Commodities have plummeted since reaching an all-time high two month ago as recession fears ravage what was one of the most resilient corners of the market.
Commodities have plummeted since reaching an all-time high two month ago as recession fears ravage what was one of the most resilient corners of the market. The S&P GSCI Commodity Total Return Index, which tracks energy, metal and crop futures contracts, has lost about 13% (in euro) after touching the record in June. Prices for everything from gasoline to wheat are slumping on concerns that a stagnating economy will hurt demand. But the correction was stronger for industrial metals (-27%) than for other commodities (see the chart), as their inventories have increased significantly due to supply exceeding demand.
Commodities had been advancing since the early days of the worldwide pandemic as massive government spending and ultra-low interest rates bolstered demand while production was curbed. Russia’s war in Ukraine exacerbated supply disruptions. But sentiment has shifted as fears grow that the Federal Reserve won’t be able to tame the highest inflation in four decades without throwing the economy into a recession.
A surge in the U.S. dollar (+8%, against a basket of 10 major currencies, since the beginning of the year), which makes it more expensive to buy raw materials priced in the greenback, has also weighed on USD- traded commodities.
Supply Chains inflation owes a lot, if not everything, to stretched supply chains. This problem is beyond the reach of central banks, but still threatens to make the task of monetary policy far harder by embedding inflationary pressure and prompting higher wage demands. On this issue, there is some good news. The New York Fed now keeps an index of global supply chain pressure, which smooshes together shipping and freight costs and other measures of how swiftly supply chains are moving. These rose sharply in 2020, declined, and then surged once more as fresh Covid-19 lockdowns affected activity, particularly in China. The latest version of the index shows that pressure remains elevated, but is unmistakably declining (see the chart). This doesn’t mean the issue is over. It does, however, suggest that one of the world’s most acute problems is beginning to ease. Which is reason to reduce the upward pressure on commodity prices.
Still, recession is a highly anticipatory concern, and markets have clearly overreacted by bringing prices for commodities back to pre-war levels even as supplies of many raw materials such as oil remain tight and vulnerable to disruptions. Commodities are the biggest winners since the beginning of the year for many investors, and some have cashed in, using commodity profits to cover losses in the equity and bond markets. While the recent surge in energy and food costs worked as a “very big tax” weighing on consumption, demand should re-accelerate in the next months and keep markets tight.
- As the world faces inventories 19% below historical norms, according to JPMorgan, the commodities retreat, especially in the crude oil market, could provide much-needed relief to consumers struggling with surging inflation.
- China is contemplating a direct stimulus to its economy by bringing forward $220 billion in bonds issuance to back infrastructure. You could take this as tacit confirmation that the economy is in trouble. It is a return to the old strategy of pumping up construction spending whenever growth is running out of steam. And it’s only a matter of bringing forward spending that had already been planned; the idea is that local governments building projects can now access financing that would not otherwise have been available to them until next year. However, the plan also shows that the authorities are prepared to relent in the face of signs that local governments are using the financing that’s there. If they are prepared to go back to an old playbook that worked, that should be fine by global commodities investors.
- At the most fundamental level, the world is now struggling to produce all the oil it needs. Despite the recent selloff, oil time-spreads remain very strong. Nearby oil contracts continue to trade at a big premium to contracts for later delivery. The downward curve slope, known as backwardation, is a hallmark of a very tight physical oil market. At about $9 a barrel, the 1-to-12 front month backwardation is still near one of its strongest ever (see the chat). Back in July 2008, the oil time-spreads were in the opposite condition: a contango, with spot barrels at a discount to forward contracts, a sign of an oversupplied market. Today the demand for crude oil continues to outpace supply, with no sign that the economy is slowing enough to balance the market in the short term ! According to Goldman Sachs, oil demand exceeds output by around 2 million barrels a day !
- Although Russia has found willing buyers in China and India, Russia’s overall production has fallen by more than a million barrels a day, weighed down by sanctions and a broad reluctance to do business with Moscow. And the prospects for finding production growth outside of Russia are dim. OPEC, which produces about 40% of the world’s crude, is finding it difficult to meet production targets. Aging infrastructure, years of historically low investment, and political trauma have combined to hold back output - in May, OPEC+ (the Organization of the Petroleum Exporting Countries and allies) produced 2.7 million barrels a day less than its collective target. Last month, OPEC responded to months of diplomatic efforts from the US for more oil with one of the smallest production increases in its history (+100.000 barrels/day). This is unlikely to ease the tightness in the physical market !
- There is also the refining bottleneck. More than 2 million barrels a day of refining capacity outside of the US has been shut since 2019 ! The pandemic forced several aging, inefficient refineries to shut for good, leaving the world so short on capacity that the price of crude, which once almost single-handedly dictated prices at the pump, is no longer an accurate gauge of what consumers are paying. The “3-2-1” crack spread - a measure of gasoline, diesel and jet-fuel’s strength relative to crude - has been almost halved in recent weeks but is still trading above $30 a barrel, i.e. $13 above its historical average !
- While the gas market priced in a short-lived crisis, lasting perhaps a couple of months, it is now flashing extreme danger for next winter, through 2023 and, increasingly, into 2024. Today, the closely watched Dutch TTF contract, a European benchmark for spot gas prices, rose to about €200, more than doubling since Russia cut supplies via the Nord Stream 1 pipeline into Germany. Even so, spot gas prices remain about 10% below the record high settlement of €227 set during the early days of the war — worrying, but not alarming; prices are high, but not that high. But that is if you ignore the action on the back end of the future curve. On March 7 — when spot gas prices surged to about €230 — the contract for delivery in December 2022 rose to about €127; today, when the spot price is slightly lower (€195), the December contract traded at nearly €150 (see the chart). A year into Russia manipulating European gas supplies, the market is finally convinced that Moscow will continue to do so, and perhaps with greater intensity. Natural gas is the hottest commodity in the world right now. It is a key driver of global inflation, posting price jumps that are extreme even by the standards of today’s turbulent markets — some 885% in Europe since the start of last year, pushing the continent to the brink of recession. It is at the heart of a dawning era of confrontation between the great powers, one so intense that in capitals across the West, plans to fight climate change are getting relegated to the back-burner. In short, natural gas now rivals oil as the fuel that shapes geopolitics!
In this context, we continue to see commodities, and more specifically its energy component – we keep our preference for energy versus industrial and precious metals –, as a good hedge against a supply shock which will continue to generate inflationary pressures.