HIGHLIGHTS

• Strength in base metals and energy prices drives TDCI up 7% in the second quarter
• Rapid appreciation of the loonie leaves the index in Canadian dollar terms in the red
• Commodity prices to lose ground in the third quarter as demand from China loses steam
• A sustained recovery in commodity markets to begin in the final quarter of this year, with the overall index rising by 22% from current levels by the end of 2010
• The index in Canadian dollar terms will outperform, rising by 33% from current levels

With all the green shoots sprouting up around the world, markets were increasingly becoming more optimistic about a global economic recovery. This bout of confidence trickled into commodity markets in the second quarter, with several sectors springing back to life. The non-precious metals and minerals sub-index (+16.7%) enjoyed the largest bounce, while energy prices were next in line. Interestingly, the 9% gain in the energy sub-index was solely due to a near 40% jump in crude oil prices, as natural gas and coal prices were both down relative to the first quarter. Forest products was the only sector to decline during the quarter, despite a small uptick in lumber prices. Overall, the TD Commodity Price Index (TDCI) jumped up 7%, following three quarters of double digit declines. Excluding energy, the index was up by a more modest 3.5%.

In Canadian dollar terms, the index fared much worse as a result of a rapid appreciation of the loonie from 77 US cents to 92 US cents between March and June. The index as a whole tumbled by nearly 6%, while the index excluding energy slid by 9%. The non-precious metals and minerals sector was the only one that managed to record a gain in Canadian dollars during the second quarter.

The rise in the loonie was not so much a story of a stronger Canadian economy, but more so a result of disinvestment in the U.S. dollar, which slumped 11% on a tradeweighted basis since reaching a cyclical peak in March. This rapid decline in the greenback across several currencies sent investors looking for a hedging tool back into commodity markets. Accordingly, the negative correlation between commodity prices and the greenback strengthened dramatically, and for some commodities, in addition to the renewed optimism surrounding the economic recovery, was a driving force behind the second quarter price rally.

Another common theme across several commodities was the robust demand from China. A wide array of imports to the country, from base metals to forest products to agricultural products, surged well above year-ago levels. These rising imports, coupled with improving Chinese manufacturing production data, helped give prices a boost in the second quarter. But much of the demand in China has been due to government-led stimulus spending, which likely cannot persist at current levels for much longer. Moreover, we suspect that inventories in the country have been mounting, as underlying demand does not appear to be as strong as the trade data suggest. As such, Chinese commodity imports are likely to cool off in the near term.

While a soft tone in the U.S. dollar should continue to support prices throughout the remainder of this year, the deceleration in the pace of Chinese imports is expected to expose a picture of ongoing underlying weakness in commodity demand in the third quarter. As well, it appears as though the market has snapped back into reality, recognizing that despite some improvement in some economic indicators, the economy is still in a very weak state. As a result, some commodity prices have lost ground in recent weeks, and we expect this trend to continue throughout the quarter. On the whole, we expect the TDCI to fall by about 8% from current levels over the summer months, with the non-precious metals and minerals and energy subindices suffering the largest pullbacks.

Sustained recovery to begin in Q4

The rebound in commodity markets will be closely tied to a slow healing in the global economy. Accordingly, we continue to expect a sustained, yet gradual, recovery in commodity prices to begin in the fourth quarter of this year. The rebound in 2010 will be dominated by the energy sector, while precious metals will be the sole sector to see prices decline. Overall, by the end of the forecast period, we expect the TDCI in U.S. dollars to jump 22% from third quarter levels. Excluding energy, the index will rise by a more modest 11%. While a decent performance in percentage terms, this will only bring the index back to the levels seen in the fourth quarter of 2008 - after a significant portion of the massive slide in commodity prices had already taken place. Aside from the recent down cycle, the index will only rise to levels last seen in mid-2005. As the loonie retreats in 2010, exchange rate effects on commodity prices will be softer. In fact, we forecast the index in Canadian dollar terms to outperform, rising by 33%, while the index excluding energy will jump 21%.

ENERGY

Crude oil to trade within a tight range in 2009-2010

Crude oil prices switched gears in May, beginning a strong rally that drove prices up past the US$70 per barrel mark in June. As a result, crude oil was the top performer in the TDCI during the second quarter, rising by a whopping 39%. However, this surge in prices was not a reflection of an improvement in the fundamental picture, but rather the return of hungry investors to the market.

The sharp decline in the U.S. dollar has renewed interest in oil as a hedging tool, as evidenced by a considerable strengthening in the negative correlation between crude oil and the U.S. dollar in recent months. This, along with optimism surrounding the global economic recovery, has been the key driver of the price rally. Indeed, higher prices have found little support from the supply-demand fundamentals, as the drop in consumption continues to outpace production curtailments. The U.S. is the world's largest consumer of the fuel, and while demand in the country was flat in May, it was still down 9% from year-ago levels. Meanwhile, China - the world's second largest oil consumer - saw a rise in demand for two consecutive months, bringing it closer in line with year-ago levels. But even with this improvement in China, global consumption was still down 3.5% Y/Y.

Lagging behind, global output in May was only 2.1% below year-ago levels. OPEC output ticked up 1% from April, driven by increases in Nigeria, Venezuela and Angola. Non-OPEC supply was flat on the month as a 10% decline in Norway offset increases elsewhere. Still, non- OPEC output is up 3% from year-ago levels, partially offsetting the 8% decline in OPEC production.

With producers still pumping out oil faster than it can be consumed, the global supply overhang remains rather large at 2 million barrels per day. Furthermore, inventories have continued to mount, with global stocks sitting at 97 days supply in May - the highest level since 1991, when prices were US$21 per barrel (US$34 in today's dollars).

Going forward, we suspect that oil prices will trade within a tight range between US$60-75 per barrel. The third quarter will likely see prices stay in the bottom of the range - and could even temporarily fall below - as the economic data reveal that the recovery will indeed be slower and more gradual than many in the market have been anticipating, despite some of the green shoots that have been sprouting up around the world. Nonetheless, continued U.S. dollar weakness will provide some upward pressure on prices towards the end of this year.

Even so, we expect that any upward momentum driven by financial inflows will be limited by the weak fundamentals in the market. Even once the economy begins a sustained recovery, demand will be rebounding from such a low level - and at such a tepid pace - that it will take a significant amount of time to bring inventories back down to historically normal levels. And as prices rise, producers are likely to ramp up production, as several projects become more viable. OPEC countries in particular, which rely heavily on oil revenues, will be among the first to increase output, regardless of quotas, which we expect to hold steady until inventories are worked off. We have already seen evidence of this behaviour, with the compliance rate falling as prices edged up to the US$70 per barrel mark. As such, we expected prices to trade sideways over the next 12 months, before pressing moderately higher in the second half of 2010.

Poor fundamentals hammer natural gas prices

The fate of the natural gas market has not been as great as that of crude oil, with prices experiencing double digit declines for a fourth consecutive quarter. Notwithstanding a few stints above US$4 per MMBtu, prices have on average, remained within the US$3.50-4.00 trading range, resulting in the lowest quarterly average since 2002. Accordingly, the ratio between crude oil and natural gas prices - which is typically in the 8-9 range - has risen dramatically, reaching a record high of 20 in June. Given that crude oil prices were on the rise during the latest leg of the declines in the natural gas market, natural gas prices were predominantly driven by the ongoing deterioration of the fundamental picture.

The weakness that characterized natural gas demand during the winter - when we typically see a rise in consumption - has extended into the spring, with considerable declines in industrial demand leading the way. As a result, we entered the summer injection season (which began on April 1st) with inventories in the U.S. and Canada 22% and 32% ahead of the 5-year average. Moreover, the larger-than-average injections throughout the second quarter put storage levels at 70% of total capacity, 8 weeks sooner than in 2008. This has triggered some concern that inventories will reach maximum capacity before the summer is out.

In an attempt to bring production more in line with demand, producers have accelerated the reduction in drilling activity in recent months. Active rig counts in North America were down by 54% Y/Y in June, compared to only -14% in January. But while this had yet to translate into sizable declines in output as of April, (latest available data) total production is still expected to slide in 2009 as a whole, and remain weak in 2010. This drop in production, however, will likely be partially offset by an increase in LNG imports, as sluggish Asian demand, new LNG capacity, and limited storage capacity elsewhere will leave North America as the only destination with room to store excess LNG supply.

Despite lower output, natural gas prices will likely remain subdued throughout the forecast period. Sluggish demand - particularly from industrial users - will continue to be a major headwind, although with natural gas prices cheap relative to coal, a rise in consumption from the power generation sector will provide some offset. Nonetheless, with storage levels on track to fill capacity ahead of schedule, prices will likely succumb to another bout of downward pressure in the third quarter, before rebounding modestly in the fourth quarter alongside a seasonal uptick in demand. The only real upside for prices in the near term is if the U.S. experiences an overactive hurricane season, forcing a large amount of production to be shut in. In 2010, prices should gain some traction as an economic recovery takes hold, though they will remain well below historical norms.

Asian demand to underpin stronger coal prices

Thermal coal prices bottomed out at the start of the second quarter, before feeding off the rally in crude oil prices and recouping 25% by mid-June. In addition to spillover from the oil market, the run-up in coal prices was supported by increased demand in China. A string of small mine closures in the country, coupled with the failure of power companies to negotiate a deal with domestic suppliers, drove imports to record highs in April and May. This turned China from a net exporter of the fuel to a net importer for the very first time. Nonetheless, the rally in coal prices has lost some steam in recent weeks, as exports from the world's largest port in Newcastle, Australia declined and other energy prices experienced a pullback.

Going forward, coal prices will likely remain under pressure in the near term as the current pace of Chinese imports is not likely sustainable given the recent rise in prices, and the fact that global demand remains sluggish. Nonetheless, demand from Asian countries is likely to give prices a boost towards the end of this year and into next. In particular, India will likely be forced to ramp up imports over the next few years in order to meet domestic use, as power consumption is on the rise and already the country cannot produce enough coal to meet demand. Consumption in the rest of the world is expected to pick up as the global economy recovers, likely leading to a steady rise in coal prices throughout 2010.

PRECIOUS METALS

Gold prices to lose ground in 2010

Notwithstanding a minor correction in April, precious metals prices continued their upward trend in the second quarter. Gold prices have remained above the US$900 level over the past two months, though they can't seem to break through the US$1,000 mark. With jewelry and fabrication demand quite sluggish, prices have been propped up by robust investment demand. Traders continued to rebuild their paper holdings, as non-commercial net long positions on the COMEX have nearly tripled since reaching the recent trough in November. Moreover, physical demand from investors also gained momentum, with Exchange Traded Fund (ETF) holdings reaching a new high of over 1,700 tonnes.

Gold prices have also been benefiting from a weak U.S. dollar, as its recent depreciation against the euro and a basket of other currencies has sent more investors to the safety of the yellow metal. So after a brief disconnect earlier this year, the strong negative correlation that typically holds between gold prices and the greenback has now been restored.

Going forward, investment demand is likely to be the driving force behind movements in the price of gold. We suspect that the U.S. dollar will continue to have a softer undertone for the remainder of this year, trading in the 65- 70 US cent range against the euro, as domestic growth remains sluggish and short-term interest rates linger close to zero. Next year, investment demand will be more of a mixed bag. As the economy improves, investor risk tolerance will rise, monetary and fiscal policy is likely to tighten, and the greenback will begin to recover - all reducing demand for safe haven assets. On the flipside, while we don't believe significant inflation will break out globally, fears of price pressures due to recent quantitative easing by the U.S. Federal Reserve and other central banks are likely to persist, providing some offsetting demand. Overall, we expect the downside to win out in 2010, with gold prices falling to about US$865.

Silver to outperform gold in 2010

Silver continued to outshine its yellow counterpart in the second quarter, with prices rising by 9%. This time, however, the superior performance was due in part to an uptick in demand for base metals, rather than solely as a result of its precious metals characteristics. Indeed, silver's industrial properties began to provide some price support after signs that industrial production is picking up hit the market. Still, similar to gold, investment demand played a key role as well. After taking a dive in March and April, non-commercial net long positions on the COMEX more than doubled by the end of the quarter, while ETF holdings grew at a healthy pace.

Silver prices will likely follow gold prices up through the rest of this year, before losing some steam in 2010 as the economy embarks upon a gradual recovery and investment demand subsides. However, a steady rise in industrial production next year will help to soften the blow, reducing the gold-to-silver ratio to the 60-65:1 range, from the second quarter average of 70:1.

Source

TD Bank Financial Group

The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.