still significantly above normal levels. OECD forward demand cover was running at 62 days in May, which is 7.5 days above the 2008 level and close to 10 days above the preferred OPEC level. US demand is also quite weak. The latest weekly data from the EIA showed that total products supplied to the US were down more than 10% y/y in the beginning of June.

In our view, the market is pushing oil prices higher in anticipation of a tighter market later this year when the OPEC cuts start to feed through into stocks and demand recovers. The story is much the same in other commodity markets. Prices are pushed higher in anticipation of an improved market balance. But one should always be cautious when markets are moving on expectations alone. There is a risk that markets once again start to focus on current fundamentals. Commodity prices could be quite vulnerable if there is a setback in risk sentiment. It is never healthy for commodity prices in the long run if price movements have to be explained by speculative investors that are in the market to gain inflation and dollarweakness protection.

Hence, hedging clients might consider staying on the sidelines for a while awaiting a possible setback in prices before hedging commodity exposure. However, as the turnaround in the global economy seems for real this time, one should certainly not expect to see significantly lower prices, and the risk is that the positive sentiment continues and the market just neglects the current weak fundamentals. If the recovery in global PMIs is followed by an equal improvement in hard data, there is further upside risk for commodity prices in Q4 and in 2010. Furthermore, one should not underestimate the power of investors purchasing commodities to position for a global recovery. Investors might very well have the ability to ‘sit and wait' for better fundamentals to prevail later this year. In other words, there is certainly a risk that the long-awaited setback in prices will never materialise to any significant degree.

Energy: OPEC Sends a Strong Price Signal to the Market

Oil prices have risen significantly during the past month boosted by the general improvement in sentiment in financial markets, a weaker dollar and a general perception in the market that we have now seen the worst of the recession in respect of weaker demand.

We have followed OPEC closely over the past month. In our view, OPEC has started to flag a more hawkish message to the market. As widely expected, OPEC kept oil quotas unchanged at its May meeting. The cartel stayed on course as OPEC put it.

The important piece of news from the meeting was the apparent change in attitude among many OPEC countries. There is little doubt that OPEC has, over the past six months, been quite concerned about the state of the global economy. Indirectly OPEC accepted - more or less voluntarily - that the era of very high oil prices had come to an end.

However, the OPEC stance now seems to be changing. Many countries, including influential Saudi Arabia, sounded surprisingly optimistic at the OPEC meeting. The Saudis stressed that they now see demand picking up in Asia, Latin America and the Middle East, and in general the cartel sounded positive regarding the outlook for the global economy.

The Saudi oil minister al-Naimi in fact went so far as to argue that the global economy can now cope with an oil price of USD75-80/bbl. OPEC also argues that an oil price in this range would secure adequate investments in the oil sector. The latter argument is often put forward to sweeten the call for a higher oil price by OPEC. A higher oil price is not exactly what policymakers in the oil-importing countries are looking for at the moment, though the protests have in fact been very few. Nevertheless, it is hard to see the comments from OPEC as anything else but a strong price signal to the market.

In our view, it seems that OPEC embarked on a strategy actively trying to push oil prices towards USD80/bbl. It seems that the market does believe OPEC. The market analysis is quite straightforward.

First, OPEC is expected to keep production low for the rest of this year, which means that global oil stocks will begin to fall sharply over the next couple of quarters. Forward demand cover is now running at 62 days, but stocks should reach a more normal level (52-53 days is the preferred level by OPEC) in six to nine months' time. We have already seen a decrease in the weekly data from the US, and global stocks will almost inevitably fall during Q3 and Q4. This is the scenario that the market is discounting. In other words, it is turning a blind eye to the current imbalance in the market reflected in the high stock levels.

Second, the market has become more upbeat about global demand. It is beginning to believe that we are on our way out of the global recession. Optimism has been fuelled not least by the encouraging figures for China, which is particularly important for the entire commodity market. In that respect, note that the International Energy Agency in its latest oil market report for the first time in ten months revised its demand forecast higher for 2009.

Finally, the market has seriously started to focus on the supply side. Despite recent years' high oil prices, which would previously have led to many new projects, non-OPEC production might decline this year. Over the past six months, low prices and the financial crisis have also seriously begun to put a dent in the oil companies' investment plans for the coming years. It is estimated that these plans have been scaled back by more than 20% this year.

On top of that we should not forget about the speculative side in oil. There is much anecdotal evidence to suggest that investors are back in commodities. Just like commodities were the perfect place to play the global downturn, it is also the perfect market place to position for a global recovery. Inflation scares and the risk of pronounced dollar weakness have also pushed investors back into commodities. If we take a look at the IMM positions we see that speculators lately have been building long positions in oil. The latest data show that long noncommercial long positions in oil rose by 8.2k contracts to 47.9k last week compared with the week before.

But by nature speculative money is quick and it does seem likely that we might see some profit-taking in the oil market in the near future. Hence, short term, we are somewhat cautious about oil prices. The surge in oil prices has come despite still high global stocks. It would appear that near-term weakness is being completely ignored.

One important issue we will follow strictly is OPEC compliance. According to the IEA, the compliance rate dropped from 76% in April to 74% in May. OPEC11 (Iraq has no quota) is now producing 26 mb/d compared with the quota of 24.85 mb/d.

It could be a first signal that OPEC is losing a bit of control as the price has gone up again. It is once again Iran and Angola that are the culprits responsible for 55% of the above-target production. If the market gets the impression that OPEC is losing control, it could be the factor that puts an end to the oil rally. Short term, we also expect the dollar to gain some strength.

Oil forecast changes

In terms of our oil price forecast, we have incorporated a number of changes into our oil forecast since last month's edition of this publication.

• We are now more certain that the global economy is on track for recovery, and that the recovery in China and in Asia in general will surprise even further. See the latest issue of Global Scenarios.
• We believe that sentiment has improved in financial markets and we expect the dollar to weaken further and global stock markets to trade higher going forward.
• We argue that OPEC has embarked on a more aggressive pricing policy.

Hence, we now expect oil prices to end the year close to USD80/bbl and trade on an average of USD73/bbl in Q4. However, we do not expect this new leg up in prices before Q4. The market will, in our view, need confirmation that stocks are in fact shrinking before prices will turn higher.

We therefore continue to advise the risk-averse client to hedge oil exposure for 2009 and 2010 despite the contango in the market. We would also like to point to the relatively tight crack spreads in the distillate segment that might widen again if transport demand picks up together with an expected recovery in the global economy.

But in the very short term we continue to be a bit more cautious. The surge in oil prices has come despite high global stocks and is very much based on an expected tightening of the market. We would not be surprised to see a correction of 5-10% over the next month. The less risk-averse client might consider waiting for a correction in prices before entering any long positions. That said, be aware that sentiment is very strong in the market, and our USD80/bbl end-2009 target could arrive earlier than expected.

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