Commodity markets: Macro headwinds clash with micro tailwinds

Many of the key themes that defined commodity markets since the onset of the war in Ukraine continued during the six months to the end of March 2023.

At the start of our financial year, inflation remained high and central banks continued to raise interest rates to levels that are now proving restrictive for growth.

The turmoil seen earlier this year in the banking sector, primarily in the US but with some spill-over into Europe, has been one of the direct results of tighter monetary policy.

The idea that looser credit conditions in China, combined with the re-opening of the country late last year after the end of its zero-COVID-19 policy, would offset the impact of tighter financial conditions in the West, has yet to play out.

Unlike previous periods of weakness, it appears that China’s problem is not the supply of credit. Rather, it is the demand for credit, as repeated lockdowns, high youth unemployment and shaken faith in real estate developers are combining to keep consumer confidence, and therefore spending, low.

Facing those macroeconomic headwinds, commodity prices unsurprisingly struggled so far in 2023, even though some OPEC members cut oil production – which should support the market later this year – and stockpiles of metal have continued to draw in China.

At the time of writing, Brent crude oil, which was close to USD90 per barrel in January 2023, was trading at USD75 per barrel, while copper is trading just above USD8,300 per tonne, having traded close to USD9,400 per tonne in January.

During the reporting period, gas and power prices in Europe were volatile, swinging from over EUR200 per megawatt hour in Autumn, to below EUR30 per megawatt hour, helped by a mild winter and demand reduction measures, particularly in the industrial sector. Higher LNG prices also allowed Europe to attract more cargoes, away from other markets." In shipping, longer transit times due to the sanctions levied on Russian oil effectively removed tankers from the market and saw so-called “oil-on-water” volumes increase materially.

Looking forward, the most recent data points to a US economy that is still running hot, especially in terms of employment and in the services sector.

As such, commodity prices may struggle in the months ahead, especially if higher interest rates slow growth, the US dollar continues to rise and downbeat sentiment around China persists. Manufacturing globally is already contracting.

Still, across the major economies there are significant shock absorbers in the form of savings built up over the last three years that should provide some support.

Consumers in the US, Europe and China still have around USD4-5 trillion of excess savings thanks to stimulus efforts and deferred consumption during COVID-19.

The situation is therefore very different to the run-up to the 2007-08 financial crisis when savings were stretched and consumers had taken on significant amounts of debt.

An eventual end to the rate hiking cycle should allow consumers to deploy pent-up savings and growth to resume.



Oil markets

Last year, oil markets were buffeted by the threat of Russian disruptions, China’s zero-COVID-19 policy and record oil releases from strategic reserves in the US and its allies.

In the end, lockdowns resulted in China exporting significant volumes of refined products, particularly diesel, to the rest of the world, more than offsetting any possible disruptions.

The fact that there were no real disturbances to Russian flows meant that markets ended up being quite well supplied, especially as there were large releases from strategic petroleum reserves (SPR). The US SPR, for example, released 200 million barrels of crude oil following the invasion of Ukraine.

Despite higher prices for most of the year and China’s lockdowns, global demand still grew by a very healthy 2.3 million barrels per day in 2022. Given that the International Energy Agency reported China’s demand contracting by 0.4 million barrels per day over the course of 2022, that meant global demand excluding China grew by over 2.7 million barrels per day, which would be one of the strongest increments of recent years.

Even with the US and Europe seeing demand falter slightly due to higher interest rates and rising recession risk, China’s re-opening at the turn of the year has helped support demand.

Demand growth projections for 2023 are again above 2.0 million barrels per day, led by China, which is expected to account for almost half of that gain. Much of that global demand comes from demand recovery in jet fuel, as air travel has picked up.

Looking back to the financial crisis, global oil demand contracted by 2.0 million barrels per day over 2008-09. Despite concerns about an economic slowdown, the forecast is for something much milder in 2023.

Set against any demand losses, voluntary production cuts announced by some key OPEC members that are in theory as high as 2.0 million barrels per day, although in reality will probably be around half that. However, Saudi Arabia continues to make additional voluntary cuts, including those announced at the June OPEC+ meeting. Those supply cuts plus emerging market demand growth should still point towards material draws in inventories later this year.

For over a decade, tightening oil markets could always rely on the US shale industry to ramp up production to bring markets back into balance.

However, it is difficult to see how US production is going to increase this year given lower oil prices, higher interest rates and rising costs – and certainly not by the levels many forecasters were projecting coming into the year, in some cases as high as 1.0 million barrels per day. We can already see that in the number of oil rigs being deployed, which has fallen steadily by a total of 72 rigs since the most recent peak in November 2022 (which in itself was down almost 1,000 rigs from the all-time peak in 2014).

But it is not just the US; across the globe, oil companies have slashed exploration and production spending, dropping to levels that are 40 percent or less of the last peak of spending in 2014.

Thus, while refining capacity, which has previously been a bottleneck, is now starting to expand, led by extra capacity in China and the Middle East, there will likely be a structural dearth of crude oil in the coming years to feed both these refineries and any future demand growth needed to meet the needs of a growing global population.

This raises the prospect of higher prices and heightened volatility in the years ahead, despite the rapidly increasing adoption of electric vehicles.



Metals markets

For most of last year, tightening fundamentals, highlighted by stock levels, which declined to historically low levels in many cases, did not translate into higher prices for metals, as normally would be the case.

This unusual dynamic was driven in large part by investment flows; specifically, the strength of the US dollar, which meant capital flowed into that market and out of other assets, in particular commodities. At the same time, there was also a view that China’s COVID-19 lockdowns and property woes meant that metals demand was weak.

The reality was actually quite different, with China seeing record levels of demand for copper, aluminium, stainless steel and other metals.

Much of this growth was due to government-driven spending on infrastructure, especially the build-out of the electrical grid, but also the production of electric vehicles, which exceeded expectations by a wide margin. As regards the electrical grid, it has not just been an increase in overall capacity, but specifically more renewable capacity, which is metals intensive.

China added 125 gigawatts of installed renewable power generation capacity in 2022, with wind growing by 38 gigawatts and solar capacity by 87 gigawatts. Added to the growth seen in the first quarter of the 2023 calendar year, we could potentially see these numbers grow by over 30 percent and 150 percent respectively over the next six months, bringing the total to over 170 gigawatts for the 2023 calendar year.

That said, we are seeing relatively high inventories of finished goods in China, mainly as the result of consumer demand shifting from goods to services, but also due to the debottlenecking of disrupted supply chains. A persistent overhang of real estate inventory in China is also contributing to a weaker recovery than would have been hoped for, although the trajectory is still positive.

The important point to note for both metals and energy is that any economic growth slowdown this year will not just impact demand but will also further depress investment in the supply of commodities which are needed for the energy transition and to meet the needs of a growing global population.

As such, when demand recovers it will do so quickly, and run up against short stocks, low spare capacity and few response mechanisms, with new project pipelines running dry.

Saad Rahim

Chief Economist