Head of Commodity Strategy
Summary: The commodity sector remains under pressure from a whole host of negative developments, most importantly an increased focus on recession. In addition, the general reduction in risk appetite amid challenging market conditions have seen the dollar strengthen to levels not realised in decades. At the same time China, the world's top commodity consumer, continues to struggle with Covid-19 cases and a challenged property sector. In this we take a look at what these developments mean for crude oil, copper, precious metals, gas and grains.
The commodity sector remains under pressure from a whole host of negative developments. In early June, the weakness spread from industrial metals – already suffering from China’s zero-Covid policy and continued lockdowns – to all other sectors. The trigger was the stronger than expected inflation print, forcing the FOMC to respond with a 75-basis point rate hike – a move that subsequently led to an increased focus on recession (a word that now features in most market related updates).
In addition, the general reduction in risk appetite amid challenging market conditions have seen the dollar strengthen to levels not realised in decades – most notably against the euro and Japanese yen. A stronger dollar raises the cost of dollar-denominated commodities, thereby adding additional pressures on demand in regions like Europe already struggling with punitive gas and power prices.
China, the world’s biggest consumer of most commodities, continues to struggle with mounting Covid-19 cases, and a challenged property sector. This continues to delay a recovery, especially for industrial metals which have slumped by one-third since hitting a record peak in early March. The challenge to the Chinese economy was highlighted by the 0.4% year-in-year drop in real GDP during the second quarter. While pockets of strength remain due to tight market conditions, the exit from the sector by speculators and the selling from macroeconomic-focused funds may continue to apply downward pressure until the dollar stabilises and inflation begins to retreat, thereby easing the pressure on central banks to maintain their current aggressive monetary tightening stance.
Questions are now being raised about the energy sector’s ability to withstand additional recession-focused selling. We still believe – and fear – that worries about demand destruction will be more than offset by supply constraints. Russia’s ability to maintain its current production levels will be increasingly challenged over the coming months. In addition, we are seeing several OPEC+ members close to being maxed out, with only a few oil providers still being able to raise production.
In the short term, we will see a continued battle between macroeconomic-focused traders selling “paper” oil, through futures and other financial products as a hedge against recession, and the physical market where price supportive tightness remains – most notably in Brent where buyers of physical barrels are paying a near record premium for immediate delivery. In addition, the US will eventually have to stop pumping close to a million barrels per day into the market from its strategic reserves. On that basis, we see Brent crude oil trading not far from support. However, in response to the current recession focus, we lower our Q3 target range to $95 to $115.
From a technical perspective, the price of High-Grade Copper has, during the past three weeks, cratered non-stop since breaking key support around $3.95. In the process, it has corrected by a massive 61.8% of the $3/lb surge from the 2020 pandemic low to the record high on March 11 this year. Responding to these developments, hedge funds now hold a net short of 26k lots – still well above the 68k lots short held in the aftermath of the pandemic-led slump in early 2020.
A break below $3.14/lb may signal a complete reversal of the uptrend and a return to the pre-pandemic trading range between $2.5 and $3.0. In order to avoid a downward extension of this magnitude, the recessionary pressures and the dollars’ advance both need to slow.
For gold to find fresh support, some of these recent headwinds – most importantly the dollar – need to reverse. We view gold’s recent weakness as overdone as the threat of stagflation has not gone away. However, we also respect the market’s ability to create pain, not least during the liquidity-thin holiday months where momentum in either direction is often allowed to run with limited appetite to oppose the prevailing trend. As a result, we have seen a sharp reduction in exposure held by investors in ETFs (Exchange Traded Funds) and speculators in futures. The latter group have cut bullish bets to a three-year low.
Having challenged $1700 for the first time since a brief visit last August, a break below will put $1675 within reach – a level that has provided support on several occasions during the past two years. Meanwhile, silver is down 40% to an 18-dollar handle from the 2021 peak around $30 after slicing through several layers of support. In the process, speculators have switch positions back to the largest net short in more than three years. At this stage, a sentiment change will be needed to prevent further losses and for buyers to return to challenge the mentioned short position.
Record high gas prices driving up the cost of heating and electricity are one of the reasons why EURUSD has reached parity for the first time in 22 years. As a result, we are currently seeing a high correlation between Russian gas flows to Europe and the euro. In other words, next week's decision by Gazprom/Russia on Nord Stream 1 shipments may trigger additional weakness or potentially, together with an expected ECB (European Central Bank) rate hike, help create a floor under the common currency.
Speculators, sensing a market running out of steam, began cutting back exposure across the six major grain and soybeans contracts in late April. This came after the total length exceeded 800k lots – a level that on three previous occasions during the past decade had led to a sharp reversal in prices and positions. As of July 5, that length had been cut to 391k lots. However, with production uncertainties in the US and especially Europe caused by the current heatwave, we doubt that prices have much further to fall until we get more clarity on production levels.
Talks held this week in Turkey between Russia, Ukraine and the UN over unblocking millions of tons of Ukraine’s grain exports has been described as constructive and, if successful, it would further reduce the risk of a food crisis over the coming months. Ukraine, a major exporter of high-quality wheat, corn and sunflower oil has seen its main export artery through the Black Sea blocked since March. This helped send wheat and edible oils sharply higher before a level of calm was restored in the early weeks of the war.
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