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WCU: Fuel price surge lifts inflation and risks killing demand

Ole Hansen

Head of Commodity Strategy

Summary:  The commodity sector recorded a fifth monthly gain in April, however compared with the broad gains in March the gains were concentrated in the agriculture and energy sectors led by edible and fuel oils. Precious and industrial metals suffering a setback in response to extended Covid-19 lockdowns in China, worries that a rapid succession of US rate hikes will hurt an already weakening economic outlook and not least a surging dollar.


The commodity sector raked in another monthly gain in April with the Bloomberg Spot Index tracking 23 major commodity futures, rising for a fifth consecutive month, and in the process hitting a fresh record high. However, the gains were concentrated in the agriculture and energy sectors with precious and industrial metals suffering setbacks in response to extended Covid-19 lockdowns in China hurting growth and demand, and worries that a rapid succession of US rate hikes will hurt an already weakening economic outlook. In addition to this, the dollar reached multi-year highs against several currencies, most notably a 20-year high against the Japanese yen and a five-year high against the euro.

China’s current situation has by a major investor in Hong Kong been described as the worst in 30 years with Beijing’s increasingly fraught zero-Covid policies slowing growth while raising discontent among the population. As a result, global supply chains are once again being challenged with congestions at Chinese ports building, while demand for key commodities from crude oil to industrial metals have seen a clear drop. While being short on details, China’s Politburo responded on Friday to this growing unease by promising to boost economic stimulus to drive growth. Earlier this week, President Xi highlighted infrastructure as a big focus and if implemented it would become a key source of extra demand for industrial metals, hence our view that following the recent weakness a floor is not far away.

In my latest online seminar and, in a podcast on MACROVoices this past week, I highlighted the reasons why we see the commodity rally has further ground to cover, and why they may rise even if demand should slow down due to lower growth.

Crude oil continues to trade rangebound within a narrowing range, in Brent currently between $98 and $110 per barrel. It did, however, not prevent the cost of fuel products from surging higher. Diesel, the workhorse of the global economy, rallied strongly led by tightening supply in the New York area driving prices to historic highs. The war in Ukraine, and subsequent sanctions against Russia, have upended global supply chains while at the same causing a significant amount of stress in the physical market, especially in Europe where Russia for years has been the most important supplier of fuel products.

To fill the void and to benefit from soaring prices, U.S. Gulf Coast refiners have been sending more cargoes to Europe and Latin America at the expense of the U.S. East Coast where stockpiles consequently have dropped to the lowest since 1996. With New York harbor serving as the delivery point for futures trading in the NY Harbor Ultra-Light Sulphur Diesel contract, the tightness there is having an outsized impact on visible prices.

These developments highlight the importance of focusing on the cost of fuel products, and not crude oil, when trying to determine the price levels where demand starts to be negatively impacted by higher prices. As a result, refineries are currently earning a lot of money with margins hitting record levels both in the U.S. and Europe. The charts below show the crack spreads, or the margin achieved by producing diesel from WTI in the U.S. and Brent in Europe.

With the war ongoing and the risk of additional sanctions or actions by Russia, the downside risk to crude oil remains, in our view, limited. In our recently published Quarterly Outlook, we highlighted the reasons why oil may trade within a $90 to $120 range this quarter and why structural issues, most importantly the continued level of underinvestment, will continue to support prices over the coming years.

With regards to the lack of investment currently creating concerns about future level of supply, we will be keeping a close eye on earnings next week from European oil majors such as Shell, Enel, BP and Equinor. Also, given the mentioned surge in refinery margins, the result from Valero.

Gold was heading for its first monthly loss in three months with an expected turbocharged tightening pace by the US Federal Reserve as well as the mentioned dollar strength being two major catalysts. Silver led the weakness falling to a 2-½-month low around $23 per ounce due to China-related weakness across the industrial metal sector. As a result, the XAUXAG ratio broke above resistance at 80 ounces of silver to one ounce of gold. Renewed focus on Chinese stimulus initiatives, as mentioned above, would help create a floor under silver, thereby reducing its recent negative pull on gold.

Recently, I have been asked the question why gold is doing so poorly considering we are seeing inflation at the highest level in decades. To this my answer continues to be that gold is doing very well and in line with what a diversified investor would hope for.

We tend to focus primarily on gold traded in dollars, and XAUUSD as can be seen from the table below has ‘only’ returned around 5.5% so far this year. But if we add the performance of the S&P 500 Index and long maturity US bonds the picture looks a lot better. Gold in dollars has outperformed these two major investments sectors by +15% and +23% so far this year. Turning to gold traded in other currencies, the performance looks a great deal better due to the impact of the strong dollar.

Investors in Europe seeking shelter amid rising inflation and a sharp deterioration in the economic outlook have achieved 24% and +21% better returns in gold compared with the Euro Stoxx 50 benchmark and euro government bonds. We maintain a positive outlook for gold driven by the need to diversify from volatile stocks and bonds, inflation becoming increasingly imbedded and ongoing geopolitical concerns. Having found support at $1875 this week, a weekly close above $1920 may see renewed upside driven by fresh momentum and technical buying.

Copper broke the uptrend from the 2020 low resulting in a drop to near a three-month low around $4.40 per pound, before sentiment received a boost from China’s pledge to maintain the 5.5% growth target, a level the Chinese economy is currently operating well below. While the short-term outlook has worsened and inventories at exchange-monitored warehouses have risen during the past four weeks, the outlook in our opinion remains price supportive. The demand for action to isolate Russia through a reduction in dependency of its oil and gas is likely to accelerate the electrification of the world, something that requires an abundant amount of copper.

In addition, Chile, a supplier of 25% of the world’s copper, has seen production slow in recent months, and with an “anti-mining” sentiment emerging in the newly elected government, the prospect of maintaining or even increasing production seems challenged. In addition, Chile’s 13 years of drought and water shortages are having a major impact on the water-intensive process of producing copper. Moreover, government legislation has been put forward to prioritize human consumption of water and if voted through it may delay investment decision but also force mining companies to invest in desalination facilities, thereby raising the cost of production further.

Agriculture: Soybean oil futures in Chicago reached a record high as Indonesia’s sweeping ban on palm oil exports and rationing of sunflower oil at supermarkets in Europe further stretches global supplies of edible oils. Export restrictions for palm oil used in everything from cooking to cosmetics and fuel will stay in place until domestic prices ease and given that Indonesia consumes only one-third of its production, we should expect exports to resume once inventories are rebuilt and prices stabilize. The edible oils sector, which according to the UN’s food index has risen by 56% during the past year, is the hardest hit by weather woes and the war in Ukraine, the world’s biggest exporter of sunflower oil, and it is leading to food protectionism by producers which inadvertently may boost prices further.

Speculators have recently increased their exposure to U.S. crop futures to a record with slow planting progress and deteriorating crop conditions highlighting a challenged and price supportive situation. In their latest weekly update, released on Mondays, the US Department of Agriculture said corn planting had advanced by 3% to being 7% complete, the slowest pace in almost ten years and trailing last year’s pace of 17%. Winter wheat rated good/excellent dropped 3% to 27% and was near the worst on record. The planting delays and conditions have been caused by the weather being too cold, too wet, or a combination of both. Big grain harvests in North America are needed this year after Russia’s invasion of Ukraine has reduced shipments out of the Black Sea, from where 25% of the global wheat export originates, while raising doubts about this year’s crop production in Ukraine.

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