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STRATEGY FOCUS
Prepared by
Merrill Lynch & Co.
Global Securities Research & Economics Group
The El Nino weather watch continues to be a feature in agricultural commodities with cocoa and coffee among the most impacted markets. A drought that is sweeping through parts of Southeast Asia is thought to be El Nino linked and threatens cocoa and coffee output in a number of areas. Historically, El Nino causes a warming pattern in sea surface temperatures in the South Pacific and this results in abnormal global rainfall and wind patterns. In some areas this translates into drought while others can be subject to flooding. In Indonesia, rainfall in the South Sulawesi region last fell in mid-June with little currently anticipated until early November. Pod counts per tree are running only about 6 versus a norm of 18 to 20 pods. However, the final Indonesian crop may not be that bad compared to last year due to increased acreage. The Indonesian Cocoa Association previously forecast the 1997 crop at 319,000 to 330,000 tonnes, up 10 percent from 1996. Recently, they have expressed optimism that the crop will still approach that level despite the drought. The West African crop, including the Ivory Coast, appears to be in fairly good shape as normal September seasonal rainfall has started to arrive. And historically there is no strong correlation between El Nino and Ivorian cocoa production. Senior Softs Analyst, Judith Ganes, still views the supply/demand picture for cocoa as bearish. And while El Nino may have some impact, the concerns appear to be more hype than reality. In our view, the recent highs in cocoa represent the top of the broad intermediate- term fundamental range.
In coffee, Colombia's private exporters have indicated that the longer than expected drought caused by El Nino could affect the quality of the crop but probably not the quantity and that production forecasts remain unchanged. Similar quality problems are likely in Central America and Indonesia. However, the global situation seems hardly a disaster and the overall impact of El Nino on coffee is probably less than many are projecting. Some time ago we wrote a piece titled “El Nino, Is Its Bark Worse Than Its Bite?– In the case of cocoa and coffee this seems to be the case.
In the base metals arena, copper prices plunged to a 10-month low on the London Metals Exchange at $2050 per tonne while COMEX skidded to its lowest point since early November at 93.30 cents. In our view, the weak Asian scenario is the primary factor in the market's weakness and it could result in further price erosion. A depressed Japanese economy, the currency crisis in the “Asian Tiger” nations and less than anticipated Chinese demand have all contributed to the market's demise. In China, GDP growth has slowed and a large inventory overhang seems to be developing. In addition, the Chinese economy is facing structural challenges as it gradually shifts away from the state-owned manufacturing system toward privatization. This type of structural change can result in extended periods of economic chaos, at least to some degree, and commodity policies and patterns might be impacted with base metals along with the Chinese stockpile and procurement systems likely being affected. Some evidence of this has already been seen in the cotton market. China may be in for a rough ride for awhile, and when combined with the Japanese economic malaise and the currency situation it does not bode well for Asian copper demand. Fairly buoyant U.S. demand and at least steady European offtake are not likely to fully offset this. When you add in the fact that world production is on the upswing, it leads us to a mostly bearish conclusion. Copper prices appear to have a broad range of about 85 cents to $1.10 per pound. Over the next 3 to 6 months prices might be expected to trade mostly in the lower quarter of this range.
As for commodities in general, there continues to be no major trend with few if any inflationary implications. Over the next few weeks the overall technical picture has leaned bearish. The CRB Index recently broke below the 20-day moving average for the first time since late August. History tells us that this is an important barometer for the index. Momentum indicators are also pointing lower. Among the weaker sectors of commodities are precious and base metals, crude oil and products, wheat and to some extent tropicals even with the El Nino factor which may have been mostly discounted. Another negative sign for the overall commodity outlook is that the Journal of Commerce Index suffered its largest one-day loss since April 3 on September 16 while at the same time taking out key support on the weekly charts. The current reading of 105.96 is not that far away from the August 1994 low of 104.42.
In summary, while we are not forecasting a collapse in commodity prices, they remain very tame and over the next few weeks they might be expected to have a modest downside bias.
(Reprinted by permission. Copyright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
September 18, 1997 Bill O'Neill
Merrill Lynch & Co.
Global Securities Research & Economics Group
North Tower, 21st Floor
World Financial Center, New York, New York
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