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Recession fears have been a steady undercurrent in the commodities markets lately. Against the backdrop of high inflation and interest rates, markets are worried about a global recession which could lead to demand destruction.
In response to growing demand concerns, OPEC+ had agreed to cut its collective output limit by 2 million barrels a day. While the actual cut is smaller, it is still enough to dramatically change the oil balance over 2023.
For metals, the short-term demand outlook remains weak. China’s insistence on a zero-COVID policy have weighed on the demand for industrial metals, but nevertheless, the green transition is a long term tailwind for the sector.
The on-going Russia-Ukraine war has ramifications for the global food supply. Beyond this, climate change will be a key factor that continues to challenge agricultural yields over time.
Even with the current volatility, the long-term outlook for commodity prices in general is higher for longer. Investors can consider the Blackrock Natural Resources Growth & Income Fund to get exposure to the commodities sector.
The commodities sector has rallied this year, outperforming other sectors of the market. However, fears of a global recession have raised caution within the commodities sector. While structural supply tightness in commodity markets should keep up, not all areas of the commodities sector – energy, metals, agricultural – will be impacted equally in view of the ongoing demand destruction. Nevertheless, the prices of energy, metal, and food prices are likely to stay elevated in the years ahead, contributing to higher inflation.
Recession fears are brought to the forefront
Recession fears have been a steady undercurrent in the commodities sector lately. Against the backdrop of high inflation, central banks around the world are aggressively increasing interest rates, and markets are worried about a global recession which could lead to demand destruction.
Concerns over future Chinese demand weighed, after President Xi Jinping signalled that the country has no plans to scale back its strict zero-COVID policy. A series of lockdowns under the policy have severely hampered China’s economic activity, denting the demand for oil and metals. Moreover, a strong US dollar, buoyed by aggressive interest rate rises is also making commodities such as oil and industrial metals more expensive for buyers.
In fact, the IEA lowered its 2022 oil demand growth forecasts by 60,000 barrels a day (bpd) to 1.9 million bpd, and by 470,000 barrels a day to 1.7 million bpd for 2023. For 2022, the IEA now expects total oil demand of 99.6 million bpd and 101.3 million bpd in 2023.
Table 1: The International Energy Agency (IEA) oil demand and supply forecasts
|
In million barrels per day (bpd) |
2022 |
2023 |
|
Oil demand forecasts |
99.6 million bpd |
101.3 million bpd |
|
Oil supply forecasts |
99.9 million bpd |
100.6 million bpd |
|
Source: IEA Oil Market Report Data as of October 2022 |
||
(Related article — Recession fears have struck markets. Can the commodities sector overcome them?)
Energy – remain higher for longer
a) OPEC cannot be counted on to alleviate supply fears
Growing demand concerns have left members of the Organization of Petroleum Exporting Countries and its allies (OPEC+) uneasy. On 5 October 2022, they dropped a bombshell that they had agreed to cut its collective output limit by 2 million bpd squeezing supplies in a tight market, and surpassing earlier predictions of cuts of 1 to 1.5 million barrels, in a move intended to raise crude prices.
The decline in OPEC+ supply however, will be smaller than the announced 2 million bpd reduction in production targets, given that the majority of the alliance’s members already producing well below their ceilings due to capacity constraints.
Where it stands, it is likely that only Saudi Arabia, UAE, Kuwait, Iraq, Gabon, Algeria and Oman will need to cut output. All other members are already producing below their new target production, and according to IEA estimates, underproduction among the group means that this would probably translate to a 1 million bpd cut.
Even with the decline in global demand growth, the cut in oil supplies would reduce the ability to replenish stocks (Figure 1) through the rest of the year and into 2023, increasing energy security risks worldwide. More importantly, it sends a message that OPEC+ is willing to take action to defend a floor in oil prices, presumably around USD 80 per barrel for WTI Crude, and USD 90 for Brent Crude.
Figure 1: Oil reserves are declining
Do not expect US domestic oil producers to pick up the slack. The private sector response in the US seems to remain contained so far. US oil rig count tracked by Baker Hughes has failed to rise in line with prices (Figure 2) and structurally, the oil and gas sector is a market that is defined by underinvestment. This is a persistent problem that is difficult to change, with investment being on a downward trend since 2014.
(Related article — A new commodities supercycle: Why oil could reach 150!)
Figure 2: US domestic oil production are less responsive to prices than in the past
b) Price caps are unlikely to work
Capping the price of Russia oil, an approach that the G7 nations — Canada, France, Germany, Italy, Japan, the UK and the US, as well as the European Union – are seeking to pursue is unlikely to work.Another key area of concern is that of enforcement. With the details of the plan not yet revealed, there is uncertainty over how exactly the G7 nations will enforce the price cap plan.
c)
Governments have been spending to shield
against higher energy bills
In response to the energy crisis, governments worldwide have been spending to shield consumers and businesses from the impact of higher electricity prices.
For example, Britain has allocated funding worth 6.5% of GDP in the next year to shield households and firms from higher energy bills, and this is more than it spent on its furlough scheme and support for the self-employed in 2020-21.
Germany is preparing to borrow an additional EUR 200 billion to finance a plan to limit the impact of soaring energy costs, while France has frozen gas prices this year and capped electricity price rises at 4% for households. The US has also spent, with state governors doling out “gas cards” and suspending fuel taxes to help people refuel.
These measures come at a big cost to governments, but they also mean that energy demand while slowing, has not been as bad as expected, and demand destruction has not really materialised.
Metals – short term headwinds remain, but there’s no stopping the green transition
For metals, the short-term demand outlook remains weak. The industrial/base metals sector is an economically sensitive sector. Slowing economic growth across the globe is reducing the demand for metals, and the behaviour of an importer as big as China moves prices.
Figure 3: Base Metals Price Index has been on a decline since its highs on March 2022
Beyond China, the European metal manufacturing has seen a wave of shutdowns amid the ongoing energy crisis, with energy-intensive metals like aluminium and zinc most at risk from soaring energy prices in Europe.
However, in the longer term, the energy transition could give a renewed lift to the prices of some metals. The green transition is likely to create a huge boom in demand for metals, such as cobalt, copper, nickel, and lithium that are vital for the technologies underpinning everything from electric cars to renewables.
For example, an electric car uses roughly 210 kilograms of metals and minerals per vehicle, while a conventional car uses 40 kilograms (Figure 5). The same goes for wind and solar technologies, which are far more metals and minerals intensive.
Figure 5: Green transition is highly metals intensive
The current supplies of these critical metals are inadequate to satisfy future needs. As noted by the International Monetary Fund (IMF), the current production rates of cobalt and nickel appear inadequate, showing a more than two-thirds gap versus demand. Similarly, copper and lithium supplies are also inadequate to satisfy future needs, with a 30-40% gap versus demand.
Mining projects have long lead times and require large investments. Lead times from resource discovery to production average 17 years, including 12.5 years from discovery to feasibility and 4.5 years for planning and construction, according to the IEA. The unintended result of the green transition will likely be “greenflation”, sharply increasing prices for the metals and minerals that are critical to the transition.
Agriculture – myriad of food security concerns persists
Concerns about food security amidst Russia’s invasion of Ukraine have continued to persist. The Black Sea Grain Initiative was brokered by the UN, and was created in July for an initial four months to allow for Ukrainian grain to flow out of ports in the Odesa region.
Russia announced that they would be suspending their participation in the Black Sea Grain Initiative on 29 October 2022, after an attack on Russian warships in the Black Sea port that was blamed on Ukraine. This is significant as the world relies on the Black Sea region for more than a quarter of annual wheat and barley exports, and about a fifth of its corn cargoes and the bulk of its sunflower oil shipments. Additionally, the termination of the Black Sea deal puts at risk a main export route of fertiliser relied on by farmers to grow ample crops.
However, as of 2 November 2022, Russia has re-joined this agreement after receiving written guarantees from Ukraine that the safe-passage corridor will be used only for grain exports. Nevertheless, they have warned that they could pull out again from this agreement, highlighting that large amounts of uncertainty around this deal remains.
New era of higher for longer
Figure 6: Energy and materials are trading at attractive valuations
Figure 7: Energy and materials offer some of the highest yields amongst the GICS sectors
Investors can gain exposure to the broader commodities sector via the Blackrock Natural Resources Growth & Income A2 USD Fund. We believe that this fund is representative of the commodities sector, with an allocation to energy, mining and agriculture sectors (Figure 8). Its benchmark is the S&P Global Natural Resources USD Index which is one-third energy, one-third mining, and one-third agriculture.
Figure 8: Sector allocation of the Blackrock Natural Resources Growth & Income Fund
Figure
9: Natural resources sector is also trading at attractive valuations
Investors may also wish to consider the Blackrock World Energy Fund A2 USD, if they are seeking a dedicated fund 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 a higher for longer inflationary environment.
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