Have analysts got their commodity price forecasts wrong?

Jason Forssman, Fund Manager at Ashburton Investments.

Commodity prices such as Iron Ore are trading at more than double their prices from a year ago and well above analyst consensus.

But why have they outperformed what the market was expecting?

Last week, Chinese foreign exchange reserves fell below $3 trillion to a near six year low, all the while domestic debt levels keep pushing new highs and the threat of potential trade wars remains pervasive. This is fertile ground for a weaker Yuan.

Only a year ago the fear of devaluating Chinese Yuan sent shock waves through the already depressed commodity basin, a weaker currency would make commodities more expensive to the world’s single largest consumer thereof, reducing demand in a seemingly oversupplied market, pushing already low prices even lower.

Why then are current bulk commodity prices such as Iron ore and copper materially higher than analyst forecasts?

The answer may be simple, but because it lies outside the supply and demand dynamics that ordinarily determine commodity prices, it may not be that obvious.

Faced with the potential of a weakening currency, participants in open markets will hedge themselves by converting a potion their savings into alternative currencies. In China however, the average citizen is restricted from doing so and is therefore forced to seek alternative hedging mechanisms.

One of the alternatives available is to buy commodity futures, the underlying prices of which are denominated in U.S dollars. As China is such a large economy, even marginal actions have significant effects on market prices.

According to Bloomberg, Chinese investors traded a record $25.5 trillion in commodity futures last year, with volume up 27%.

From a local perspective this implies that analysts may have it wrong in predicting a decline in the likes of Iron Ore prices to more normalised levels any time soon.

Consequently the financial results of companies like Anglo American and Billiton may surprise to the upside supporting an already impressive run in their share prices.