Recent rally is a prologue to the rally on economic recovery . Commodity returns as indicated by the S&P GSCI Enhanced Total Return Index increased by a massive 16.8% in May, driven by a sharp rise in energy returns as well as strong gains across much of the rest of the complex. These substantial gains naturally raise the key question: is the fundamental commodity rally already behind us? In our view, the answer is no. Instead, we believe that driving the recent rally (particularly in oil) has been the reversal and/or avoidance of pricing dislocations caused by the credit crisis and exceptionally high oil inventories that threatened to breach storage capacity constraints. Because this rally has largely owed to a reversal/avoidance of these dislocations, we view it as a prologue to the commodity price rally that we continue to expect to accompany improving fundamentals as the economy recovers amid tighter supplies.
Oil & Metals: For oil and metals in particular, we continue to believe that improvement in fundamentals will lend meaningful support to prices and returns on a 6-18 month horizon. For oil, we maintain that a combination of demand stabilization and OPEC production cuts will draw inventories back to normal levels by the end of 3Q2009. Further, we believe that by late 2010, even OPEC production running at full capacity will be insufficient to avoid a return to a tight balance in the context of expected Non-OPEC production declines against rising demand. Given normalization in storage funding costs as well as a reduced likelihood of breaching oil storage capacity constraints, we have raised our near-term oil price target to $75/bbl and believe that oil prices will rise to $95/bbl by year-end 2010 as fundamentals tighten.
Agriculture: Although agricultural returns have increased substantially in the recent period, these gains have been driven by weather-related supply concerns, particularly for wheat. Support for wheat has spilled over to corn, which has also benefitted from an improved ethanol production outlook, while very tight US soybean inventories on strong Chinese demand for US exports have continued to lend support to soybean prices and returns. The potential for weather-related risks to materially reduce harvests presents upside risks to our agricultural forecasts. However, higher-than-expected inventories heading out of the current crop year has been a key driver of a recent downward revision to our 12-mo wheat price view at the same time that we continue to believe a supply response to recent high soybean prices will soften soybean balances over a 12-month horizon. Although we maintain significant upside on our 12-mo corn views, on net, we are lowering our 12-mo agricultural returns forecasts to -1% from 14%.
Revising returns forecast lower, but recommending overweight
Changes to our returns expectations for the individual sector strategies, especially a material downward revision to our forecasts for agriculture, are leading us to modestly revise our forecast for the S&P GSCI Enhanced Total Return Index to 17.5% from a prior 19.1%. However, our belief that we are approaching the initial phase of the fundamental rally in commodities, reinforced by generally higher commodity returns expectations relative to other asset classes, are leading us to shift our recommendation to an overweight from a neutral allocation to commodities.
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