No storm lasts forever. Why this time it’s different for commodities and what it means for investors

Looking ahead, 2023 is set to be yet another year with plenty of volatility. While markets will be trying to gauge the demand impact from slowing global growth, supply risks have not disappeared, and are in fact growing when it comes to commodities.

Entering the eye of the storm – stagflation

2022 marked an inflection point where multi-decade loose monetary policies of currency printing and declining interest rates were swiftly reversed. Today, the Fed faces very different circumstances: record low unemployment, strong wage growth, and rates of inflation that are far above the central bank’s target. Even with aggressive rate hike, inflation remains elevated, and well above the Federal Reserve’s longstanding 2% target. 

Related article: How long will it take for inflation to hit 2%? Hint: much longer than you think

Not to mention, tighter monetary policy is starting to bite. Leading economic indicators are already pointing towards a slowdown. Purchasing managers’ indices (PMIs) across most major markets currently show a contraction, reflecting the headwinds faced by the global economy. When it comes to engineering a soft landings — slowing an overheating economy without inducing a recession, the Fed has a somewhat mixed track record (Figure 2).

Figure 2: Key contributors to US Recessions

Taken together, the concerns of rising prices and slowing growth likely means that a stagflationary environment is unfolding. There have been very few extended periods of stagflation. The last time a major period of stagflation occurred was in the 1970s – and it was not pretty. Interest rates were soaring, there was widespread food and energy inflation, and the economy was a mess back then.

The good news is that commodities typically perform well when inflation rises (often because they are the cause of the rise in inflation), making commodity-linked equities an inflation hedge. For instance, the S&P Global Natural Resources Index has a 10 year correlation of 0.6 with the US CPI Index, much higher as compared to the S&P 500 Index, with a correlation of 0.2.

Regardless, stagflation or not, what we will particularly witness is the tugging forces of a possible demand slowdown and supply tightening playing out in full effect in the commodities market in 2023. While the short-run price movement of commodities are often unpredictable, they are more predictable in the long run. With this, we believe that there are opportunities present for the reasons below.

Related article: Even with an imminent recession, higher for longer commodity prices will remain. Here’s why

Energy – volatile but skewed to higher prices

Oil prices surged after the Russia-Ukraine war, but saw a decline at the back end of 2022 amidst the bleak macroeconomic environment. This sell-off comes about despite lower OPEC+ production and a relaxation of China’s Covid restrictions. More importantly, we continue to see underinvestment within this space. Without sufficient capex to create supply capacity, oil and gas will remain stuck in a state of further shortages, with higher and more volatile prices.

a)      OPEC+ production issues to linger  

OPEC+ has largely ignored calls from the US and other key consumers to increase oil supply more aggressively this year amid higher prices and supply concerns. OPEC+ has zero motivation to try and boost production, as squeezing tight oil markets will prevent oil prices from dropping too far, and continue to benefit producers.

Moreover, due to a weaker economic backdrop, OPEC+ has announced production cuts by 2 million barrels per day (bpd) on 5 October 2022. The cartel opted to keep its production levels unchanged, with the production cut of 2 million bpd starting from November 2022 and lasting through end-2023.

However, this is only one side of the story. There are physical constraints on OPEC production, as evidenced by the consistent failure of the group to hit even their own reduced production targets (Figure 3). The actual reduction in production in November was much smaller than the 2 million bpd (around 0.5 million bpd), largely because many members were already producing well below their ceilings due to operational issues and capacity constraints.

Figure 3: Shortfall in OPEC+ production for 2022

Even after the reduction in the production target, the group’s actual production was still short by 1.7 million bpd. Spare production among the group remains low by historical standards, at around 3.5 million bpd or 3.5% of global oil demand, adding to supply fears. 

b)      The China wildcard

2022 has been a year where China has largely been in lockdown. China, the second largest oil consumer, is now trying to reopen. The progress on its reopening efforts could provide some upward momentum for oil prices and the rapid dismantling of its Covid Zero policy has prompted optimism over the long-term outlook for commodities demand. However, energy consumption in the near term is uncertain as virus cases surge across the country.

c)      No long-term supply response in sight

The US and other OECD countries have released large amounts of oil from their strategic reserves, equivalent to about 1 million barrels per day since March. These releases have sharply reduced the level of strategic reserves (Figure 4). For example, the US Strategic Petroleum Reserve (SPR) is currently at its lowest level since 1984 — reducing available buffers in the event of future disruptions to supply.

Figure 4: Declining crude inventories

Despite falling inventories, the private sector response in the US seems to have remained contained so far. Looking at US domestic oil producers, the US oil rig count tracked by Baker Hughes has failed to rise in line with prices (Figure 5) 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.

Figure 5: US domestic oil production are less responsive to prices than in the past

High oil and natural gas prices are not translating into increased production due to investor pressure to maintain capital discipline (Figure 6). Moreover, adding to this lack of desire for investment is the on-going transition in energy markets to lower-carbon fuels. With the green transition underway, we are unlikely to see as much exploration and development of new fossil fuel sources of energy.

Figure 6: Federal Reserve Bank of Dallas Energy Survey reveals the primary reason for underinvestment 

Metals – No stopping the green transition despite the near-term headwinds

China looms large for the metals complex, as the country is the world’s biggest user of metals like steel and copper. The dismantling of the country’s zero-Covid policy added some optimism to the metals market, and may get a boost from improvements in China's economy over time as the country reopens.

However, where it stands, there has been a lot of uncertainty over demand, and particularly over whether China will recover. In the short term, China’s unravelling of zero-Covid poses a volatility risk, and demand has yet to show signs of a meaningful recovery.

China’s USD 2.4 trillion new-home market has shown little signs of recovery, and is plagued by a confidence crisis. Homebuyers are not even convinced that developers have the ability to deliver the properties that have been pre-sold. The slump in this sector has also put downward pressure on the demand for iron ore – which is used to make steel (Figure 7).

Figure 7: Iron ore prices tracks China’s property crisis

While recession concerns are weighing on current metal spot prices, the space looks compelling from a fundamental perspective. The medium to long-term outlook for metals particularly attractive, as the energy transition becomes a priority and represents a significant driver of incremental demand for copper, nickel, lithium, and other metals which are essential in renewable technologies (Figure 8). 

Figure 8: Global decarbonisation efforts are creating a strong demand for green metals

Governments and companies around the world are now scrambling to secure critical resources, and we expect the mining and materials sector to play a vital role in the near future. However, mining projects have long lead times and require large investments. For instance, 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 – Feeding the world has become especially challenging in recent years 

Agricultural commodities had a strong 2022, with the Russia-Ukraine war and extreme weather conditions pushing prices higher.

While the Russia-Ukraine war has gone on for about ten months now, concerns about food security amidst Russia’s invasion of Ukraine, one of the world’s biggest grain and vegetable oil exporters, still remains.  Ukrainian wheat output is estimated in the region of 20 million tonnes, down from 33 million tonnes in the previous season.

The issue around Ukrainian supply this season is not just about production but the ability to export. The Black Sea Grain Initiative has allowed for larger export volumes, but wheat exporters are still down around 55% year-over-year. While the Black Sea grain deal was recently renewed, there is still plenty of supply risk from the Black Sea, given that it subjected to the whims of Putin.

The effects of rising food prices have been felt through the economy, from governments imposing price controls and trade restrictions, to higher grocery prices for consumers. While food prices have come down a bit since the summer, they remain high by historical standards (Figure 9). 

Figure 9: Food prices remain elevated

Not to mention, global agriculture demand remains strong in spite of tightening crop supplies. Take for instance, global grain supplies are expected to tighten in 2022-23. This comes as poor weather in key agricultural regions from the US, France, to China is shrinking grain harvests (Figure 10), heightening the risk of famine in some of the world’s poorest nations. Climate change will likely continue to hamper food production either through severe flooding or widespread droughts, challenging agricultural yields and supplies in years to come.

Figure 10: Global grain supplies are expected to tighten 

Moreover, while the next few months may be worrying, we think the years ahead will be exciting for commodity investors. In the longer term, we think the growth in demand for energy, transition metals, and food, coupled with the focus on sustainability and security, presents an enormous number of opportunities for the space.

To gain exposure to the broader commodities sector, investors can consider 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 12: Sector allocation of the Blackrock Natural Resources Growth & Income Fund

Figure 13: Natural resources sector is also trading at attractive valuations

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.