Commodities: The pain and the opportunity

The trend following school of technicians generally prefers commodity futures to most other financial instruments. Commodities have long cycles, futures instruments can be traded both ways and quite often, the required margins are very low, offering high leverage ratios. Base metals and gold have been hitting a succession of multi-year lows. Energy commodities, such as crude and gas have also hit lower levels.

The reasons are generally linked to China's slowdown and more broadly to slow global growth. China's GDP growth projections have been cut several times. China in itself, contributes over 10 per cent of global GDP and about 11 per cent of global trade. Global growth projections, including projections from outside China, have also been pared down.

The impact of lower energy prices is beneficial for India. The windfall in term of lower subsidies on the energy is essentially responsible for keeping the fiscal deficit and the current account deficit under control. The central government decontrolled petrol and diesel prices, which has helped refiners and marketers repair their balance sheets to a large extent. The real test of commitment to those reforms will come as and when fuel prices rise again. Will the government refrain from re-imposing an administered pricing mechanism (APM)?

One negative long-term impact is that investments into exploration and production will slow down. Another is that investments into renewables could get hit because conventional fuel is cheap. A third, more insidious problem could arise if investments are made by corporates assuming that these prices will last forever.

Given the situation, the government should see this as a short window of opportunity and it will have to clarify policy on exploration to try and attract investments. There has been talk for a while for moving to an open acreage system where, instead of the New Exploration & Licensing Policy concept of auctioning of blocks, companies will be allowed to bid anytime.

But that requires a lot of technological sprucing up to offer high-quality geological data, and it requires clearly demarcated contractual arrangements. Sudden backdated tax demands or a lack of clarity on contracts, could scare off potential investors. If the government gets complacent, none of the desirable things will happen in a hurry. Since India will remain a net energy importer, encouraging exploration is all the more important.

The base metals situation is more complex. Indian metal manufacturers are under the gun and corporates in that space have seen share prices hitting lows. The mining sector in general is under pressure. Cheap steel, copper, zinc products could flood the country because Chinese manufacturers will have huge over-capacity and they are getting desperate. Given that India has a large internal demand - steel is essential for all sorts of construction, copper is required in large quantities for electrical grids. Zinc is also in a global over-supply situation and that will mean lower costs for the auto industry. Aluminium is in similar dire straits.

Inevitably, Indian manufacturers will be struggling to cope as prices head down. They might well ask for countervailing duties or higher customs duties or "anti-dumping" measures. Whether they get it or not, there will be a struggle to cope with low prices and competition. On the other hand, downstream industries could revive if they can cut costs and pass the cuts along to generate consumption demand. Revival of the commodity cycle could be a long, painful process. The primary metal sectors will be under pressure for long periods, maybe for years to come. The energy area will on the other hand, see a continuing bounce.

The author is a technical and equity analyst