Rubber near record high, margin deterioration inevitable
Rubber recently broke one of the longest records in commodity history by topping its all-time high of US$3.5/kg after almost 60 years. The upward trend in the natural rubber price is growing more pronounced due to tight supply/demand, with the price rising to US$3.8/kg (up 2.5X yoy) in early April. Rubber supply/demand is likely to remain tight for some time given production concerns in rubber-producing countries and rising demand from China, India, and the rest of emerging Asia, which account for nearly 70% of demand. We raise our natural rubber price forecasts to
US$3.4/kg for 2010 and US$3.6/kg for 2011, but expect the pass-on to
tire prices to be insufficient to offset margin deterioration.

But earnings expectations (and valuations) remain high
Natural rubber accounts for a third of tire materials costs and as such has the largest impact on earnings. Tire makers need to raise prices by 5% to offset the impact of a 10% rise in all materials. But passing on higher costs to consumers may very well prove to be difficult for two reasons: (1) a slow recovery in developed market replacement tires, and (2) vicious competition in emerging markets. Aggressive hikes could also dampen the demand recovery. In line with this, we lower our earnings estimates for tire companies; on average, our estimates are around 20% below consensus. We believe that market expectations are too high; and the sector is not pricing in all the risks.

Rise in rubber prices could be structural
There is a risk that the rise in rubber prices is more structural due to competing economics of alternative agribusinesses such as palm oil and changes in demand in India and China. Thus while there could be seasonal decline in rubber prices later in the year, longer term we expect rubber prices to remain higher than in the past. Moreover, tire makers may be less able than in the past to pass on these rising costs. The markets could thus come to view the tire sector as more cyclical, and less defensive.

Eoin Treacy's view Here is a section from Wikipedia on rubber:

Rubber latex is extracted from Rubber trees. The economic life period of rubber trees in plantations is around 32 years - up to 7 years of immature phase and about 25 years of productive phase.

If it takes 7 years for a new tree to become productive then it could be a while before supply catches up with demand, putting Rubber into the Supply Inelasticity Meets Rising Demand commodity theme. It remains to be seen at what price synthetic rubber will now become competitive with natural rubber given the continued relatively steady uptrend for oil prices.

Singapore listed Rubber continues to trend consistently higher and while becoming increasingly overextended relative to the 200-day moving average, a break of the progression of higher reaction lows, currently near 320¢, would be required to question the consistency of the overall uptrend.

Tokyo traded Rubber has a relatively similar chart pattern but has yet to break to new highs. The Shanghai listed contract has been ranging, mostly below CNY25,000 since January, but has held the progression of higher reaction lows and is pressuring the upper side of the range once more. A sustained move below CNY22,000 would be required to question potential for a successful upside break.

Car manufacturers, particularly in Asia, have been some of the higher profile beneficiaries of the growth of the Asian middle class. (Also see Comment of the Day on March 24th). A logical step would be to assume that since every new car has four tyres and these need to be replaced from time to time, that tyre manufactures would be positively leveraged to auto sales growth. However, as with any business input costs need to be taken account of and high rubber prices are acting as a headwind for the sector.

Bridgestone, Michelin and Continental all remain rangebound following rallies from last year's lows. They need to sustain moves to new recovery highs to indicate demand is returning to dominance. Rubber prices are probably worth watching because if prices were to fall back meaningfully, these shares would likely be swift beneficiaries