What’s behind the recent commodity rally?
Commodities have been in a positive trend since mid-June of last year, when oil began moving higher from the low $40s1. After a period of consolidation in February and March, commodities have seen some strong price advances, particularly in energy and metals, so we felt that this was a good time to outline our thoughts about near-term and intermediate-term prices.
Clearly there is some near-term risk premium that has been built into industrial metals on the back of U.S. sanctions against Russia. The London Metals Exchange (LME) has taken action to stop accepting aluminum produced by Rusal, the Russia-based aluminum producer, after April 17, 2018, unless owners can prove that it does not violate the latest sanctions. Reuters has recently reported that Rusal is now stockpiling large quantities of aluminum at one of its sites in Siberia because it has lost access to its market.2 A knock-on effect is that banks that finance Rusal’s operations are looking to close their financing relationship in order to comply with the U.S. sanctions, and this is putting pressure on Russian industrial loans in Europe’s secondary market. Depending on the duration of the U.S. sanctions, there is a non-zero probability that this kind of fallout can have a lasting effect on Rusal and 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 aluminum supplier by a significant margin. In 2017, China accounted for 57% of global aluminum production, with Russia in distant second place at 6%.3 Regardless of this relationship, the price of aluminum rose more than 20% in a two-week period ending April 20, 2018.4 LME nickel also saw strong price gains5 during this period, largely on fears that the U.S. sanctions could be broadened to Russian nickel producer Nornickel. 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
Oil prices are now at the highest level since 20147, due largely to ongoing tensions in the Middle East as well as the recent U.S.-led strike in Syria, which has increased fear of a wider disruption. And in May 2018, we have President Trump’s decision on Iran sanctions, which should sustain market nervousness for the near term. Still, there are fundamental reasons to expect continued strength in oil:
- First is the success of OPEC (Organization 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, despite the fact that 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.
There are further potential bottlenecks: As reported by the Wall Street Journal8, Primary Vision Inc. has tracked crews, sand, water and other services used by domestic drillers and believes that the vast 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, National Public Radio9 recently reported that firms like True Drilling in Casper, Wyoming, with a total of 15 rigs, are having trouble finding people to join frack crews. Given the high production growth rate for U.S. shale, analysts are expecting a substantial portion of total global supply growth to come from the U.S. As a result, any delay in bringing product to market can lead to higher prices.
Lastly, many energy companies are focusing on financial discipline and remaining cashflow positive, because of their experience getting hurt by leverage in the last cycle. Overall, many investors view supply/demand dynamics for oil as skewed to the upside, particularly if we see continued cooperation from OPEC ahead of the Saudi Aramco listing.
Broader macro influence
There are several reasons why we expect to see robust commodity prices as we move through 2018:
U.S. tax reform – First, U.S. 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 synchronized global growth, particularly in commodity-intensive economies, is creating more commodity demand at the same time that production capacity remains constrained, as a result 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 devaluation10 and this has further supported commodity prices. 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 in commodities since 2010 and the twin-deficits in the U.S. will continue to put pressure on the dollar, which is commodity bullish.
Backwardation – Backwardation and the ensuing positive roll yield associated has supported flows into commodities. West Texas Intermediate (WTI) crude oil futures out one year have been priced at an 8-10% discount to the prompt futures contract11 and currently offer strong positive roll yield. Overall, oils and metals have approximately a +2.3% one-year forward-looking annualized roll yield12, which we believe is attractive. Record commercial shorts are adding back-month pressure and can help sustain the positive roll yield.
Underexposure – 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 remain low, due to poor performance since 2008 and due to normal investor behavior of focusing on recent performance. And inter-commodity correlations are now back down below 0.1513 ,which leads to very strong internal diversification across a portfolio of commodities.
Our outlook for commodity prices would not be complete without reviewing some potential headwinds for commodity prices. The risk to the bull case for commodities is centered on the potential for falling global growth. The narrative coming into 2018 has been one of synchronized growth across various economies. However, in light of the liquidity reduction set to take place over the next few quarters, as the Fed continues to withdraw from quantitative easing (QE), we may be embarking on the largest public-sector liquidity withdrawal in history, which may coincide with any monetary aggregates (M2) rolling over and pushing the U.S. dollar higher. This scenario is bearish for global commodities and could further dampen growth due to tightening credit conditions. The interplay between falling growth and a strong dollar can lead to a self-reinforcing retrenchment. This, however, remains a tail risk from our vantage point, and not the central view.
1 Source: https://fred.stlouisfed.org/series/DCOILWTICO As of April 24, 2018.
4 Source: https://www.lme.com/en-GB/Metals/Non-ferrous/Aluminium#tabIndex=2. As of April 20, 2018.
5 Source: https://www.lme.com/Metals/Non-ferrous/Nickel#tabIndex=2. As of April 20, 2018.
7 Source: https://fred.stlouisfed.org/graph/?g=NPX As of April 20, 2018.
11 Source: http://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude.html As of April 24, 2018.
12 Source: http://www.cmegroup.com/trading/metals/ ;
http://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude.html As of April 24, 2018.
13 Source: Russell Investments research, Bloomberg Commodity Index sub-sectors. As of April 24, 2018.