Traders fear ‘tail risks’ in commodities

Financial Times

It has only taken one business day in 2012 to demonstrate what traders see as the greatest challenge for commodity markets in the coming year: “tail risk”. Brent crude oil rose more than $4 a barrel on Tuesday, hitting $112 for the first time in a month and a half, after Iran’s army chief warned the US not to return an aircraft carrier to the Gulf, ratcheting up an increasingly aggressive war of words with the west.As commodity markets enter the new year, the price outlook, particularly for crude oil, is clouded by the risk of an economic crisis in Europe – and hence, the possibility of a price plunge – and geopolitical concerns – therefore the risk of an increase.

In the trading rooms of Geneva, London, New York, Houston and Singapore talk is of tail risks – low probability events that have an outsize impact on prices. Veteran traders and analysts reckon the risks are inordinately large.

The biggest, and more bullish, tail risk is further turmoil in the Middle East and north Africa.

If Iran goes through with a threat to close down the Strait of Hormuz, a chokepoint for a third of the oil seaborne trade, traders believe that oil prices could soar.

A crisis with Iran would not only hit oil prices, but also other energy commodities, such as natural gas and thermal coal, and even the cost of agricultural raw materials as higher oil prices would drive up biofuels consumption and make fertilisers more expensive.

Yet, there are also large bearish risks. One is a breakdown of the eurozone. Francisco Blanch, head of commodity strategy at Bank of America Merrill Lynch in New York, cites another: “The perennial commodity nightmare: a China hard-landing.”

On balance, however, most traders and analysts see price risks tilted to the upside, particularly for oil.

The new year starts after a strange 2011: oil prices surged above $125 a barrel and set their highest annual average at $110.90 on the back of the crisis in Libya. The cost of some other key industrial commodities, from copper to cotton, also hit record highs. Yet the benchmark Reuters-Jefferies CRB index, a basket that tracks the price of raw materials from oil to wheat, fell 8.3 per cent for the year, its first annual decline since 2008 and a significant U-turn after a gain of 17 per cent in 2010 and 23 cent per cent in 2009.

For 2012 oil and commodities traders and analysts expect a repetition of last year, with the price of raw materials diverging as supply disruptions, rather than strong demand, emerge as the main drivers. As such, the consensus view is largely bearish for natural gas and food commodities, but mostly bullish for oil and some industrial metals such as copper. But few traders are venturing firm price predictions due to the large tail risks.

Free from such perils, most are mildly bullish as the economic growth of China, Latin America, Africa and the Middle East – the engines of raw materials demand over the past decade – are seen as strong enough to compensate for weakness in Europe.

“The global economy is churning enough commodity demand to keep consumption reasonably healthy,” says Paul Horsnell, head of commodities research at Barclays Capital in London, who predicts Brent oil prices to average $115 a barrel in 2012. “The real macro economic risk is a discontinuity, not just slow growth,” he adds.

The consensus for Brent crude, the oil benchmark, is of $105.20 a barrel, according to the average of 32 analysts and consultants polled by Reuters.

Another supporting factor for oil prices is that 2012 inherits the progressive tightening of production, demand and inventories of last year due to supply outages in Libya, Syria, Yemen, the North Sea, Azerbaijan, Angola and Nigeria. While last January oil stocks held in industrialised countries were abnormally high, now they are well below the five-year average. In Europe, the region most affected by the Libyan supply outage, they have fallen to the lowest in 11 years.

The same is true for copper as stocks dropped last year after supply growth fell short of early expectations due to a combination of low grades, accidents and labour strikes. However, aluminium, wheat, cocoa and natural gas saw a large build-up of stocks through 2011 that will weigh on prices into the new year, analysts say.

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