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Commodity markets continue to experience tension between micro and macroeconomic drivers, and between cyclical and structural dynamics. While the macro environment continues to present near-term headwinds for commodities markets, the structural backdrop and key cyclical factors present one of the most favorable medium- to longer-term environments of the last two decades. Low inventories are supporting futures curves in backwardation and attractive annualized roll yields, which have historically cushioned downside risk during recessions. Looking out to the medium term, structural underinvestment in energy and metals over the past decade continues to dampen new production growth and has exposed limited spare capacity. Commodities have gone from a state of abundance during the 2010s to a state of structural scarcity, with the potential to constrain global economic growth, elevate inflation, and drive concerns around food and energy security.
A wide range of potential outcomes for oil prices in 2023 presents both bear and bull cases for energy markets. The bear case centers on concerns over slowing global growth (and possible recession), coupled with interest rates that continue to march higher. Bullish factors remain on the supply side, including announced production cuts from OPEC+ nations, ongoing discipline from US shale producers, and the expected end to the “inorganic” supply of oil and gas from US strategic reserves.
In thinking through the two scenarios, we view a higher probability for upside asymmetry in oil prices resulting from several factors. First, the removal from the market of OPEC+ supplies will likely result in a deficit for at least the next several quarters. OECD governments have been releasing strategic reserves since May, dampening prices. But these releases are ending. Sanctions on Russian oil and gas exports and potential escalation in the war in Ukraine present additional upside risks that appear under-discounted by the market. Lastly, we expect some normalization in China’s economic growth in 2023 as zero-Covid policies move away from large-scale lockdowns. This should allow the world’s second largest oil consumer to resume its demand growth in an environment of very tight supplies.
For their part, US shale producers remain disciplined, slowing production despite persistent higher oil prices. Importantly, even if public US exploration and production companies (E&Ps) wanted to ramp up extraction from shale reserves, ongoing supply- and value-chain challenges, stemming from a tight labor market to limited availability of high-quality pressure pumping equipment to water scarcity in the western US, are preventing a near-term production-growth acceleration. In addition, a growing focus on environmental, social, and governance (ESG) has pressured many companies, including E&Ps, to prioritize sustaining shareholder returns over accelerating supply growth.
Across Europe, energy worries continue, intensifying in the wake of significant reductions in natural gas flows from Russia, particularly via Nord Stream 1 and 2 pipelines, which have been forced to halt operations. Barring a cold winter, the near-term situation in Europe should be manageable. Given current supply challenges, natural gas inventories may be difficult to restock in any event, however, clouding the picture for the following winter.
In the US, natural gas prices have come under pressure from a near-term production increase and complications at a key liquified natural gas (LNG) export terminal, which have allowed inventories to grow. This situation has alleviated tight supplies and presents a more balanced outlook for fundamentals and prices in the near term. The US natural gas outlook for 2024, however, appears more mixed, unless LNG export capacity growth resumes by then.
Finally, a notable and relatively new dynamic we’re watching is global decarbonization policies. National net-zero pledges and other efforts to shift away from dependence on fossil fuels toward renewable energy sources are disincentivizing new production of many commodities, including oil, by raising the cost of capital and introducing an implicit carbon price. This looks to be impacting supply sooner than demand, therefore adding an additional risk of energy shortage in the medium term.
Overall, the fundamental outlook for the traditional energy complex supports our belief that a compelling return opportunity remains, at least through 2023 and possibly into the latter half of the decade.
Industrial metal prices continue to reflect the market’s fears of slowing global growth resulting from interest-rate tightening. Investors are also wary of weakening metals demand in China, whose ongoing zero-Covid policy continues to dampen consumer confidence and challenge the property market. But while recession concerns are weighing on current metals spot prices, the complex continues to look compelling from a fundamental perspective: low inventories, limited investment in new production, and risk of further supply disruptions in Europe. Finally, where decarbonization was a secular headwind for energy, it is a notable tailwind for metals. We find the medium- to long-term outlook for metals particularly attractive, as the energy transition represents a significant driver of incremental demand for copper, nickel, lithium, and other metals. Add this to the current underinvestment scenario, and we anticipate a strong long-term setup for these commodities.
Current recession fears have also pressured silver and platinum prices. Both metals have industrial and manufacturing uses, making them more susceptible to macro-driven weakness, compared to gold, which is largely considered a market safe haven and a hedge against inflation and a weak US dollar. Despite significant geopolitical instability in 2022, the gold price has not been able to overcome rising real interest rates and an appreciating US dollar. Given the US Federal Reserve’s commitment to rate increases, albeit at a slower pace than originally expected, we continue to believe that gold is likely to face headwinds.
The prices of agriculture commodities have been supported by a tenuous geopolitical environment and increasingly challenging climate conditions. The on-again/off-again grains export agreements out of Ukraine (one of the world’s foremost corn producers), excessive heat across North America toward the end the 2022 growing season, and continued drought conditions across Europe buoyed corn and wheat prices, which are likely to carry over into 2023. At the beginning of 2022, grain supplies were already at their lowest levels in a decade, creating one of the best roll-yield environments for the sector in recent years. Grain inventories failed to be rebuilt for the balance of 2022, mainly because of the threats of supply disruptions in the Black Sea (a main Ukraine export passage). For 2023, the hangover from these situations should lend strong support for agricultural commodities, given additional price-appreciation potential and ongoing positive roll yield.
We expect macro, geopolitical, and climate volatility to continue or increase in 2023 against a precariously tight supply backdrop in commodities. We will be watching several macro risks that could impact commodity supply-demand fundamentals, including Russia’s ongoing war in Ukraine, rising recessionary fears (amid higher rates and inflation prints), and continued economic slowdown in China. The coming year will not be without challenges for pockets of the commodities complex, but we remain confident that these risks are mainly cyclical, and the structural case for commodities remains strong.
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