The Bloomberg Commodity Spot Index reached a fresh record high during the second quarter before entering a phase of consolidation, as global growth concerns received an increased amount of attention.
However, while demand destruction through high prices and lower growth through rapid rising interest rates may help pause the rally, the long-term challenge to supply remains. Supply is being driven by factors that are not easy to fix, such as 1) historical bad returns on commodity investments, 2) a high level of volatility that makes it difficult to project future revenues and 3) environmental, social and governance (ESG) legislation that has increasingly prevented old-economy companies within mining and energy production to attract investors and get the necessary approvals from local authorities.
While the energy transformation towards a less carbon-intensive future is expected to generate strong and rising demand for many key metals, the outlook for China is currently the major unknown, especially for copper where a sizable portion of Chinese demand relates to the property sector. But considering a relatively weak pipeline of new mining supply beyond 2024, we believe the current macro headwinds from China’s property slowdown will moderate throughout 2022. We also need to consider that the People’s Bank of China (PBOC) and the government, as opposed to the US Federal Reserve, are likely to stimulate the economy, with a special focus on green transformation initiatives that will require industrial metals.
Inelastic supply and robust demand, despite the risk of an economic slowdown, has led the International Energy Agency (IEA) to warn about a rising supply deficit into 2023. The lack of refinery capacity, made worse by closures during the Covid pandemic, has moved the crisis from crude oil – which remains well below the 2008 record at $145/bbl – to the refined fuel market where gasoline and diesel have already reached record levels.
Oil majors swamped with cash, and investors in general, showing little appetite for investing in new discoveries is the long-term reason for the cost of energy likely remaining elevated for years to come. Besides the already mentioned challenges of high volatility and historically bad returns on investments, the immediate challenge relates to future expectations for demand.
The green transformation which is receiving increased and urgent attention will eventually begin to lower global demand for fossil fuels. It’s the timing for this transition that keeps the investment appetite low. Unlike new drilling methods like fracking where a well can be productive within months, traditional oil production projects often take years and billion-dollar investments before production can begin. In other words, oil producers are not looking at a very appealing spot price for crude above $110/bbl, but rather at where the market will price oil in the future.
The following chart shows the forward curves for Brent and West Texas Intermediate (WTI) crude oil, and the dilemma producers face five years out with both crude varieties trading more than $40 below current spot prices. These prices project a market with falling demand and with that, an even greater uncertainty about the long-term profitability of new projects.
With these considerations in mind, we suspect corrections in the energy market during the second quarter may end up being short-lived, with the risk of a prolonged period of high prices the most likely outcome. A brief return to the 2008 record high cannot be ruled out, but in general we believe that some emerging demand weakness on the other side of the peak summer demand season should keep prices capped within a wide $105-to-$130 range. We maintain our long-held view that the basis – and from a global growth perspective, the unfortunate risk – for a long-lasting cycle of rising commodity prices has not gone away.
Ole Hansen, Head of Commodity Strategy, Saxo Bank