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Demand indicators are showing signs of weakness, with a recession being the key downside risk for commodity markets in 2023.
A major factor underpinning the commodity market’s strength in recent years is significantly tight supply across many sectors.
Oil markets for instance are expected to go into deficit in the second half of the year after OPEC+ surprise production cuts, inventories for metals remain low, and declining stocks-to-use ratios for agricultural commodities remain.
With inflation continuing to prove persistent, investors may be re-evaluating whether their portfolios include sufficient inflation protection, which the commodity sector can potentially offer.
With diversified exposure to the energy, mining, and agriculture sectors, investors can consider the Blackrock Natural Resources Growth & Income Fund to get exposure to the commodities sector.
Commodities markets continue to experience tension between the impact of a slowing economic growth and a tightening supply. Currently, the macro data has not been constructive, with an increasingly subdued global economic environment being touted as a key factor triggering some demand easing.
Where it stands, the continuing tightness in the labour market and sticky inflation will make it a daunting task for the Fed to cut rates this year, which means the economic damage from higher-for-longer rates will likely snowball. This also comes about as leading economic indicators have been on a downtrend, suggesting that the US economy is likely to slow even further in the months ahead (Figure 1). 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.
Figure 1: Leading indicators are already pointing towards a slowdown in the economy
Related article: No storm lasts forever. Why this time it’s different for commodities and what it means for investors
Energy: Expect the market to tighten in the second
half of the year after OPEC+ production cuts
The biggest news within the energy markets is the surprise cut to output targets made by OPEC+. OPEC+ announced further voluntary cuts ahead of the Joint Ministerial Monitoring Committee (JMMC) meeting scheduled for 3 April 2023. The cuts would amount to 1.66 million barrels a day (bpd), and this comes on top of the 2 million bpd cuts announced last October. The new cuts will start in May and run through until the end of 2023, with the bulk of the cuts coming from Saudi Arabia, which will reduce supply by 500,000 bpd.
Related article: The era of cheap oil has come to an end. Don’t expect a recession to change this.
Table 1: Voluntary supply cuts announced by OPEC+ members
In ‘000 barrels per day | Current target production levels | Voluntary supply cuts | Voluntary production (May – Dec 2023) |
Algeria | 1,007 | -48 | 959 |
Gabon | 177 | -8 | 169 |
Iraq | 4,431 | -211 | 4,220 |
Kuwait | 2,676 | -128 | 2,548 |
Saudi | 10,478 | -500 | 9,978 |
UAE | 3,019 | -144 | 2,875 |
Oman | 841 | -40 | 801 |
Kazakhstan | 1,628 | -78 | 1,550 |
Russia* | 10,478 | -500 | 9,978 |
Total (excluding Russia) | -1,157 | ||
Total | -1,657 | ||
Source: OPEC, reports, ING Research *Russian supply cuts are an extension of recently announced cuts | |||
According to the International Energy Agency (IEA), the oil market will fall into a far larger oil deficit sooner than expected following surprise production cuts from some of OPEC’s leading members. There is not much room for remedy with little supply response from the US in sight and low inventory levels. There are currently little buffers against high oil prices with US emergency oil reserves at its lowest levels since 1984. The reserve currently contains 372 million barrels—almost half as much as its all-time high of 727 million barrels in 2010 (Figure 2).
Figure 2: Oil reserves are at historically low levels
Overall, the global oil market is expected to run short of supply in the second half of the year. The implied deficit in global oil supplies would amount to 1 million barrels per day (Figure 3).
Figure 3: Global oil market has been expected to run short of supply
Metals: Structural case is strong, but expect cyclical swings
Industrial metal prices continue to reflect the market’s fears of a recession. Base metals have been mixed since the start of the year, with only copper rising, while aluminium was flat and nickel lower, with demand concerns remaining the key factor in the short term.
Broadly speaking, demand may soften as we head into 2H23 due to the decline in global manufacturing and construction activities amidst an economic slowdown. However, metals with large exposure to China demand, such as copper and aluminium (> 50% of global consumption) may see greater support. China metals demand growth is well-positioned to climb in 2023 relative to last year as the country abandons its demand sapping Zero-Covid policy.
On the supply side, metal inventories are generally low (Figure 4), and global inventory levels are pointing towards a looming supply shortage. The medium to long-term outlook for metals also look 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 5).
Figure 4: Low metal inventories
Figure 5: Global decarbonisation efforts are creating a strong demand for green metals
Supply would take some time to catch up, according to Goldman Sachs, as regulatory approval for new copper mines has fallen to the lowest in a decade, and will remain a major challenge as it often takes 10 to 20 years to permit and build a new mine. As such, within the metals space, there is an ongoing battle between short-term demand headwinds versus a long-term outlook pointing to tight market conditions as the electrification of the world gathers momentum and miners struggle to meet future demand.
Agriculture: Farm margins remain strong, and stocks-to-use ratios remain low
The prices of agriculture commodities have been supported by the current geopolitical environment and increasingly challenging climate conditions that have resulted in elevated food prices. More than one year after Russia’s invasion of Ukraine upended agricultural commodity markets, food prices remain elevated even after retreating from their record highs in early 2022 (Figure 6) and are at levels where farmers have healthy profits.
Figure 6: Food prices remain at elevated levels
Looking ahead, net farm income is poised to moderate in 2023 after a record 2022. The USDA recently updated its forecast, with US net farm income expected to decrease by 15.9% from USD 162.7 billion in 2022 to USD 136.9 in 2023. However, this would still be the second-highest level on record, well above long-term averages and at levels supportive of continued replacement demand (Figure 7).
Figure 7: US net farm income over the years
Another figure that is closely being watched in this space is the stocks-to-use ratio, which indicates the level of carryover stock as a percentage of the total use of the commodity. Having adequate stocks-to-use ratios are crucial for buffering the impacts on market prices caused by production shocks such as droughts, extreme weather, conflicts, or other disruptions. Currently the stocks-to-use ratio for key agricultural commodities such as corn, soybeans, wheat are low, and are below their long term average levels (Figure 8).
Figure 8: Stocks-to-use ratio for key agriculture commodities
Beyond low inventory levels, climate change is something to be concerned about especially when it comes to agriculture commodities. Climate change would likely continue to hamper food production either through severe flooding or widespread droughts, challenging agricultural yields and supplies in years to come. Of late, there has been no shortage of headwinds with poor weather in key agricultural regions from the US, France, to China.
A good addition to one’s portfolio
The world’s dependence on commodities, the interaction between supply, demand, and the structural shifts in commodity markets make for a compelling investment case. Historically, commodities have been particularly helpful in hedging a portfolio against inflation and geopolitical risk, two factors seen in spades of late.
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.
Many of the companies within the commodities sector have spent the last few years restructuring their business models and strategies. As a result, they have secure balance sheets, lower operating costs, and improving returns on capital (i.e., dividends and share repurchases) and thus are positioned to weather the current environment (Figure 9). The sector (represented by the S&P Global Natural Resources Index) is also trading at attractive valuations, well below its historical average (Figure 10).
Figure 9: Stronger balance sheet over the years
Figure 10: Sector is trading at attractive valuations
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.
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