Oversupply in commodities?

Commodities had a flat year for 2012 and now we are seeing articles on the potential oversupply in some markets. Unfortunately, many of these stories are based on a superficial reading of the market dynamics. The key to understanding commodity indices is that they not behave like the indices found in equities or fixed income. The correlations across commodity markets are significantly less than that found in other asset classes. This means that it is not effective to talk about general oversupply. There will be common swings in commodities based on macroeconomic factors that will affect demand but effective commodity investing has to look at individual markets.

There can be over-supply in some commodity markets but that does not tell us anything about the dynamics of oversupply across all commodity markets. A case in point is when we look at the dynamics in the agriculture markets. There are clear issues of potential shortages within the row crops. The stock to usage in wheat, corn, and soybeans all look like there can be significant increases in price if there is another poor harvest in these markets. However, if we look at coffee, cocoa, cotton, and sugar, the markets look significantly different. Here there is an issue of oversupply which depressed prices. One sector, but two very different world view on supply and demand. The agriculture sector saw a significant gain in 2012 based on the Midwest drought but looking at the sector overall will tell a more muted story. 

In the energy markets, there is no issue of under supply. For oil, the inventories in the US are strong. In natural gas the supply is still biased to excess from shale discoveries. Profit margins for refiners are strong. Hence, there is strong production of refined products. Metals mining has still been profitable so supply is available in the markets. However, the expectation is that production will slow with falling demand.

The key to commodity markets which have better supply conditions will be demand factors as displayed by global growth. Growth will be the driver of energy and metals markets while weather will again be the driver in agriculture markets. These are not wild predictions because the history of business and commodity cycles would give the same answer. It is usually best to fall back on history as the guide for commodity direction.