Commodities Dance to the Recession Tune

Summary

• After major supply shocks earlier this year, commodity prices are falling as markets adjust and become less unbalanced. But supplies remain tight in the energy and agricultural sectors.
• Commodities as an asset class are down 10% – mostly in recent days – since we recommended an overweight position in early April. Despite the recent selloff, commodities are still up 13% year to date.
• We see limited further downside for energy and agricultural markets and continued upside risks due to tight supplies and potential supply shocks.
• The outlook for industrial metals depends on how China’s reopening proceeds. We expect it will be measured rather than aggressive, which should keep further downward pressure on prices.

Market Implications

• We are overweight in energy, although more cautious investors may prefer marketweight for now.
• We are marketweight in agriculture but will look to move to overweight as the ongoing adjustments run their course.
• We are underweight industrial metals. We see little likelihood of a rally in coming months unless China significantly ramps up its reopening.

Commodity Sector Correlations Break Down

In early April, we recommended an overweight in commodities as an asset class. This was primarily because the Russian invasion of Ukraine and rising geopolitical tensions were hindering supply flows in the grains, industrial metals and energy markets. Our primary focus was energy, particularly oil.

By early June, the BCOM commodities index^[1] had risen 10%. But it then sold off and is now down about 10% from the April level (Chart 1). More importantly, the high correlation earlier in the year among subsectors broke down. After Tuesday’s recession-fuelled selloff, energy is near flat; agriculture is down 10%; and industrial metals dropped 30%. We turned more cautious on metals in mid-June.

Risk-Off Time

Several factors contributed to the general weakness in commodities in recent weeks. Chief among them is a general de-risking as investors become more concerned about recession risks; uncertainties over Russian energy and Russian/Ukrainian grain entering global markets; and, in the case of industrial metals, the Covid-related lockdowns in China over the past three months. Another factor may be margin calls at some major commodity-trading firms.

Given these various recent strands, how should we currently be positioned in commodities?

Commodities Have Been Here Before

Before we answer that question, let us look at commodity indices over the past 20 years (Chart 2).

Evidently, commodities have been rather more stressed in the past than now – particularly energy, which has traded at both multiples and fractions of its 2000 level. The extraordinary rallies in 2004-2005 were due to hurricanes in the Gulf of Mexico that shut down oil and gas production – particularly Katrina and Rita in 2005. The rally in energy and industrial metals in 2007-08 was primarily due to China’s massive infrastructure program to prepare for the 2008 Summer Olympics.

Agricultural commodities seem pricy today but are near 2000 levels.^[2] They traded higher  in 2008 because of high energy costs and a strong La Niña pattern that caused droughts in producing nations.^[3] Another La Niña episode during 2010-2012 again drove agricultural commodity prices higher. But they traded below 2000 levels much of the time.

Industrial metals is the one subsector experiencing historically elevated prices. But even it is well below the highs of the past two decades.

We offer two takeaways here. First, demand for commodities is relatively inelastic. It depends primarily on population growth and change in the mix of GDP over time. The sharp variations in commodities prices have been mostly due to supply shocks. Further, during more stable times, the supply of commodities has tended to be higher than organic demand, causing prices to trade below 2000 levels. Indeed, that has been one reason inflation has been relatively low for much of this century.

Second, after the disruptions from the Ukraine war pass, we can reasonably expect supply to swell again, lowering commodity prices.

So, What Now?

Barring some major regime shift in Russia, the Ukraine war and related fallout will persist for some time. This suggests to us that commodities remain vulnerable to supply shocks and volatility.

That said, various markets are devising workarounds that could offset some of the risks. Farmers have probably planted additional acreage of crops because of the likely shortfall in Russia/Ukraine exports. US President Joe Biden has ordered the daily release of one million barrels of oil from the Strategic Petroleum Reserve, and he is reportedly planning to lobby Saudi Arabia and OPEC to pump more crude oil. But these measures amount to little more than band-aids.

At this point, it makes more sense to focus on the subsectors rather than think simply in terms of over/underweighting the entire asset class. We acknowledge specific components of each major subsector have varied widely, too. However, our focus is more on macro trends and implications.

Industrial Metals – Underweight

The outlook for industrial metals largely depends on how quickly China reopens from Covid lockdowns and the extent and nature of the oft-mooted stimulus program. When the global economy started reopening during the second half of last year, a sharp increase in demand for industrial metals amid supply-chain snarls drove the industrial metals index to near-record highs by early 2022 (Chart 2).

We certainly do not expect that rally to repeat.

The more likely scenario is that the reopening will be measured rather than sudden. We think China is seeking more balanced growth that relies on social programs and infrastructure. Even if China pushes for a more rapid reopening, there is the ongoing risk of new Covid outbreaks leading to more lockdowns. Demand for industrial metals will rise, but (barring some new shock) prices should remain in a range near present levels or possibly drift lower. Even as demand from China rises, demand from other industrialized countries could soften as rising rates lead to slower economic growth.

As China’s stimulus program runs its course and supply chains continue to normalise, we believe industrial metals could settle into a new range higher than the pre-Covid range. The demand for clean energy technology should strongly support industrial metals, including copper, zinc, and nickel. Along with aluminium, these metals comprise the BCOM Industrial Metals subindex.

For now, we expect further downward pressure on industrial metals prices and consequently underweight them.

Energy – Overweight

Risks remain skewed to the upside due to the ongoing Ukraine conflict. Oil and gas prices may trade in a range for now, but we see little prospect of a sustained decline soon. If the Russian invasion of Ukraine ended soon, it could ease natural gas supplies to Europe and lower prices. That currently seems unlikely. Regardless, sanctions would likely remain in place for oil and many other products.

Other scenarios that could lead to lower oil and gas prices are either a sharp recession that cuts demand or US producers increasing supply – the marginal source of global supply today.

A recession remains distinctly possible but, barring some major shock, is still distant.

And so far, US energy companies have been remarkably cautious about adding capacity (Chart 3). The US and global rig count has been rising but remains far lower than previous oil price booms. Even if they started responding to higher prices like earlier in the decade, new supply would take time to come online.

The next big risk on the horizon is that Russia cuts off or severely curtails natural gas supplies to Europe. That would increase gas prices. As long as this threat remains credible, natural gas prices will remain high.

On the downside, Biden is reportedly exploring steps with international partners to force Russia to sell its oil at a deep discount. It is unclear that this would work or have much impact on non-Russia oil prices. As noted, he is also reportedly planning to ask OPEC to supply more oil.

Russia has also been selling oil to China and India at a discount. Indian refineries have been producing refined products and exporting them globally. Whether or how sanctions affect this trade is unclear. However, demand for ‘clean’ tankers to ship refined products has jumped threefold since the Ukraine war started, suggesting it is significant (Chart 4). This is putting downward pressure on oil prices.

There is little on the horizon that might push energy prices sharply lower, although they could drift lower in coming weeks. Meanwhile, risks remain tilted to the upside. Given these fundamentals, we are comfortable overweighting the energy sector. More cautious investors may prefer a marketweight position for now.

Agriculture – Marketweight

Twin shocks have hit the agricultural sector so far this year. These are soaring prices of grains due to the Russian invasion of Ukraine and a massive spike in fertilizer prices to more than three times pre-Covid levels at one point (Chart 5). Fertilizer is now about twice the pre-Covid level, but still extremely high relative to the past two decades.

The shocks have jammed farmers between a rock and a hard place. Higher prices encourage planting more acreage, but higher fertilizer costs dampen the incentive to do so – or they encourage farmers to use less, which hurts crop yields.

The problem is simple: Russia was a major exporter in these markets. Russia and Ukraine previously supplied about 28% of global wheat exports, and Ukraine 14% of corn exports. Russia and Belarus supplied nearly a quarter of the global supply of fertilizer and fertilizer ingredients (primarily ammonia, urea and potash).

Agricultural prices have eased about 9% over the past three weeks for several reasons. Harvests to date in Brazil and Australia have been very good. Concerns about bad weather have eased for now. And there is talk Russia is working with Turkey and the United Nations to export some Russian and Ukraine grains through the Bosphorus Strait to reduce the risk of food shortages in less developed countries. Even if they reach an agreement, however, issues remain steep, including ruined Ukrainian port facilities and mines along the Ukraine coast.

Fertilizer prices are down partly because farmers are using less of it and partly because producers in other countries have increased production.

Agricultural commodities markets are becoming less unbalanced. Still, we believe they remain subject to supply shocks. Apart from the Ukraine war risks, this is a La Niña year. It is currently forecast to be less severe than the 2008 and 2010-2012 episodes. But there is still risk of drought conditions in the prime US farmlands this summer, which extreme weather could exacerbate.^[4]

We expect supply conditions in agricultural commodities to remain tight this year and subject to more adverse shocks. Meanwhile, demand is highly inelastic. 7.8 billion people must eat.

For now, the news flow is mostly positive, and prices could fall further in the near term. Given this ongoing adjustment, we move to marketweight on the agricultural sector. But given underlying fundamentals and upside risk, we will look to move to overweight when this process runs its course.

The Bottom Line

Commodities have fallen from the extreme heights of this past spring. This is partly because panic buying was overdone (industrial metals and wheat) and partly because markets have adjusted and become less unbalanced.

In the energy and agricultural sectors, we see little change in the fundamentals that drove their rallies earlier this year. They remain subject to supply shocks. While prices may fall further on near-term technicals, we see little likelihood of them returning to pre-Ukraine war levels. These technicals may provide opportunities for trading oriented or more aggressive investors.

We suggest an overweight in energy and agriculture over the medium term. From a tactical standpoint, we are comfortable with an overweight in energy and suggest a marketweight in the agricultural sector.

The outlook for industrial metals depends on how China’s reopening progresses. Unlike energy and agriculture, we see little likelihood of prices increasing meaningfully; risks appear weighted to the downside. We suggest an underweight position for now.

[1] The BCOM index is Bloomberg’s broad commodities index. It covers industrial metals, agricultural products, energy, and precious metals subsectors. See here for more information.

[2] These indices are not adjusted for inflation or currency effects. On a real basis commodity prices are lower than 2000 levels.

[3] La Niña is the counterpart to El Nino, a periodic weather pattern in the equatorial Pacific. During La Niña years west-to-east winds blow harder than normal, pushing warm ocean water into the Pacific. This affects weather pattens in North and South America, notably increasing the likelihood of drought conditions in agriculture-producing regions, and severe hurricanes in the Atlantic.

[4] La Niña also causes the jet stream across the US to blow harder, which can lead to more severe hurricanes. If these storms form in the Caribbean or travel through that area, oil and gas production will be at risk. If storms mostly strike the Atlantic coast, they will cause major damage but will have little impact on the oil and gas industry.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)