Commodity rally not yet out of fuel; Special focus on carbon

Ole Hansen
Head of Commodity Strategy

Summary:  Is the commodity boom cyclical or structural? The prospect of a supercycle should not be sniffed at.

Despite five consecutive quarterly gains, the commodity sector looks set to continue higher during Q3-21, albeit at a slower pace, with some of the recent strong drivers starting to lose a bit of momentum. Since the pandemic and global lockdown lows March last year, the Bloomberg Commodity Spot index, which tracks the front-month futures performance of a basket of raw materials from energy to metals and agriculture, has surged higher by 75% to reach a ten-year high. This development has fuelled speculation that we have entered a new commodity super-cycle.

A super-cycle is characterised by prolonged periods of mismatch between surging demand and inelastic supply. These supply and demand imbalances take time to correct due to high start-up capex for new projects, along with the time needed to harness new supply. For example, in the copper industry it can be ten years from decision to production. Such long periods often cause companies to postpone investment decisions while waiting for rising prices, at which point it is often too late to avoid further price gains. 

Previous demand-driven super-cycles included rearmament before WW2, and the reform of the Chinese economy which accelerated following its accession to the WTO in 2001. Up until the 2008 global financial crisis China’s unstoppable appetite for raw materials helped drive the Bloomberg Commodity Spot index up by almost 350%. Super-cycles can also be supply driven with the most recent case being the OPEC oil embargo of the 1970s.

Some economists believe the current boom in commodity prices is cyclical rather than structural as it has been driven by exceptionally strong Chinese demand. This demand is now slowing as credit tightens, while stimulus-induced growth in Europe and the US is overlaid with supply chain disruptions. Adding to this are key food commodities at multi-year highs following the worst Brazilian drought in 90 years, strong Chinese demand for animal feed, and increased competition for edible oils from the biofuel industry. 

However, we believe individual developments across the three sectors will continue to add support. While not in short supply, the oil market will be supported by a period of synchronised global demand growth where OPEC+ can increasingly control the price given the prospect of a lack of response to higher prices from non-OPEC+ producers; this is especially true for those producers in North America who are no longer pumping at all cost. 

In metals, the combination of increased government spending on infrastructure and decarbonisation will continue to drive strong demand for metals including copper and iron ore—the key ingredient to make steel—as well as aluminium, zinc and even semi-industrial metals such as silver and platinum. On top of this is the prospect for increasingly volatile weather potentially preventing a much-needed stock build in key agriculture commodities.

It’s also our view that rising inflation is likely to be longer-lasting than transitory, thereby creating continued demand from investors as they will need real assets such as commodities to hedge their portfolios. Combining this with our overall negative dollar view, precious metals—both gold and silver—should continue to attract demand, especially if an expected rise in Treasury yields are driven by rising inflation expectations, thereby preventing real yields from rising too far. 

Tightening market conditions emerging during the past six months are another reason why, for the first time in a number of years, asset managers are once again viewing commodities as an interesting investment case. With several commodities seeing tightening conditions their forward curves have moved in backwardation, meaning the front month contract trades are at a premium to the deferred. The higher the spread, the higher the yield that can be harvested when rolling futures contracts out the curve. 

The chart below shows how market conditions have changed more favourably for passive long investors during the past year. A positive one-year roll yield has emerged across a majority of major commodities, with agriculture and energy futures yielding the highest carry

While rising physical demand is seen as the main reason behind the continued run up in commodity prices, investment demand plays an equally important role. What they both have in common is that the vast majority of investment flows from asset managers and hedge funds into commodity investments and will eventually find its way to the futures market. These investments flows, which often are initiated for reasons that have nothing to do with individual commodity fundamentals, are therefore adding a layer of support. Examples of motives for asset managers deciding on a broad commodity investment, apart from the fear of missing out (FOMO), can be momentum and hedging against rising inflation and a weaker dollar, both triggering reallocations from other asset classes. 

Three of the best-known commodity indices that in some form are tracked by billions of dollars are the Bloomberg Commodity index, the S&P GSCI and the DBIQ Optimum yield diversified commodity index. Exchange-traded fund providers such as Invesco, iShares, iPath and WisdomTree offer different varieties of these commodity indices. Some aim to track the index with no discretion while others look to optimise the return by finding the most opportunistic location on the futures curve to invest.

Special focus: Carbon

The European Emissions Trading Systems (ETS) started back in 2005, and is today by far the largest and most successful market. It’s a very liquid cap and trade system where the authorities set a cap for the maximum amount of carbon emissions that can be produced within and economy or region. The main source of EU ETS supply comes from allowances that are granted for free to the emitters; a second source of supply comes through auctions. 

The ETS is by now very well established and carries a high degree of transparency. It covers roughly 40% of the greenhouse gas emissions (GHG) in Europe through sectors like utilities and industrials. Other sectors like agriculture, construction and transportation (including shipping) are currently not included, while some are expected to be included over the coming years.  

Source: Saxo Group

Before breaking above €50 per tonne of CO2 earlier this year, the ETS had gone through several phases, the first of which ended in failure a few years ago as too many emission permits were issued and the selling of excess permits kept the price under pressure. During the two years up until 2019 many of the original problems had been solved but the price remained low, thereby failing to achieve its objective to force polluters through rising costs to focus on renewables and move away from the most polluting sources of energy, such as coal. 

During the past year, and especially since November, the ICE EUA futures contract (Ticker: CFIZ1) which represents one tonne of carbon emissions, has rallied strongly to trade €40 or 300% above the average price from the previous five years. What happened in November was the first vaccine announcement signalling a clear path towards a global recovery and Joe Biden, with his more environmentally friendly policies, being elected as President of the US. 

Politicians have finally understood that more aggressive action is needed in order to achieve a 55% emissions reduction below 1990 levels by 2030. Having achieved less than half the 55% reduction during the past 30 years and with only 9 years left, the system is finally showing signs of working. The next 9 years also will see additional industries being included while the total number of allowances in circulation (TNAC) will be steadily withdrawn into the so-called Market Stability Reserve, reducing supply and putting upward pressure on prices.

With these developments in mind, the cost of emissions is likely to continue higher. Given the strong momentum seen in the past year it will also attract an increased number of speculators, which will almost guarantee increased volatility and periods of corrections. Overall however, the price is forecast to continue to move higher and could reach €100 per ton before 2030. 

In order to achieve such a massive reduction, utilities, industry and other heavy polluters will increasingly be looking towards alternative low emission sources of energy. My colleague Peter Garnry will take a closer look at some of these in his outlook. Among others they include hydrogen, nuclear and solar, and also carbon capture as a way to collect emitted CO2.

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