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Commodities 2011 outlook

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Commodities 2011 outlook

  1. 1. MORGAN STANLEY RESEARCH GLOBAL Morgan Stanley & Co. Incorporated Hussein Allidina, CFA Hussein.Allidina@morganstanley.com +1 212 761 4150 Chris Corda Tai Liu Bennett MeierDecember 10, 2010 Morgan Stanley Australia Limited Peter G Richardson Peter.Richardson@morganstanley.comCommodities +61 3 9256 8943 Joel B Crane2011 Outlook: A CommodityBull MarketWe see most commodity prices moving higher in2011 as global GDP, at an above-trend 4.2%,bolsters demand, led again by emerging marketeconomies.After growing by nearly 5.0% in 2010, global GDPgrowth is poised to grow by 4.2% in 2011 — importantly,over 70% of this growth will come from thecommodity-intensive EM, with China, India and LatinAmerica poised to see GDP growth of 9.0%, 8.7% and4.1%, respectively.Growing demand, together with a tightening supply side,provides the fodder for our broad constructivenessacross the commodity space. Declining inventories willnot only lift spot prices but will also improve roll returns(as drawing inventories move markets from contango tobackwardation).We are most constructive on crude oil, copper, gold,and corn and soybeans. We are least constructive onnatural gas, live and feeder cattle, and zinc.Our favorites: The need for increased OPECproduction will lower spare capacity, sending oil pricesabove $100/bbl in 2011, in our view. Copper, our favoritebase metal, should continue its move higher as strongOECD demand growth and resilient Chinese demandare contained by supply downgrades. Corn and soybeanprices both need to rise to ration demand — simply put,demand is running too hot given tight inventories andlimited acreage. Gold will benefit from continued Table of Contents Pageinvestment demand, stemming from a continued Snapshot 2expansion in global money supply and lingering Energy 3sovereign risks. Metals 6 Agriculture and Softs 11Risks: Despite our constructiveness, we expect the Livestock 17ascent in price to be volatile. Lingering sovereign risks,fears of policy missteps in the EM, and bouts of USD Forecasts 19strength will all present headwinds. For important disclosures, refer to the Disclosures Section, located at the end of this report.
  2. 2. MORGAN STANLEY RESEARCH December 10, 2010 CommoditiesSnapshot Commodity Bearish Neutral Bullish Rationale • Global inventories contracting, with demand reaching an Crude Oil all-time high in 3Q10. • Spare capacity to decline, falling to 2007/08 levels by 2012. • Tightest US inventories since 1995/96. Corn • Drought concerns in South America. • Stiff competition for US acreage in 2011. • Strong demand from Chinese crushers. Soybeans • Drought concerns in South America. • Record US exports forecast for 2010/11. • Fears of currency debasement fuelling demand. Gold • EU sovereign debt issues driving safe-haven demand. • Declining official sector sales tightening market. • Strong OECD consumption growth and resilient demand in Copper China driving tightness in physical markets. • Downgrades to mine production by major producers. • Chinese supply disruptions driving demand for US and Indian Cotton exports. • DM textile demand improving. • Comparatively full US balance. Wheat • FSU, Australian supply disruptions forcing more customers to the US. • Demand recovery has returned the market to balance. Nickel • Laterite projects likely struggle to meet ramp-up timetables, keeping markets tight. • Early end to Brazilian crush leaves inter-harvest balances Sugar tight. • Indian production and export outlook unclear. • Modest retail demand growth prospects in 2011. Lean Hogs • Building cold storage and reduced sow slaughter temper our bullishness through first half of next year. • Market likely to be in surplus until 2012, with strong demand Aluminum not eliminating effects of excess capacity. • Physically backed ETFs likely in 2011. • Expected demand slowdown in live cattle and higher grain prices are challenges. Feeder Cattle • Herd reductions through 2010 have continued to pare supply, mitigating bearishness. • Chinese mine and smelter capacity has responded quickly to Zinc improved demand from galvanized steel. • Stock-to-consumption ratio has risen in 2010. • High inventory in North America. Natural Gas • Drilling remains elevated despite record production. • Substantial overhang of well inventory. • Heavier live weights and higher slaughter rates in the fall Live Cattle boosting inventories. • Higher feedlot placements suggest greater supply. 2
  3. 3. MORGAN STANLEY RESEARCH December 10, 2010 Commodities Exhibit 1ENERGY Inventories Outside the US Have Already Returned to Normal…CRUDE OIL — Returning to a Supply- (Aggregate of available data from Singapore, ARA, Japan, and China, mmb)Constrained Market 340 330Through 2010, crude oil prices traded very much in sync with 320the macro, with flat prices trading mostly between $70-80/bbl.More recently, prices have broken through $80/bbl and are 310trading either near (WTI and Dubai) or above (Brent) $90/bbl, 300as oil market fundamentals have tightened in 2H10, as we 290discussed in our 2010 commodity outlook (2010 CommodityOutlook: Fundamentals Will Matter, Dec 22, 2009). Economic 280events such as the European sovereign debt crisis (in May and 270again in November), the double-dip scare, QE2, China’s 260goldilocks scenario and subsequent inflation worries all moved Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Decprices meaningfully through the year. 2007 2008 2009 2010Inventories, though higher than we had envisioned them to be Source: Norwegian Energy, EIA, Morgan Stanley Commodity Researchat the start of the year, have drawn significantly in the past few Exhibit 2months. Draws were first seen from floating storage at the endof summer, and offshore inventories for Nov now sit at 21.2 With Inventories in the US Drawing Sharply of Late (MoM Δ in total US inventories, mmb)mmb, well off the Jan highs of ~109 mmb. With offshore 25inventories largely depleted, growing demand is being 20 18.4increasingly satiated with onshore inventories — OECD 15industry inventories fell by 42.8 mmb in Sep (vs. a 5Y average 10build of 3.7 mmb), while weekly data globally shows further 5draws in both Oct and Nov. Most notably, US inventories fell - -0.511.6 mmb in Oct and a further 21.2 mmb in Nov (Oct and Nov (5) -1.5 -1.1 -4.5typically see inventories falling by only 0.5 mmb and 1.1 mmb, (10) -6.7respectively), while global inventories excluding the US, (15) -11.6 (20)captured by weekly data where available, have returned to (25) -21.2‘normal’. Aug Sep Oct Nov 2010 5-Year Avg Source: EIA, Morgan Stanley Commodity Research 3
  4. 4. MORGAN STANLEY RESEARCH December 10, 2010 CommoditiesExhibit 3 If demand grows as envisioned, inventories will decline2011 Demand Growth Skewed to the Non-OECD significantly in 2011, allowing for a continued improvement in(Total demand growth, YoY % Δ) curve structure (towards a sustained backwardation) and the India 9.8% need for increased OPEC production — our estimates show China 6.5% the need for increased OPEC flows sometime in 1H11. We believe that a formal increase in OPEC production quotas will FSU 4.4% force the market’s attention back to supply constraints and Middle East 4.0% dwindling spare capacity — we see spare capacity falling to 4.1 Total Non OECD 4.0% mmb by end-2011, from 5.9 mmb/d currently. Africa 3.7% Exhibit 4 Increased OPEC Production Needed in 2011 to Latin America 3.0% Prevent Significant Inventory Draws World 1.7% (Left axis: OECD industry inventories, bln bbls; right axis: MoM Δ in OPEC Production, mmb/d) 2.85 1,250 OECD Europe 0.0% 2.80 750 North America -0.3% 2.75 2.70 Total OECD -0.3% 250 2.65 Other Asia -0.4% 2.60 (250) 2.55 OECD Pacific -1.0% 2.50 (750) Non OECD Europe -4.3% 2.45 -5.0% 0.0% 5.0% 10.0% 15.0% 2.40 (1,250) 2005 2006 2007 2008 2009 2010 2011 2012 OPEC Crude Prod MoM Δ - RHS OPEC Adds/CutsSource: IEA, Morgan Stanley Commodity Research estimates Stocks - LHS (bln bbls) MS Forecast - LHS (bln bbls) Inv. Path without OPEC Invervention Source: IEA, Morgan Stanley Commodity Research estimatesWe attribute the recent inventory draws to robust demandglobally. Total world demand in 3Q10, as reported by the IEA in As spare capacity is poised to tighten meaningfully and withtheir latest OMR, reached a record high 88.5 mmb/d, up 3.1 demand relatively inelastic in the short run, we reiterate ourmmb/d YoY, driven largely by the non-OECD. Nonetheless, view that higher prices are needed to ration demand.OECD demand has also improved notably in the past twoquarters, as demand has posted seven consecutive months of We forecast prices in 2011 and 2012 to average $100/bbl andYoY growth through Sep – a first since Mar 2005. $105/bbl respectively and recommend investors take exposureIn 2011, we see global demand growing by 1.5 mmb/d to to Dec ’11 WTI, current trading at $90.14/bbl, well off the 2010average a record high 88.5 mmb/d, driven again by the high of $95.45/bbl seen this past May.non-OECD. We expect robust GDP growth in the EM,particularly in China and India — where we see oil demandgrowth of 6.5% and 9.8% — to lift non-OECD demand by 1.6 NATURAL GAS — Systemic US Oversupplymmb/d (4.0%). The Middle East will again be a noteworthy Will Continue to Pressure Pricescontributor to global demand growth, higher by 295 kb/d YoY(4.0%). We see demand in the OECD declining only slightly. Natural gas prices were challenged through 2010, tumbling by 20% YTD as supply proved to be a significant headwind.On the supply side, we see non-OPEC supply falling slightly by Heading into 2011, many of the bearish forces we saw in 2010~ 380 kb/d or 0.7% YoY. Increases in production from the are likely to remain in place. Natural gas remains mired in anCanadian oil sands, the oil shale plays in the US, the over-supplied environment with high inventory levels, highdeepwaters of Brazil and EOR methods in Colombia are not drilling activities, elevated production, and limited structuralenough to offset declines in the North Sea, Mexico and Asia. demand growth. On the bullish side, coal prices have risenFor more details please see, Crude Oil: Tightening Supply to considerably since our initiation report (Natural Gas –Send Prices Higher, Nov 1, 2010. Fundamentally Oversupplied, October 11, 2010), which will encourage natural gas to make more in-roads into the coal stack, a positive for demand. 4
  5. 5. MORGAN STANLEY RESEARCH December 10, 2010 CommoditiesWe entered the ’10-’11 heating season with record levels of On the other side of the balance, demand growth is unlikely toinventory (+3.8 tcf) and barring a frigid winter, we are likely to provide much relief. In 2009, industrial gas demand plunged byexit the ’10-’11 heating season with record amounts of gas in 1.5 bcf/d YoY as industrial activity declined. In 2010, industrialstorage (1.9 tcf). gas demand recovered significantly as the world economy rebounded. We estimate industrial gas demand will averageThe latest EIA data points to Sep dry gas production of 60.4 18.2 bcf/d in 2010, a YoY increase of 9%. If realized, thisbcf/d, a 0.5 bcf/d MoM and 4.3 bcf/d YoY increase. Drilling also represents a complete recovery to 2008 levels. For 2011, weremains elevated; the latest data from Smith Bits Stats indicate are building in a considerable YoY increase of 4.9% to 19.1the rig count near 860. The resiliency of rig activity will carry bcf/d (based on an industrial production forecast of 5.1% YoYproduction momentum well into 2011. increase). Unless the industrial sector performs well beyond our expectations, we believe there is little upside potentialExhibit 5 beyond what we are currently modeling, in our view.US Gas Production Remains Robust Amid ElevatedDrilling Activities There are, however, bullish developments since we published(left-axis: rig count; right-axis: bcf/d) our initiation piece in Oct. With more normalized inventory 1,600 63 levels and a strong overseas market, coal prices have risen 1,400 61 considerably, and the 12-month coal strip has increased by 59 1,200 $10/ton. At current coal and gas prices, the 8,000 btu/kwh gas 57 1,000 units in the Southeast are deep in-the-money compared to 55 800 10,000 btu/kwh coal units. Unless coal prices pull back from 53 600 here, we will likely continue to see substantial coal-to-gas 51 substitution in 2011. 400 49 200 47 Weather will also have major ramifications for natural gas - 45 demand. During the heating season, the difference between a Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 milder 10-yr normal winter (with 3,776 GWHDD) and a colder Horizontal Vertical & Directional Production, bcf/d 30-yr normal winter (with 3,931 GWHDD) can translate into 200–250 bcf of heating demand. Summer demand is no lessSource: Smith Bits Stats, EIA, Morgan Stanley Commodity Research estimates prone to these fluctuations. The summer of 2010 was 22% warmer than the 30-yr normal, which translated into an extraIn addition to the bearish production and inventory outlook, 200-250 bcf of gas demand in the power sector. Extremethere is also a sizable inventory of wells awaiting completion. weather can wear down inventories and support gas prices.The oil & gas service industry estimates that some 2,500 to3,000 wells will remain uncompleted YE2011 (Halliburton, While any combination of bullish demand scenarios (extremeQ310 earnings call). To put this in context, there was an weather, strong coal prices, strong economic performance)average of 30,500 natural gas wells drilled between 2004 and has the power to draw inventories lower, the root cause of the2008 in the US. In 2009, when drilling activity slowed markedly, low gas price environment stems from the supply side. Hence,there were still over 19,000 gas wells drilled. An inventory of the onus is on the gas producers to balance this market byclose to 3,000 wells can easily represent an overhang of 10% scaling back drilling activities. Unless and until this is achieved,in terms of annual wells drilled. This suggests either: natural gas will remain oversupplied. We re-iterate our price forecast of $4/mmBtu for 2011. 1.) the production momentum will likely be sustained even after rig activity moderates; or 2.) we will see a pickup in production if the service industry brings more capacity online. 5
  6. 6. MORGAN STANLEY RESEARCH December 10, 2010 CommoditiesMETALS Exhibit 6 clearly shows. Although LME on-warrant stocks have declined slowly to their lowest level since 2Q 2009 (4.29Mt atBase metals, having undergone a significant correction in 2Q the end of November), reported total stock-to-consumptionand early 3Q 2010, are expected to show continued price ratios remain well above the industry clearing level of 5.8appreciation in 2011-12. In our view, this reflects the combined weeks at 8.4 weeks.influence of improving physical market fundamentals (asreflected in strengthening leading indicators such as industrial Despite continuous market speculation over the potential for aproduction, continued investment demand as a result of low tightening market, we estimate that 2010 will be the fourthinterest rates and loose monetary policy in the DM) and, in consecutive year of global market surpluses in aluminum.some metals, inventory financing arrangements or physically Under these circumstances, producers and financialbacked Exchange Traded Funds (ETFs). intermediaries have resorted to the innovation of inventory financing deals to prevent a significant fall in prices belowOur preferences in this sector remain copper, tin and nickel — marginal costs. This development has come at the cost of aall metals where the potent combination of sustained EM fundamental and effective purging of excess capacity from thedemand growth, limited refined production growth, and low global aluminum industry.inventories provide the basis for a sustained backwardation in Exhibit 7nearby prices and elevated cash prices. Aluminum Stock-to-Consumption Ratio – WellExhibit 6 Above Average (left axis: Kt, right axis: days of consumption)Relative Performance of LME Metals in 2010 7,000 80(Prices Indexed, where Jan 1 = 100) 70 160 6,000 150 5,000 60 140 50 4,000 130 40 120 3,000 30 110 2,000 20 100 1,000 10 90 - 0 80 Nov-96 Nov-98 Nov-00 Nov-02 Nov-04 Nov-06 Nov-08 Nov-10 70 Total commercial stocks (LHS) Stock to consumption ratio (RHS) Avg ratio 60 Source: World Bureau of Metals Statistics, Morgan Stanley Commodity Research Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Nickel Tin Copper Aluminum Lead Zinc Data from the World Bureau of Metal Statistics (WBMS)Source: Bloomberg, LME, Morgan Stanley Commodity Research through 3Q10 indicates a supply surplus of 285Kt or an annualized level of 380Kt. This would make the 2010 surplusCurrently, we are more cautious on metals such as aluminum, the smallest since 2007, when the market recorded a surplus oflead and zinc, whose markets will be slower to return to deficit 244Kt. Despite a 78.5% contraction in the market surplus on aand where supply discipline or restraint is noticeably less YTD basis, details of this market balance indicate an ongoingevident. However, we are cognizant that inventory financing problem of excess capacity.deals in aluminum, or their successor in the form of physicallybacked ETFs, will provide price tension and support, despite Through 3Q10, primary aluminum production increased byweaker fundamentals. 23.3Mt, or 12.2%, to 30.38Mt. Over the same period, adjusted world refined consumption rose 17%, or 4.31Mt, to 29.79Mt.ALUMINUM — Bloated Inventories Will Despite such a substantial increase in consumption, the supply and demand imbalance is largely the result of a 37.3%Weigh on Prices increase in Chinese production and a 9.1% rise in Indian output.Aluminum remains one of the laggards of the base metalssector both in terms of YTD price appreciation (-44.2% vs tinand -21.4% vs nickel), and relative price performance as 6
  7. 7. MORGAN STANLEY RESEARCH December 10, 2010 CommoditiesAgainst this backdrop of improving fundamentals, but ample Production downgrades from some of the world’s largestinventory, a sharp move in cancelled warrants during Sep copper producers (BHP Billiton, Freeport McMoRan,fuelled speculation about the launch of a physically backed Kazakhmys, Antofagasta and Rio Tinto) have accelerated anETF in late 2010 or early 2011. already extraordinarily tight concentrate market. The ensuing drop in spot treatment charges and refining charges (TC/RC)In our view, while such a product may attract some investors, prompted a number of smelters to cut production. Spot TC/RCsthe existence of a physical fund is unlikely to transform the have since rallied on these smelter cuts and a sharp increase infundamentals of the market despite an anticipated relocation of secondary copper supply (which has risen 20.6% YTD),exchange stocks into these funds. While a successful launch of without altering primary market fundamentals, in our view.physically backed aluminum ETF would, as now, have aprice-tensioning impact in the short term, absolute and relative Coupled with weak supply growth, resilient demand hasprice performance over the longer term will depend on a return pushed the stocks-to-consumption ratio nearly back to beforeto a deficit market. On our current estimates, this will not be the global financial crisis levels of 3.4 weeks through 3Q10.before 2012. This is a remarkable feat given market expectations for a protracted economic recovery on the back of a below-parCOPPER — Tight Physical Market, growth in the DM and risks to EM growth arising from risingDiminished Production Driving Sector inflation.Favorite Exhibit 8 Copper Stock-to-Consumption Ratio – Getting TightThe copper market surprised even the strongest of bulls by (left axis: Kt, right axis: days of consumption)defying traditionally weak 3Q inventory and pricing trends in 2,500 602010. Despite signs of rising volatility, the upward trend in cash 50 2,000copper prices has continued into Q4 2010 amid signs of anemerging front-end squeeze. Although prices are currently 40 1,500trading close to their all-time high, strong demand trends, low 30inventory and ongoing supply constraints have reinforced our 1,000conviction that copper fundamentals remain the strongest in 20the base metal complex. 500 10The latest statistics from the International Copper Study Group - 0 Oct-96 Oct-98 Oct-00 Oct-02 Oct-04 Oct-06 Oct-08 Oct-10(ICSG) show the global market recorded a cumulative deficit of Total commercial stocks (LHS) Stock to consumption ratio (RHS) Avg ratio368Kt YTD through Aug 2010 after refined consumption grew Source: International Copper Study Group, Morgan Stanley Commodity Researchby 7.9%; however, refined supply only increased by 5.3%.Non-China demand has surprised to the upside. Consumption,again through Aug 2010, was up 7.5% YoY in the US, 24.3% NICKEL — Surplus Dwindling; Deficit LikelyYoY in Germany, 12% in the EU-15 and 29.5% in Japan. After in 2011a 36.8% increase in apparent consumption in 2009, Chinesegrowth has been more modest this year, rising only 3.6% YoY Nickel remains one of our most preferred exposures in theYTD through Aug. However, this indicates that the impact of base metals complex, given our expectations the metal willde-stocking in China after last year’s aggressive campaign of move from a balanced market to a deficit in 2011. According toimports has been modest. the latest data from International Nickel Study Group (INSG), the primary nickel market was in a small surplus of 4Kt at theLME stocks have fallen each month since Feb, declining by end of Aug-10, compared to a surplus of 71.4Kt at the same36% over this period to 355.8Kt through Nov, their lowest level time in 2009.since Oct 2009. Shanghai exchange stocks ended 3Q 2010 attheir lowest level since Aug 2009, while Comex copper stocks Primary nickel demand increased by 16.2% to 932Kt YTD-Aug.ended 3Q at their lowest level since Nov 2009. While a At this rate of consumption, primary nickel usage will be thesustained recovery in global demand contributed to this trend, highest since 2006 and very close to an all time record. Thistighter market conditions are also a function of supply recovery reflects the strength of stainless and non-stainlessconstraints. demand, especially in Europe, Asia and the USA. 7
  8. 8. MORGAN STANLEY RESEARCH December 10, 2010 Commodities Exhibit 9By contrast, production of primary nickel has increased by only6.9% over the same period to 935.9Kt. The long-running strike Nickel Stock-to-Consumption Ratio, 1996-2000 (left axis: Kt, right axis: days of consumption)at Vale Inco’s Canadian operations and operational difficulties 300 80in Australia lowered production by 38.9% and 13.7% YoY, 70respectively. Elsewhere, primary nickel production increased 250sharply, with output in China, Indonesia and Brazil increased 60 200by 37.9%, 59.4% and 14.8% respectively. 50 150 40According to Brook Hunt, in the past 2-3 months the market has 30moved from a modest surplus to a deficit of 11Kt, increasing 100the likelihood that we will move into 2011 against the backdrop 20 50of a deficit market and strong demand. 10 0 0The execution of the supply pipeline will likely dominate the Nov-96 Nov-98 Nov-00 Nov-02 Nov-04 Nov-06 Nov-08 Nov-10degree of price strength in the coming quarters, with risks Total commercial stocks (LHS) Stock to consumption ratio (RHS) Avg ratioskewed to the upside against any project delays. Following the Source: International Nickel Study Group, Morgan Stanley Commodity Researchreturn of Vale Inco’s Sudbury operations, the global nickelmarket will depend on the success of a number of technically ZINC — High Inventories and Rapid Supplycomplex and high-cost new and brownfield laterite projects. In Response Pressuring Pricesour view, it is unlikely the projected timetable of productionramp-up will be realized without issue, increasing the likelihood Zinc fundamentals remain amongst the weakest of the majorthat the refined market will again be in deficit in 2011. base metals, with global inventories close to their highest since May 1995. The monthly stock-to-consumption ratio at the endAfter dipping to a 2010 low of 116Kt in late Jul, LME nickel of Sep was 5.2 weeks compared to an estimated long-runinventories increased by 14Kt before stabilizing amidst clearing level of 4.3 weeks. Increases in exchange stocks sincestrengthening demand. We expect inventories to resume a the end of Q3 suggest that the stock-to-consumption ratio hasmodest declining trend in 1H11 as stainless steel production risen further.accelerates along with industrial production. According to the latest data from the International Lead andAccording to the International Stainless Steel Forum, stainless Zinc Study Group (ILZSG), the refined zinc market was in asteel output returned to pre-crisis levels in 1H10. While the surplus of 175Kt at the end of 3Q10, compared with a 271Ktdestocking cycle appears to be over and inventory levels have surplus at the same time in 2009. This rate of contraction in thenormalized, according to the stainless producers, increased supply overhang is less than half the rate of improvementorder inflow indicates some consumers believe the global recorded in the aluminum market over the same period.economy is strengthening. Total stainless production iscurrently forecast to increase by 20.7% in 2010, to a new This slower rate of market adjustment is primarily the result of arecord of 30.3 mt, of which 72.2% is estimated to be in faster supply response in refined zinc than in aluminumaustenitic grades. production. ILZSG data indicate in the nine-month period ended Sep-10, refined zinc production increased by 15.3% while primary aluminum production rose by 12.2%. By contrast, consumption of both metals increased by 17% over the nine-month period. Like the aluminum market, the increase in refined zinc production is the result of increased output from Chinese smelters, which increased production by 23.7% YoY, accounting for 58% of the increase in global refined production. 8
  9. 9. MORGAN STANLEY RESEARCH December 10, 2010 Commodities Exhibit 10The rapidity of the zinc supply response is only partially Zinc Stock to Consumption Ratio (left axis: Kt, right axis: days of consumption)explained by a ramp-up in mine production, which rose by 1600 80885Kt or 10.7% to 9.14Mt, indicating smelters relied on 1400 70secondary supply and concentrate stocks to lift refined outputto 9.46Mt. Almost all of the increase in mine production YTD is 1200 60also the result of increased mine output in China, which has 1000 50raised production by 600Kt or 29.6%. 800 40 600 30Total commercial stocks of zinc at the end of Nov-10 were1.35Mt, of which 68% were exchange stocks. 632Kt of the 400 20exchange stock total were on LME warrant, with the balance of 200 10296Kt on SHFE warrant. Part of the exchange stock increase 0 0represents transfer of producer stocks into the LME to take Nov-96 Nov-98 Nov-00 Nov-02 Nov-04 Nov-06 Nov-08 Nov-10advantage of inventory financing deals. According to Metal Total commercial stocks (LHS) Stock to consumption ratio (RHS) Avg ratioBulletin, this accounted for around 50% of LME metal on Source: International Lead and Zinc Study Group, Morgan Stanley Commodity Researchwarrant as of early Oct.While we expect the refined zinc market will continue to movetowards a more balanced market over the course of 2011, webelieve zinc prices will continue to underperform relative toother LME metals until we see clear evidence of a reversal incurrent inventory trends. 9
  10. 10. MORGAN STANLEY RESEARCH December 10, 2010 CommoditiesGOLD — Expansionary Monetary Policies Finally, trends in official sales and purchases continue to beand Sovereign Risks to Support Prices supportive for gold’s price outlook. In 3Q10, the sector posted its sixth consecutive quarter of net purchases, with centralWe are increasingly positive on the outlook for gold in 2011. banks purchases outpacing sales by 21.9t according to theThis is in part due to the adoption of renewed Quantitative World Gold Council.Easing (QE2) by the US FOMC at its meeting on Nov-10. During the first year of the third Central Bank Agreement onThe positive impact on gold prices from QE2 derives from the Gold, which concluded at the end of Sep 2010, Eurozoneboost to investor demand for hedges against the threat of banks sold just 6.9t of the precious metal, the lowest annualimminent deflation or subsequent inflation because of excess sales total since these agreements began in 1999. Thisgrowth in the money supply. An age-old fear of inadequate markedly reduced desire to dispose of gold reserves isdemand, or too much money chasing too few goods, is occurring at a time of rising sovereign debt risks and distress inexpected to boost demand for assets such as gold that are public finances. Within the official sector, only the IMF haslikely to perform well in deflationary or inflationary shown any material appetite for selling gold this year, with onlyenvironments. 52.2t of remaining IMF gold to sell from the original allocation of 403.3t at the end of Q310. As a result of these supportiveWe also expect investment demand for gold to remain strong developments, gold as a percentage of total central bankgiven the resurgence of the European sovereign debt crisis. reserves has risen to 10.1% in 1H10 from a decade low ofFears of contagion risks should boost gold prices as investors 8.6% in 2Q07.seek out safe havens. However, the anticipated policy Exhibit 11response to this contagion risk could also boost gold demand if Inflationary Concerns Supportive for Gold Pricesthe European Central Bank moves to adopt quantitative easing (Left axis: USD; right axis: US 5-year tips yields, inverted, % points)through the unsterilized purchase of peripheral Euro members’ $1,450 -1.00government bonds. $1,350 -0.50Following the events of Nov 2010, we also expect strong $1,250 0.00investment demand for gold in 2011 as the political risk $1,150heightens in the Korean peninsula. After eight months of 0.50 $1,050escalating tensions between North and South Korea, the Nov 1.002010 event was one of the most serious incidents between the $950two nations since the Korean War ended in 1953. The desire to $850 1.50hedge political as well as financial and economic risks makes $750 2.00the current situation a near perfect storm for an asset such as Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10gold. Gold Price - LHS US 5-year TIPS - RHS Source: Reuters, Morgan Stanley Research 10
  11. 11. MORGAN STANLEY RESEARCH December 10, 2010 CommoditiesAGRICULTURE AND SOFTS We expect corn production to increase by 3% YoY in 2011/12 as higher prices encourage additional acreage, particularly inCORN — Balances Too Tight, Demand the US and China. These acreage gains are largely contingent on relative performance in the soy and wheat pits, which haveNeeds to Be Rationed shown strength to-date, into 1H2010. We are also monitoring the situation in South America where dry weather in Oct2010 marked the return of tightness to global corn markets. delayed soybean planting in the major agricultural state ofDespite an increase in planted acres, production in the US Mato Grosso. A delayed bean harvest would tighten thedeclined YoY as a dry hot summer in the Eastern Corn Belt and window for planting Safrinha (double-cropped) corn later instorms in the Northern Corn Belt during harvest weighed on their summer. With nearly 40% of Brazil’s corn productionyields. (Yields are expected to average 154.3 bu/acre, which coming from the Safrinha crop last year, planting disruptionsare still “good” historically though not when compared to the could materially impact Brazilian supply in 2011.lofty estimates many had expected early in the season.) Atcurrent estimates, the US will produce only 12.54 bln bu of corn Exhibit 13this year, leaving stocks-to-use (S/U) at only 5.5%, the tightest To Gain Acreage from Soy, Corn Prices Must Risesince the 1995/96 marketing year. Globally, the balance fared (Nov Soy/ Dec Corn Price Ratio)no better as marginal production growth failed to offset 3% YoY 2.8growth in demand. The result: we expect global S/U this year to 2.7 Favorsfall to 13.7% in 2010/11, its lowest level since the 2006/07 2.6 soymarketing year. 2.5 planting 2.4 2.3Tightening inventories have sent prices rallying to levels not 2.2seen since mid 2008, up 35% YTD. Corn has seen pressure 2.1 Favorsinto year-end as speculative longs have taken profits on fears 2.0 cornsurrounding the likely expiry of the ethanol tax credit, index 1.9 plantingrebalancing and a typically slow news period. However, we feel 1.8that prices will need to move significantly higher in the 2005 2006 2007 2008 2009 2010spring—above $6.00/bu—to ration demand and incentivize SX6/CZ6 SX7/CZ7 SX8/CZ8needed acreage to keep S/U in the US and globally from falling SX9/CZ9 SX0/CZ0 SX1/CZ1further. Source: Bloomberg, CBOT, Morgan Stanley Commodity ResearchExhibit 12 While we predict a slight global production surplus next year,At Current Prices, Global Corn S/U Unlikely to Build demand will likely continue to grow YoY, limiting the extent toSignificantly in 2012(stocks to use, %) which supply shocks can be absorbed. Higher prices and a surge in the supply of feed-quality wheat available next spring 35% should encourage some limited protein feed switching, driving 30% below-trend growth in global corn feed demand of 0.3% YoY despite surging protein consumption. In the US, ethanol will 25% continue to consume a growing share of domestic production. 20% Under the 2011 RFS mandate, refiners will be required to blend 15% 12.6 bln gal of ethanol into the gasoline pool, translating into 10% baseline demand for 4.58 bln bu of corn. In 2012 the mandate is slated to increase to 13.2 mln gals, requiring 4.8 bln bu corn. 5% While the fate of the tax credit to ethanol blenders remains a 0% question mark at the time of this writing, we have growing 1995/1996 1999/2000 2003/2004 2007/2008 2011/2012e confidence in the resilience of discretionary blending into next World US year, even if corn/ethanol prices pressure blending margins. As such, the risks to our ethanol demand numbers remainSource: USDA, Morgan Stanley Research estimates squarely to the upside. 11
  12. 12. MORGAN STANLEY RESEARCH December 10, 2010 CommoditiesExhibit 14 With crops in China also disappointing, the country has liftedEthanol Mandates Imply Growing Corn Demand imports to satisfy demand. Much of these beans have been(RFS-implied corn demand from ethanol, bln bu) sourced from the US, where total export sales MYTD are up 5 17% YoY and shipments are up 14% YoY. Exhibit 15 4 78% of USDA’s US Export Forecast Already Sold (Current MY Total Soybean Export Commitment, mln bu) 3 1500 2 1300 1 1100 900 0 2007 2008 2009 2010 2011 2012 700 500Source: EPA, Morgan Stanley Commodity Research estimates 300We suspect that the China will continue to grow as a Jul Jan Feb Jun Oct Mar Nov Dec May Sep Aug Aprdestination for exports from the US and South America.Despite recent official statements that China’s 2010 crop will 2009/10 2010/11 USDA 10/11 Forecastensure adequate supply, we remain skeptical, as Chinese corn Source: USDA, Morgan Stanley Commodity Researchprices did not follow the rest of the agricultural complex lowerafter the government announced a renewed focus on curbing Against this backdrop, we forecast Chinese import demand forfood inflation. Private forecasters in the country have raised MY 2010/11 will grow 13% YoY before flattening out in 2011/12.questions over official production estimates, and it would not While we believe that growth in Chinese production next yearsurprise us to see the USDA revise historical stocks numbers should limit the need for additional imports, our growthlower as recently witnessed with Cotton (see page 14). We assumptions may ultimately prove too conservative, implyingcontinue to expect that China will be an importer of US corn in more downward pressure on western hemisphere S/U.spring 2011, and becoming an even bigger importer in theyears to come. In South America, we also anticipate the overall soybean balance to tighten into next year. Argentina is expected to plantGiven historically tight corn balances, and the need to a record 46.1 mln acres for soybeans, however, we expectreserve adequate US acreage against surging soy and yields to decline YoY in 2010/11 to 41.5 bu/acre, as a result ofwheat values, we reiterate our preference to be long Dec dryness caused by La Nina. We forecast S/U to decline from11 corn (currently trading at $5.60/bu, first recommended 46% in 2009/10 to 38% 2010/11 as strong global consumptionin our Oct 25 note Agriculture Update: Still See Further (including renewed demand for Argentine exports from China)Upside to Corn and Beans Prices). coupled with positive crush margins should keep demand elevated. In Brazil, we expect soybean acreage will reach aSOYBEANS — China’s Insatiable Appetite record high of 59.3 mln acres in 10/11. However, dry weather inand the Need for New Acres Brazil has offset the potential for additional acreage expansion as farmers have responded to the reduced likelihood of gettingIn similar fashion to corn, record US soybean production in in a Safrinha corn crop by planting cotton instead of soybeans.2010 has barely been able to keep pace with growing demand We are also building in a slight increase in soybean exports forfrom crushing industries in the EM, feeding ever-increasing 2010/11 and expect Brazilian S/U to remain largely unchangedcalls for protein feed and cooking oil. US S/U in 2010/11 looks at approximately 25%.poised to increase only slightly to 4.6%, up from 4.5% last year,though this is down markedly from expectations earlier in theyear, as US yields have disappointed. 12
  13. 13. MORGAN STANLEY RESEARCH December 10, 2010 CommoditiesExhibit 16 albeit not by the same magnitude, in an effort to maintainWorld Heading for Trade Deficit in Soybeans acreage.(Soybean Global Trade Deficit, mln bu) 1,200 Severe drought in Russia devastated the spring wheat crop 1,000 (responsible for one-third of total Russian wheat production). 800 The greater than 30% YoY drop in Russian production tightened domestic inventories, which are seen falling to below 600 200 mln bu from 440 mln bu, and prompted an official export 400 ban. While a turn in weather (above-normal rainfall which 200 started at the end of Aug) accelerated Russian winter grain planting, planted area is still estimated to decline 3 mln ha YoY. 0 Additionally, the late planting has resulted in greater winter-kill -200 risk as root structures are weak heading into the winter. Our recent visit to Moscow leads us to believe that exports may -400 2009/2010 2010/2011e 2011/2012e 2012/2013e 2013/2014e remain scarce until late-2011 or even into 2012 as next year’s spring wheat crop is also likely to be smaller than expected —Source: USDA, Morgan Stanley Commodity Research estimates owing to a shortage of seeds.In spring 2011, aggregate planted acreage must increase in In other major wheat producers, the outlook for the 10/11 croporder to satiate demand in a world of rising consumption. At an and beyond is mixed. In Argentina, early season rains providedaverage yield of 45 bu/acre, our trade deficit analysis much-needed moisture into the key kernel developmentunderscores the need for 10, 15, and 25 mln additional acres months, and dryness into the harvest period bodes well forbetween 2011/12 to 2013/14, respectively. With many of the quality. Argentine production is likely to offset some of themajor soybean producers at or near historical highs, new impact from Russian production disruption; Egypt recentlyacreage is needed. announced that it would resume imports from Argentina to make up for lost supply from Russia.The best hope for new acreage will come from Brazil. However,development of marginal acreage in Brazil requires higher Exhibit 17prices as transportation presents a significant cost hurdle. As US Export Sales Responding to Global Supplysuch, we believe that soybeans next year need to average a Shocksprice above $12.50/bu in order to incentivize Brazilian farmers (US Weekly Wheat Export Sales, ‘000 mt)to bring marginal acreage into production. 2200 Russian Export BanWith the US balance unable to give up significant acreage, and 1700 Australia Productioncorn needing to gain at least 2.5 mln acres to keep from Worries 1200plummeting to record tightness, we expect that the fight forspring acreage will be bullish for soybean prices at least 700through spring 2011. 200WHEAT — Quality at a Premium after 2010 -300Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr MayRains -800The US will likely shoulder much of the world’s demand 5-yr range 10/11 Averagefor wheat as production disruptions in the EU, FSU, and Source: USDA, Morgan Stanley Commodity ResearchAustralia have limited their ability to export. Productiondisruptions lit a fire under wheat prices late in the summer — Recent La Nina-related rains in Eastern Australia, with moresimilar, but muted relative to the situation in 2007/08 with forecast through the first half of December, have dashed priorinventories today more comfortable on a global basis, driven hopes of a stellar 2010/11 crop. Farmers to date have onlylargely by a surplus in the US. Although we are comparatively harvested 8 mln mt out of a forecast 26.8 mln mt as excess soilneutral on wheat (relative to corn and beans), we believe that moisture has kept them from getting into their fields. Qualityprices will track higher with rising corn and soybean prices, 13
  14. 14. MORGAN STANLEY RESEARCH December 10, 2010 Commoditiesdeclines are now a prime concern, with higher than normal wheat crop would suggest the need for increased wheat acreagepercentages of the crop likely to be rated only feed-grade. next year linking wheat prices more closely to the expectedMeanwhile, drought in the Western Australia will likely halve appreciation in the corn and soybean pits.wheat production YoY from 2009/10 levels of 8.2 mln MT. COTTON — Historic Prices Failing toRains during the wheat harvest in Germany, a major European Soften Demandsupplier of mill grade wheat, also prompted quality declines thisfall and resulted in only about 50% of the crop deemed suitable A host of supply disruptions and resilient textile demand hasfor milling versus 80% in average years. driven global cotton S/U to 17-year lows of 27% and pushed front month prices to 140-year highs.Although the US has the wheat to meet dislocated demandfrom a continued ban on Russian exports and supply Chinese 2010/11 production is expected to decline 6% YoY ondisruptions in Australia, the ability to export record wheat lower harvested area (down 4% YoY) and lower yields as cold,volumes, while also exporting elevated levels of corn and wet conditions during planting hampered plant developmentsoybeans, may be challenging. and flooding in late summer resulted in higher rates ofExhibit 18 abandonment. The USDA currently expects production of 30US Responsible for Outsized Portion of Exporting mln bales this year (vs. demand of 47 mln bales), althoughCountry Stocks domestic consulting firms give estimates nearly 1.0 mln bales(Stocks to Use, %) below that. Additionally, the USDA admitted in November to systematically overestimating Chinese mill stocks, lowering 25% their 2010/11 beginning stocks number by 3 mln bales and further corroborating the under-supplied situation in the country 20% which high prices have seemed to indicate. 15% Pakistan’s flooding also devastated cotton growing regions, 10% and we expect production to decline 5% YoY, dislocating 400 mln bales of export demand to other suppliers, likely the US. 5% However, we expect a modest improvement in production of 1% in 2011/12, though infrastructure constraints following the 0% floods may provide barriers to that growth. 1995/1996 1999/2000 2003/2004 2007/2008 2011/2012e Top 5 Exporters Ex-US US With strong crops in 2010, the US and India will have to take up much of the slack into 2011. With the US crop just harvestedSource: USDA, Morgan Stanley Commodity Research estimates and only now starting to enter warehouses along the Gulf Coast, 13.9 mln bales of exports — out of an estimated 15.75A comparatively full US balance sheet should limit the upside to mln bale total for the marketing year — have already been sold.US prices through the first half of 2011 though we anticipate India expects record production this year, and upside exists tosome divergence between different quality grades. A the USDA’s current export forecast for the country of 4.8 mlncomparative surplus of feed-quality wheat should pressure bales, particularly considering expectations that Chineseprices in those contracts, while high-quality wheat will be in prices will remain higher YoY through much of 1H11.short supply. We expect this to result in Kansas City wheatoutperformance against the Chicago contract, though we note Despite record high prices, demand has remained resilient, andthat both contracts will likely feel support from questions over we expect this trend to continue well into next year, largely owingthe adequacy of US supply. to supply shortages in China which have likely postponed some demand there. Nevertheless, Chinese yarn production is alreadyUS winter wheat entered its Dec dormancy period rated only 47% up 15% YoY MYTD through October with garment production upGood or Excellent, well below the average for this time of year. 22% MYTD. Better macro news continues to trickle out of the USWhile early season ratings don’t definitively translate into lower (where the MS Economics team expects GDP to grow by 2.9%yields in the spring, they raise the probability of such an event. in 2011), and the core of the euro-zone has shown promise,With the US likely having to pick up the slack from reduced bullish for textile demand into 2011.exports from Australia and the FSU, an underperforming winter 14
  15. 15. MORGAN STANLEY RESEARCH December 10, 2010 CommoditiesExhibit 19 SUGAR — Prices Will Trade at the Whim ofGlobal Stocks to Use Likely Flat YoY in 2011/12 Suppliers 50.0% 45.0% Sugar prices have been extremely volatile to say the least in 40.0% 2010, having traded in a near-$0.20/lb range. With global sugar 35.0% inventories at record tight levels following 3 years of production 30.0% deficits, prices have reacted aggressively to both bullish and 25.0% bearish news. Earlier in the year, prices reached near $0.30/lb 20.0% but subsequently fell aggressively to a low below $0.15/lb in 15.0% May as Indian production estimates increased, Brazilian 10.0% exports surprised and Europe decided to export. Through the 5.0% summer, tempered BRL production estimates, coupled with 0.0% weather-related disruptions in Russia and Pakistan contributed 1990/1991 1994/1995 1998/1999 2002/2003 2006/2007 2011/2012e to lifting sugar prices back above $0.30/lb.Source: USDA, Morgan Stanley Commodity Research estimates Concerns over demand from China, post-inflation-controls, drove some speculative interest out of the market. Additionally,US retail clothing sales are up 3% YoY in Oct and 3% YoY sugar production in CS Brazil rebounded unexpectedly in theMYTD. Sales in November look promising despite apparel second half of October, suggesting the crushing season maycompanies starting to raise prices to offset higher costs. Gross have a longer tail than expected, and soothing some concernsmargins at Chinese mills have improved YoY in 2010, over tightness in the inter-harvest period.encouraging further throughput. Finally, rising oil prices in 2011should also reduce the appeal of synthetic materials, Exhibit 21decreasing the likelihood of a substantial impact from demand CS Brazil Crush Lasting Longer Than Expectedsubstitution. (CS Brazil Fortnightly Sugar Production, mln mt) 3.5Exhibit 20 3.0Tight Stocks Pushing the Curve into Backwardation(Cotton Futures Curve, USD/lb) 2.5 1.6 2.0 1.4 1.5 1.2 1.0 1.0 0.5 0.8 0.6 0.0 2HMar 1HMay 2HJun 1HAug 2HSep 1HNov 2HDec 1HFeb 0.4 0.2 06/07 07/08 08/09 09/10 10/11 0.0 1 2 3 4 5 6 7 8 9 10 11 12 13 Source: UNICA, Morgan Stanley Commodity Research 7/28/2010 12/8/2010 Indian sugar production looks poised to rebound this year asSource: Bloomberg, ICE, Morgan Stanley Commodity Research adequate rainfall during this year’s monsoon improved cane yields and sucrose content. However, production estimatesAlthough near-dated prices may yet rise further, we prefer to have started to step down slightly, with the Indian governmentkeep our length in Dec 11 (currently trading at $1.38/lb, first now estimating total production of 24.5 mln mt, down fromrecommended in our Mar 1 note Cotton Update: The Fabric of earlier predictions of 25 mln mtwv. In Australia, the prospect ofRecovery), where fundamentals still appear constructive. Even if a YoY recovery in sugar production is quickly fading, as heavyUS 2011 planted area increases by the expected 2.65 mln acres rains in the East of the country have delayed harvests andYoY, along with expected expansion in Brazil and China, our raised the likelihood that cane will be left in the fields. Regionalnumbers still suggest a slightly tighter global balance next year, producers estimate that sugar production may only amount to 4with 2011/12 S/U at 26.6%. We see Dec 11 as continuing to mln mt this year, down 0.6 mln mt from ABARE’s currentperform, to garner and protect acreage from soybeans and corn. forecast, with exports down by roughly the same amount. 15
  16. 16. MORGAN STANLEY RESEARCH December 10, 2010 CommoditiesWhile Australian supply disruptions, if realized, will tighten the We have no trade recommendation in sugar, through believetrade balance into the spring, we believe that price direction that prices are likely to move lower as the Indian harvestuntil the start of the next Brazilian harvest in May will be accelerates into YE and 2011. If India decides to withholddictated by Indian exports. We estimate that India will find itself further exports under the open general license scheme,sitting on a production surplus of just over 2 mln mtrv this however, prices would likely again rally given depleted globalseason, though it is yet unclear exactly how much of that inventories. Any further weather disruptions present significantamount the government will clear for exports, particularly given upside risk from current levels, though price strength shouldthe country’s desire to rebuild stocks after two years of abate with the onset of the Brazilian harvest in May.disappointing harvests. 16

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