A year of disruption and dislocation in commodity markets
Overview
As the global economy emerged from COVID-19 and picked up speed, initial expectations were for 2022 to be a less volatile year. By any measure, this turned out not to be the case.
Indeed, at the start of our financial year in October 2021, it seemed the lack of investment in new supply, combined with post-pandemic demand recovery, would result in significant tightness in numerous commodity markets.
The fact that markets were in a fragile state to begin with magnified the shock from Russia's invasion of Ukraine in February 2022 and led to unprecedented price volatility.
The war has upended historic commodity trade flows, led to record low inventories in many commodities and created uncertainty about supply. Sanctions added multiple layers of complexity and disruption.
Throughout the tumult, commodity prices have consistently struggled to reflect underlying supply and demand.
This is due primarily to three major macroeconomic headwinds that overwhelmed the fundamentals: Central Banks, led by the US Federal Reserve, raising interest rates rapidly to combat the highest inflation in decades; Europe’s energy crisis; and China’s zero-COVID-19 policies and property sector weakness.
Taking the first point, supply chain disruptions, a surge in demand as lockdown restrictions eased, record low inventories of housing and vehicles, and a lack of workers all contributed to inflationary pressures. This was especially true in the US, as the population shifted from consuming goods to services, which in turn drove wages higher, resulting in yet more inflationary pressures. Europe, meanwhile, had to contend not just with these factors, but also with soaring energy costs resulting from Russian curtailment of gas supplies.
Central banks responded by sharply lifting benchmark policy rates in a very short period of time. Rising US yields and concerns about the impact of tighter financial conditions on the global economy saw the US dollar strengthen substantially, to the highest level in over 20 years against major currencies, and the highest ever in the case of many others. This was another challenge for commodity prices, which are denominated in US dollars.
While rising energy costs have contributed to inflation across the world, they have been particularly pronounced in Europe, due to the curtailment of Russian exports of gas. This was the second headwind.
Although Russian flows to Europe had already started to decline in 2021, it is only in the months following the invasion of Ukraine that the full weight of Moscow’s cuts came to bear.
Over the course of the second and third quarters of 2022, flows dropped by 80 percent versus pre-invasion levels and sent power and gas prices in Europe soaring to record levels. European’s benchmark gas price (TTF) rose from a long-term average of close to €20 per megawatt hour to well over €300/MWh, while power prices spiked to a record of over €700/MWh in some of the major, western European countries.
As a result, many big industrial consumers in Europe were forced to curtail output. The prospect of further cuts raised the spectre of a major industrial recession, dampening sentiment and the outlook for demand.
The third major macro-economic headwind was China’s growth, which was weaker than expected for two main reasons.
The first of these was the impacts of China’s zero-COVID-19 policies, which led to restrictions being imposed on large parts of the country in the second quarter of 2022.
Shanghai in particular saw an extended period of lockdown, and given its status as a main financial and manufacturing hub, the impacts on activity and sentiment were widespread.
More broadly, the unpredictable nature of outbreaks and the stringency of lockdown restrictions meant consumer and investor confidence remained subdued for most of the year. The impact was magnified by the second factor: ongoing weakness in the property sector, brought about in part by the government's attempts to manage the indebtedness of key players in that sector.
Although growth outside the property sector rebounded materially in the third quarter of 2022, as shown by dwindling stockpiles of base metals and other production and investment indicators, the weakness in property has soured investor sentiment.
In this “macro versus micro” environment, commodity prices struggled to perform, and in many cases seemed to have completely disconnected from physical market realities.
Oil markets
Oil markets were buffeted on one side by constrained supply, due to under-investment and sanctions, and on the other side by potential demand weakness, caused by China’s zero-COVID-19 lockdowns and higher prices.
By the middle of the year, prices seemed set to move higher thanks to stresses on the supply side, which looked difficult if not impossible to solve in the near term.
However, the underlying tightness in markets was masked as Organisation for Economic Cooperation and Development (OECD) governments chose to try and cushion the impact of higher prices on consumers by authorising unprecedented releases from their respective strategic reserves.
The impact was most acutely felt in the US, due to the release of 180 million barrels of crude into the market. This oil flowed into commercial inventories, allowing them to hold at levels that by end of the year were well within historical ranges, giving the appearance of a well-supplied market.
As a result, however, the US Strategic Petroleum Reserve (SPR) fell to under 400 million barrels for the first time since 1984, as demand remained relatively robust despite high prices, leading to inventory draws.
A major reason why SPR releases were needed is because supply has continued to be constrained. Consensus projections coming into this year were for US oil production to grow by close to one million barrels per day (December-to-December), but instead, production has grown only approximately 0.3 million barrels per day.
The lack of growth reflects lower investment rates in the sector, as companies have prioritised shareholder returns and capital discipline over increasing capital expenditures and production.
As such, while the rig count (as a proxy for overall investment) continued its post-pandemic rebound in the earlier part of the year, it has effectively flat-lined since June 2022, limiting the scope for further production gains.
The other notional source of additional supply has traditionally been OPEC and its allies. Not only did they recently agree to a two million barrel per day output cut, but their production capacity is falling short of expectations due to years of under-investment.
Even prior to the Russian invasion of Ukraine, OPEC+ producers were collectively under-performing their production quotas by over 1.5 million barrels per day, as the output of members outside the “core OPEC” countries of Saudi Arabia, Iraq, UAE and Kuwait hit multi-decade lows. New capacity is being brought on in the core group, but outside of the UAE it will take some years yet to reach the market.
And this is all before the extent of the impact of sanctions and the G7 price cap on Russian oil flows is known. While the overall intent of the EU and US is to redirect flows, not reduce them, the uncertainty involved in dealing with such an extensive and inter-connected market means that in reality there is likely to be at least some impact.
If nothing else, the redirection of Russian barrels from Europe to other markets such as India and China – and from Arabian Gulf and US barrels to Europe to compensate – has turned the shipping market on its head.
Increased transit times have effectively taken vessels out of the supply pool, pushing daily freight rates significantly higher than they were previously, with rates for some classes of clean product tankers reaching new records.
Oil demand overall has struggled to regain its pre-pandemic highs, but this is in large part due to the impact of China’s zero-COVID-19 policies, which have restricted travel both domestically and internationally. Even when these policies were relaxed, the risk of further lockdowns impacted domestic travel plans and dampened demand.
But while growth might have been softer than anticipated, it was certainly not contractionary. Indeed, the International Energy Agency's latest report estimated 2022 oil demand growth at 2.1 million barrels per day – a strong increase relative to history.
Metals markets
The dominant theme in metals this year has been Chinese demand, overwhelming all other factors, including record low inventories for key metals such as copper.
The dual headwinds of China’s zero-COVID-19 policy and weak property sector drove investor sentiment to the degree that even though demand was robust in the second half of the year and stocks dwindled, prices declined.
How metal prices perform from here will depend on China’s exit from COVID-19 lockdowns, in terms of timing and sustainability, and also on the property sector not getting worse.
Perhaps no other metal has shown the ‘macro versus micro’ conflict better than copper. By the end of our fiscal year in September, copper stocks had fallen to the lowest level in modern history in terms of days of use, and the lowest absolute levels since 2007. And yet the price was USD3,000 per tonne below the record levels reached in March.
Still, the price has started to pick up since the start of October, helped by a strong rebound in Chinese copper demand. Contrary to what media reporting and sentiment might indicate, China’s copper demand in the second half of 2022 should grow by close to seven percent year-on-year.
The pick-up has been led by many of the same sectors that drove ex-China growth in the first half of the year, but with particular emphasis on the expansion of the grid and electric vehicle production. Overall, global demand for refined copper is set to grow by a healthy 2.8 percent over 2022.
The year ahead
Looking forward, the world appears poised for more volatility and uncertainty. The war in Ukraine continues and could cause further disruption to global trade if the conflict escalates. Inflation may be coming off its peak, thanks in no small part to declining energy prices, but it remains too high for comfort.
As such, central banks are still in the mode of tightening financial conditions, and the full impacts have yet to be felt, especially as we are still not at the end of the rate-hiking cycle.
China may be looking towards a gradual re-opening, but a massive resurgence in COVID-19 cases could see Beijing revert to previous lockdown measures. A colder-than-normal winter plus any further disruptions to gas supplies could trigger a fresh spike in European energy prices.
And yet, as of now, global economic growth may be slower, but is far from contracting. Labour markets remain very healthy, consumer spending remains robust, and credit markets show no signs of stress. A continuing reversal in the US dollar, rates and inflation will all be tailwinds for global growth. Governments have embarked on major renewable and infrastructure investment programmes that should provide a source of sustained future demand, in particular for key metals.
However, renewed demand growth will run up against the realities of structural under-investment across commodities. Given how low inventories are for key raw materials already, together with a lack of readily available spare capacity, any sustained rebound in consumption could lead to significant tightness and a supply crunch.
Indeed, we appear to be running the risk of moving away from a world of commodity cycles to one of commodity spikes, where a lack of production capacity results in prices rising to levels that cause demand destruction, before falling. But even then, prices will remain elevated, given how long it takes to bring online new projects and the unyielding focus on capital discipline and shareholder returns of the major mining houses and big oil companies.
Saad Rahim
Chief Economist
