What’s behind the recent rally in commodities?
Commodities have been in a positive trend since mid-June of last year, when oil began moving higher from the low $40s.1 After a period of consolidation in February and March, commodities have seen some strong price advances, particularly in energy and metals. Today, we outline the drivers behind the recent rally, and discuss our thoughts about near-term and intermediate-term prices.
Drivers of price movements: Industrial metals
Case study on U.S. sanctions against Russia
On Friday 6 April, the U.S imposed sanctions on seven Russian oligarchs and their companies. Aluminium giant Rusal was one of those sanctioned, and since then, the company has suffered significantly. And it’s not just U.S. who have taken action. The London Metals Exchange (LME) stopped accepting aluminium produced by Rusal after 17 April 2018, until owners can prove that it does not violate the latest sanctions.
In response to this, Rusal has reportedly begun stockpiling large quantities of aluminium at one of its sites in Siberia.2 A knock-on effect is that banks financing Rusal’s operations are looking to close their relationship to comply with the U.S. sanctions. This is putting pressure on Russian industrial loans in Europe’s secondary market. Depending on the duration of the U.S. sanctions, it is likely that this kind of fallout can have a lasting effect on Rusal. In fact, it may contribute to a longer-term opportunity for less-efficient producers to supply the market, at sustained higher prices.
Interestingly, China is the largest global aluminium supplier by a significant margin. In 2017, China accounted for 57% of global aluminium production, with Russia in distant second place at 6%.3 Regardless of this relationship, the price of aluminium rose more than 20% in a two-week period ending 20 April 2018.4 LME nickel also saw strong price gains during this period, largely on fears that the U.S. sanctions could be broadened to Russian nickel producer Nornickel.5 Finally, palladium, used largely in automotive catalysts, has also moved higher in recent weeks. Russia is the world’s largest supplier of palladium, followed by South Africa.6
Drivers of price movements: Oil
Tensions in the Middle East, the U.S.- led strike in Syria and Trump
Oil prices are now at the highest level since 2014, due largely to ongoing tensions in the Middle East, as well as the recent U.S.-led strike in Syria (which has increased fears of a wider disruption).7 President Trump’s decision on Iran sanctions in May is more than likely to sustain market nervousness for the near term. Still, there are fundamental reasons to expect continued strength in oil:
- First is the success of OPEC (Organisation of the Petroleum Exporting Countries) in engineering production curbs across the cartel and Russia. Since early 2017, this has effectively cleaned up excess inventories around the globe.
- Second, even though U.S. shale production is clearly leading the U.S. towards energy independence, we are seeing signs of growing pains showing up in the steep discount for oil in West Texas, versus Cushing(Oklahoma). Pipeline capacity is emerging as a bottleneck, and ultimately this can cause producers to move oil in more expensive ways, like trucks or trains. Or perhaps even be forced to take drastic measures that could lead to lower oil production.
Further potential bottlenecks – crew, equipment and supply/demand dynamics
As reported by the Wall Street Journal, Primary Vision Inc. has tracked crews, sand, water and other services used by domestic drillers.8 They believe that the majority of the supplies and equipment consumed by fracking rigs in the Permian basin are already in use, and that producers will completely absorb available supplies within months.
Similarly, firms like True Drilling in Casper (Wyoming), who have a total of 15 rigs, are having trouble finding people to join frack crews.9 Any delay in bringing product to market may lead to higher commodity prices for investors.
Broader macro influencers driving overall price change
There are several reasons why we expect to see robust commodity prices as we move through 2018:
U.S. tax reform
First, US tax reform is playing a key role in lifting expectations for corporate profits and we expect this to translate to marginally stronger domestic demand for energy and industrial commodities. Many of our macro managers have argued that late-in-the-business-cycle demand growth outstrips the speed at which new capacity is created, and that this leads to supply constraints and higher prices. Commodities exhibit this economic construct well, because it can take years for new production capacity to come online — particularly in metals — to meet higher demand.
Growth in China
Second, China growth remains robust and is a strong component in estimates for year-over-year commodity-demand increases. BCA Research Inc. has recently reported that, while the rate of improvements to global growth is peaking, there is no imminent danger of a significant deterioration in growth. Similarly, minutes from the late-March U.S. Federal Reserve (the Fed) meeting suggest that the committee believes that the outlook for U.S. growth and inflation has improved.
We believe that synchronised global growth, particularly in commodity-intensive economies, is creating more commodity demand while production capacity remains constrained (because of lower capital expenditure (capex) in the wake of the commodity slump). While capex has begun ramping up as inventories are drawn down — specifically in energy — it is likely that higher prices and further investment are required to meet global demand. Further, nearly every major global economy is growing above potential, which makes the global expansion more self-sustaining and possibly less sensitive to shocks.
U.S. dollar weakness
Higher commodity prices have been correlated to U.S. dollar weakness. The Chinese yuan is now at its strongest level since the 2015 devaluation and this has further supported commodity prices.10 In recent conversations with our macro hedge fund managers, a common theme that has emerged is that it makes sense to own commodities at this point in the economic cycle.
Why? Because commodities remain cheap versus equities, capex has been weak since 2010 and the twin-deficits in the U.S. will continue to put pressure on the dollar (which is commodity bullish).
Lastly, it is increasingly clear that many global investors are underexposed to assets that can protect against a rise in commodity inflation that is typical for late cycle. Commodities are one of the few assets that perform well in typical late-cycle environments, however, investor interest and total assets under management (AUM) in commodities remains low, due to poor performance since 2008 and due to normal investor behaviour of focusing on recent performance.
Risks: Potential headwinds for commodities
Our outlook for commodity prices would not be complete without reviewing some potential headwinds for commodity prices. The narrative coming into 2018 has been one of synchronised growth across various economies. However, the major risk for commodity prices is likely to be centred on the potential for falling global growth. Yet, the liquidity reduction set to take place over the next few quarters (as the Fed continues to withdraw from quantitative easing), may see the largest public-sector liquidity withdrawal in history. This could coincide with the U.S. dollar pushing higher. Such a scenario would be negative for global commodities and could further dampen growth due to tightening credit conditions. The combination of falling growth and a strong dollar could see prices deteriorate. This, however, remains a tail risk from our perspective, and is not the central view.
Outlook: Commodity prices set to rise
All in all, we believe that the price environment for commodities looks set to rise. Although there are a number of headwinds for commodities, there are also significant tailwinds and positive industry outcomes to consider. For example, because of their experience of getting hurt by leverage in the last cycle, many energy companies are focusing on financial discipline and remaining cashflow positive. This, alongside a number of other drivers, means that a large sum of investors now view supply/demand dynamics for oil as skewed to the upside, particularly if we see continued cooperation from OPEC.
1 Source: https://fred.stlouisfed.org/series/DCOILWTICO. As of 24 April 2018.
2 Source: https://www.reuters.com/article/us-usa-russia-sanctions-rusal-stockpiles/exclusive-unsold-aluminum-piling-up-at-sanctions-hit-rusal-factory-idUSKBN1HQ1H6.
3 Source: https://minerals.usgs.gov/minerals/pubs/commodity/aluminum/mcs-2018-alumi.pdf.
4 Source: https://www.lme.com/en-GB/Metals/Non-ferrous/Aluminium#tabIndex=2. As of 20 April 2018.
5 Source: https://www.lme.com/Metals/Non-ferrous/Nickel#tabIndex=2. As of 20 April 2018.
6 Source: https://minerals.usgs.gov/minerals/pubs/commodity/platinum/mcs-2018-plati.pdf.
7 Source: https://fred.stlouisfed.org/graph/?g=NPX. As of 20 April 2018.
8 Source: https://www.wsj.com/articles/is-the-u-s-shale-boom-choking-on-growth-1524056400.
9 Source: https://www.npr.org/templates/transcript/transcript.php?storyId=596525938.
10 Source: https://xe.com/currencycharts/?from=USD&to=CNY&view=5Y.