Ole S. Hansen, Head of Commodity Strategy at Saxo
Supply worries offsetting growth concerns
Multiple uncertainties will continue to create a volatile environment for most commodities ahead of the year-end. While the recession drums will continue to bang ever louder the sector is unlikely to suffer a major setback before picking up speed again during 2023. This forecast for stable to potentially even higher prices will be driven by pockets of strength in key commodities across all three sectors of energy, metals, and agriculture. With that in mind, we see the Bloomberg Commodity Index, which tracks a basket of 24 major commodities, hold onto its +20 percent year-to-date gain for the remainder of the year.
It highlights the behaviour of commodities where supply and demand ultimately set the price. While we are seeing concerns about growth and demand, the supply of several major commodities remains equally challenged. An explosive rally during the first quarter was led by war, sanctions, and the backend of a post-pandemic surge in demand for consumer goods and energy to produce them. The market then retraced sharply lower during June when the US Federal Reserve turbocharged its rate hikes to combat runaway inflation, while China’s zero-Covid policy and property sector woes drove a sharp correction. During the third quarter, however, the sector has reasserted itself and while pockets of demand weakness will be seen, we see the supply side equally challenged developments that we see support the long-lasting cycle of rising commodity prices that we first wrote about in the start of 2021.
The multiple uncertainties mentioned will, first of all, mean a focus on the demand side. There’s no doubt that increased efforts from central banks around the world, led by the US Federal Reserve, to combat runaway inflation by aggressively hiking rates to lower the economic temperature, will lead to some weakness in demand. In addition, China’s month-long and so far, unsuccessful battle with Covid and harsh anti-virus restrictions has, together with its property sector crisis, driven a slowdown from the world’s biggest consumer of raw materials. However, we view the current weakness in China as temporary, and with domestic inflationary pressures easing, we expect the government and the People’s Bank of China to step up their efforts to support an economic turnaround.
Agriculture: With global demand for food being relatively constant, the supply side will continue to dictate the overall direction of prices. We see multiple challenges that could see those move higher into the winter and next spring. The main culprits are the cost of fertiliser due to high gas prices, climate change, and a “triple-dip” La Ninã during the 2022/23 northern hemisphere winter, a weather phenomenon that has driven a change in temperatures around the world and led to several climate emergencies during the past couple of years. Adding to this is Putin’s war in Ukraine which has led to a sharp drop in exports from a major supplier of grains and edible oils to the global market. With global stocks of key food items from wheat and rice to soybeans and corn already under pressure from weather and export restrictions, the risk of further spikes remains a clear and critical danger.
Precious metal traders and investors will continue to focus on the direction of the dollar and US bond yields, with strength in both being the main reason why gold trades down on the year and at the lower end of a current 300-dollar wide range. However, given the fact we have witnessed the strongest dollar rally and the fastest pace of rising real yields in decades, this weakness has generally only been seen against the dollar. With that in mind, we view gold’s performance so far in 2022 as acceptable and it points to some underlying strength that is likely to reassert itself once the dollar stops rising.
Gold is currently stuck in a wide $1600 to $2000 range and the direction towards year-end is likely to be determined by the dollar and whether the US Federal Reserve is successful in bringing inflation under control without driving the US economy into a recession. We believe the latter will be a major challenge, and the market could be forced to reprice future inflation expectations, currently priced below 3% in a year from now. With the risk of a US recession in 2023 and inflation staying higher for longer, we see gold perform well in such a scenario, especially if the dollar, as mentioned, begins to peak out. Following a period of sideways action ahead of the year end, these developments will start to add tailwind to precious metal investments in 2023, and with that the prospect of moving back towards the top of the mentioned range.
We favour silver given the current weak investor participation and the additional support from a recovering industrial metal sector where supply, especially for aluminium and zinc, remains challenged by punitively high gas and power prices. This has forced a reduction in production around the world, most notably in Europe but also in China, where a long period of drought has seen smelters suffer from electricity shortages.
Industrial metals: We maintain a long-term positive outlook on the industrial metal sector given the expected ramp up in demand towards the electrification of the world. With regards to copper, the so-called king of green metals, we expect that the prospect for a temporary increase in production capacity next year by miners around the world, most notably from Central and South America as well as Africa, will likely dampen the short-term prospect for a renewed surge to a fresh record high.
The copper-intensive electrification of the world will continue to gather momentum following a year of intense weather stress around the world and the need to reduce dependency on Russian-produced energy, from gas to oil and coal. But for power grids to be able to cope with the extra baseload, a massive amount of new copper-intensive investments will be required over the coming years. In addition, we are already seeing producers like Chile, the world’s biggest supplier of copper, struggling to meet production targets amid declining ore-grade quality and water shortages. China’s slowdown is viewed as temporary and the economic boost through stimulus measures is likely to focus on infrastructure and electrification—both areas that will require industrial metals.
Crude oil has returned to pre-Russian invasion levels as the market continues to price in the prospect of an economic slowdown hurting demand. The result is lower spot prices and a flattening forward curve to an extent that is not yet backed up by a corresponding rise in inventories. It raises the question of whether the macroeconomic outlook has driven prices down to levels that are not yet justified by current supply and demand developments.
There is no doubt demand has softened in recent months, especially following the end of the summer driving season, and continued but temporary lockdowns in China that are hurting mobility and growth. In Europe, punitively high prices for gas and power have also helped drive a slowdown in fuel demand but the region is still importing around 3 million barrels per day from Russia. The introduction of an import embargo on December 5th will likely tighten the overall market with Russia struggling to find other buyers.
We view the current weakness in oil fundamentals as temporary and side with the major oil forecasters of EIA, OPEC and the IEA who, despite current growth concerns, have all maintained their demand growth forecasts for 2023. During the final quarter prices are likely to remain challenged at times resulting in a potential lower range in Brent crude between $80 and $100 dollar-per-barrel. The main developments that could impact prices include:
- China’s continued battle with Covid versus additional stimulus to offset growth risks
- Gas-to-fuel switching supporting demand for distillate products
- EU embargo on Russian oil potentially forcing a reduction in Russian production
- The US plans to begin refilling its strategic reserves
- OPEC threat to lower production should prices drop further
- The direction of US inflation and the dollar—both key drivers of the general level of risk appetite
- US production growth, which is showing signs of stalling, thereby supporting prices
Oil majors swamped with cash, and investors in general, showing little appetite for investing in new discoveries suggest that the cost of energy is likely to remain elevated for years to come. This is driven by the green transformation which is receiving increased and urgent attention, and which will eventually begin to lower global demand for fossil fuels. It’s the timing of this transition that keeps the investment appetite low. Unlike new drilling methods such as fracking where a well can be productive within months, traditional oil production projects often take years and billion-dollar investments before production can begin. With that in mind, oil companies looking to invest in new production will not be focused on spot prices around $90 in Brent and lower in WTI, but instead at +30-dollar lower prices currently traded in the futures market for delivery in five years’ time.
