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Russia’s invasion of Ukraine has severe implications because of how resource-rich Russia is. Russia is the world’s second-largest oil exporter, and is amongst the leading producer of metals such as aluminium, nickel, copper and iron.
With foreseeable sanctions and supply-chain disruptions, sharp jumps in commodity prices were seen. Oil prices have surged past USD 100 a barrel, the highest level since 2014.
Despite the market volatility, the rationale for investing in commodities remains intact. The sector is an effective hedge against rapidly rising inflation.
The demand-supply imbalance coming from the over-reliance on fossil fuels, and the lack of investment into the sector are also driving a positive outlook. This similar imbalance can also be found in the metals market, where the clean energy transition is unleashing an unprecedented demand for green metals.
Where it stands, valuations of the energy and materials sector are attractive, with these sectors trading below their 10-year average forward PE ratios, and are amongst the cheapest sectors in the MSCI AC World Index.
Investors can consider the JPMorgan Funds - Global Natural Resources A (acc) USD Fund and the Blackrock World Energy Fund A2 USD in view of rising inflation and growing geopolitical tensions.
Tensions between Russia and neighbouring Ukraine have erupted into a full-blown invasion. On 24 February 2022, President Vladimir Putin announced the launch of a military operation against Ukraine, and Russian forces fired missiles at several cities in Ukraine and landed troops on its south coast.
Russia's invasion of Ukraine poses profound risks to a global economy, which is already suffering from soaring inflation and supply chain disruptions. Amidst all these uncertainties, we shine a spotlight on the commodities sector.
Russia’s invasion of Ukraine will likely drive commodity prices higher
Russia’s invasion has severe implications because the country is resource-rich. Russia is the world’s second-largest oil exporter, and supplies over 40% of Europe's natural gas supplies.
In view of Russia’s actions against Ukraine, the path towards a de-escalation of conflict becomes increasingly challenging. The US, coordinating with allies, would likely impose more sanctions in time to come. The anticipation of various new sanctions on Russia, have driven up oil prices. Both US and global benchmark oil prices have recently touched their highest levels since about 2014. Brent crude oil prices surpassed USD 100 per barrel on 24 February 2022, the first time since 2014.
Moreover, just a day before the invasion, the US had already imposed sanctions on the company in charge of building Russia's Nord Stream 2 gas pipeline. Germany had also halted the Nord Stream 2 gas pipeline approval. The pipeline was designed to double the gas flow capacity from Russia to Germany, and ease the pressure on European consumers facing record energy prices.
Beyond oil and natural gas, Russia is amongst the leading producer of metals such as aluminum, nickel, copper, and iron (Figure 1). It is also largely involved in the export and manufacture of other essential raw materials like palladium and platinum. Sanction-induced supply chain disruptions would further drive up the prices of these metals.
Figure 1: Russia is an exporter of many commodities
As such, commodities prices are likely to be driven higher in view of the latest escalation in geopolitical tensions, and a level of geopolitical risk premium may well be sustained for some time given market concerns over the possible effects of any supply interruption. Prices are expected to remain volatile and rise from current levels if these geopolitical concerns do not materially ease.
Commodities are an effective hedge against inflation
At the backdrop of these geopolitical tensions is inflation. Inflation is now running at its highest in a generation, with consumer prices now rising by nearly 7.5% in January (Figure 2) compared to a year earlier. Combined together, rising inflation and geopolitical tensions have no doubt created a commodities supercycle.
Figure 2: US CPI YOY data
In a high inflationary environment, commodities typically outperform other asset classes. There is a strong 10-year correlation of 0.73 between the year-over-year (YOY) growth of the Bloomberg Commodities Index (BCOM) and the US Consumer Price Index (CPI), highlighting the effectiveness of commodities as an inflation hedge (Figure 3).
Figure 3: Commodities have historically been an inflation hedge
Given Russia’s role as a commodity superstore, the economic impact of this crisis could further exacerbate the current global inflationary dynamics. Commodity prices are likely to remain at elevated levels in this current environment, making commodity-related equities a decent hedge in portfolios.
Demand-supply imbalance driving positive outlook for commodities
Despite the recent volatility, the rationale for investing in commodities remains intact given the growing demand-supply imbalance. This imbalance can be observed in both the oil and gas, and metals market.
Oil and gas: In the past decade, fossil fuels had fallen out of favour with the investing universe as Environmental, Social, and Governance (ESG) headwinds posed major challenges for a sector that badly needed new investments to keep up with the growing demand.
In fact, annual investment in upstream oil and gas peaked at USD 780 billion in 2014. Since then, the highest annual spending seen was in 2019, which amounted to USD 483 billion, just 62% of 2014 levels (Figure 4). In 2021, annual investment in upstream oil and gas amounted to only USD 351 billion, despite the fact that the world is still consuming near-record amounts of fossil fuels (coal, oil, petroleum, and natural gas).
Figure 4: Falling investment into the fossil fuel industry
Nearly all of the energy needed to meet our demands – 80% of global energy – comes from burning fossil fuels. Thus, for now, renewable energy is unable to replace fossil fuels to meet our energy needs.
Moreover, the vast oil surplus accumulated during the first few months of the pandemic has also been wiped out, with inventories of OECD countries falling (Figure 5). Going forward, weak supply from OPEC+ will further aggravate this demand-supply imbalance. OPEC+ seems reluctant to stray from its current deal and is sticking to existing policies of moderate output increases of 400,000 barrels per day.
Figure 5: Declining crude oil inventories
This comes after having reported that several OPEC members such as Nigeria, Angola, and Kazakhstan have struggled to pump even in line with their quotas due to years of under-investments or large maintenance work that has been delayed by the Covid-19 pandemic.
Currently, crude oil demand is at 97.8 million barrels per day, while supply is at 92.2 million barrels per day – a shortfall of around 5.6 million barrels per day. Russia’s daily supply is around 10 million barrels per day. So barring a big demand disruption, the demand and supply gap will remain very large (> 5.6 million barrels per days, depending on how much Russia’s oil supply will be disrupted or sanctioned).
Hence, the prospect of depleting inventories, coupled with environmental concerns and limited investments in the oil and gas sector, will only aggravate the current imbalance in the face of growing demand, pushing up oil and gas prices.
Metals: We see a similar issue in the metals space. In particular, the demand for green metals, which are used in the applications, products, and processes that enable the energy transition from fossil fuels to cleaner energy sources and technologies, have far outpaced supply.
The ongoing clean energy transition needed to combat the ill effects of climate change has unleashed an unprecedented metals demand in coming decades, requiring as much as three billion tons.
Copper, lithium, cobalt, and nickel, are tightly linked to the electric vehicle and energy storage sectors, and are seeing their demand rising exponentially. S&P Global Market Intelligence has forecasted that their demand is expected to grow by a CAGR of 15% for copper, 35% for lithium, 28% for cobalt and 35% for nickel, by 2025. This is unsurprising given that the largest economies of the world such as the US and China, have pushed stimulus plans targeted towards renewable energy infrastructure.
Moreover, according to IMF, given the projected increase in metals consumption through 2050 under a net zero scenario, current production rates of cobalt and nickel appear inadequate, showing a more than two-thirds gap versus the demand. Similarly, copper and lithium supplies are also inadequate to satisfy future needs, with a 30-40% gap versus demand (Figure 6). Where it stands, the lack of supply has already sent these metal prices surging.
Figure 6: Current production rates of metals are inadequate to satisfy demand
Energy and materials are trading at attractive valuations
In spite of the recent attention garnered by commodities, the energy and materials sectors remain one of the cheapest in the MSCI AC World Index. They are still trading below their long term average valuation multiples (Figure 7), creating an attractive investment opportunity. Not to mention, the energy and materials sectors offer attractive dividend yields (Figure 8).
Figure 7: Energy and materials are trading below long-term average valuation multiples
Figure 8: Energy and materials offer some of the highest yields amongst
the GICS sectors
As investors consider the possible inflation and growth shocks to the global economy from the geopolitical conflict and ensuing sanctions, they can seek shelter in the commodities sector.
With this in mind, investors should consider the JPMorgan Funds - Global Natural Resources A (acc) USD Fund , which invests in natural resource companies, such as those involved in oil and gas exploration and production, as well as in metals and mining.
For a dedicated energy fund, investors may also consider the Blackrock World Energy Fund A2 USD, which is involved in the exploration, development, production and distribution of energy. All in all, we believe that both these funds are well-positioned to benefit from the global commodities supercycle.
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