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Quarterly Outlook
Supply deficits to propel commodities higher still
Ole Hansen
Head of Commodity Strategy
Head of Commodity Strategy
Summary: The commodity super cycle is only gaining speed. Will gold break $2,000/oz again?
Commodities continue to attract increased attention and demand. A combination of a vaccine-led recovery in global activity, the green transformation and emerging tightness in several key commodities has seen the Bloomberg Commodity Index rise 45% since the depth of Covid-19 despair last April. This year-to-date performance has elevated commodity-related stocks to the top of Saxo’s equity-themed baskets.
Following a near decade of trading sideways to lower, the sector has embarked on a strong rally with individual commodities reaching multi-year highs. While witnessing periods of strength in individual commodities during this time, the rally has in recent months become noticeably more synchronised across all the three sectors: energy, metals and agriculture.
However, following the spike in US bond yields since early January, the sectors’ recent success in attracting record amounts of speculative buying may, in the short term and despite strong fundamentals, force a correction or at best a period of consolidation.
There are plenty of reasons why commodities are on the move, but importantly there are expectations for a post-pandemic growth sprint with large amounts of stimulus driving demand for inflation hedges and green transformation themes. This is against a backdrop of the tightening supply of several key commodities following years of under investment. These developments increasingly drive expectations that we have entered a new dawn for commodities, raising the prospect for a new 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, alongside the time needed to harness new supply. For example, in the copper industry it can take ten years from decision to production. Such periods often cause companies to postpone investment decisions awaiting 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. Then, the period prior to the 2008 global financial crisis saw the Bloomberg Commodity Total Return index surge by 215%. Super cycles can also be supply-driven, with the most recent case being the OPEC oil embargo of the 1970s.
It is expected that the next commodity super cycle will not only be driven by recovering demand, but also by heightened inflation risks at a time when investors will need real assets such as commodities to hedge their portfolios, following years of sub-par returns. In addition, following a decade when investment in technology was preferred over hard assets there has been a lack of new supply lines.
The emerging tightness across several commodities has, for the first time in seven years, helped create a positive carry on a basket of 26 commodity futures: a key development which has raised the investment appetite from investors seeking a passive long exposure in commodities.
Market tightness leading to a structure called backwardation has not been this high since 2014, and following years of dismal returns due to contango, the opposite structure caused by oversupply, we are now seeing renewed investment interest. The graph below shows the negative impact of a market in contango, a structure which means investors holding a position either in futures or an exchange-traded fund tracking them will incur a negative yield whenever exposure is rolled from an expiring contract to a higher-priced one further out on the curve.
The Bloomberg Spot index tracks the performance of the front-month contracts while the Total Return index takes roll yields into account. The near 40% difference in performance during the past five years mostly reflects the negative impact of rolling exposure in an oversupplied market.
Strong commodity momentum in recent months, alongside emerging signs of tighter supply, helped attract increased buying from speculators, some looking for inflation hedges while others simply jumping on board the momentum train. Whereas physical demand and tight supply look set to support prices over the coming months if not years, the short-term outlook may become more challenging as “paper” investments have been exposed to the reduced risk appetite spreading from the recent rise in bond yields, most notably in real yields.
Fund positions in key commodities relative to the five-year minimum and maximum showing the extent to which long positions have risen in recent months. This is especially the case within agriculture commodities, most noticeably those that have benefitted from strong Chinese demand and recent weather-related production worries in South America.
Crude oil is expected to rise further over the coming months as rising fuel demand will allow OPEC+ to further reign back the dramatic production cuts from last April, which one year later has seen the price fully recover. However some challenges remain, not least given the risk that a tight supply-led rally as opposed to a demand-driven one may slow the return to demand trend growth.
Part of the gamble in allowing prices to rally this far before demand has fully recovered is based on the assumption that US shale oil producers have turned their focus away from “pump, baby, pump” to creating value for shareholders while bringing down debt. With the price of WTI well above breakeven levels, the coming months will tell whether that discipline can and will be maintained.
Based on the assumption they will, it is clear that OPEC+ has embarked on a tight oil market strategy. It is one that will succeed as long as global fuel demand recovers by the 5.4 million barrels/day currently being projected by the International Energy Agency, and non-OPEC supply growth remains muted at less than one million barrels/day.
While Brent is likely to end 2021 somewhere in the $70s we remain sceptical about the timing as we watch a market that increasingly needs time to cool off and consolidate. Whether it will be given such a break depends on the speed with which OPEC+ adds barrels back into the market, as well as a continued vaccine-led recovery in global mobility.
Precious metals, the most responsive metals to changes in rates and the dollar, had a troubled first quarter as both gold and silver struggled to find a defence against rising US bond yields, and with that a stronger dollar. Rising yields as such are not a major obstacle as long they’re driven by rising inflation expectations. This is not what happened during the first quarter as rising real yields accounted for half the nominal yield spike towards 1.5%.
Looking ahead to the second quarter we base our belief in a recovery on the prospects for inflation starting to rise by more than the market has priced in. It will be slow-moving development which will only accelerate once momentum reach a positive pace strong enough to force hedge funds, who have cut exposure to a near two-year low, back into the market. We maintain the view that gold can reach $2000/oz this year while silver may do even better to reach $33/oz. This is based on the additional tailwind from an in-demand industrial sector driving the gold-silver ratio lower towards 60.
Copper remains one of the commodities with the strongest fundamentals, something that has already driven a doubling of the price since the Covid-driven bottom in 2020. Demand, both investment and physical, is likely to remain strong and an accelerating decarbonisation drive could see the annual supply deficit reach the highest level in many years. With Joe Biden in the White House the green transformation has gone global, and the process towards a more electrified world will require enormous amounts of copper at a time where the future supply funnel looks relatively weak. We see HG copper trade in a wide range with the uptrend from the 2020 lows capping the downside while the upside focus will initially be the $4.65/lb record high from 2011.
Agriculture: The strong rally and with that a record investor involvement look set to cool as we enter the planting and growing season across the northern hemisphere. The last year has seen several food commodities, especially grains and oilseeds, move from ample to much tighter conditions. Weather worries in South America during the first quarter, together with last year’s strong buying from China, has left projected ending stocks for the 2020-21 season at the lowest level in years. With this in mind the focus during the coming months will be planting and growing conditions, especially in the US and the Black Sea region.
Given a highly elevated speculative long, a strong beginning to the planting season could leave the most elevated positions in corn and soybeans exposed to a correction. Demand from China will also be watched closely with renewed outbreaks of African swine fever potentially reducing overseas demand, especially for those two crops.