Head of Commodity Strategy
Commodities have outperformed other asset classes so far this year. Rising oil prices have steadily been feeding into an increase in headline inflation.
These developments together with increased geopolitical and weather concerns have all helped support investor demand for broad-based commodities exposure.
Rising commodity prices led by crude oil have started to feed into headline inflation with its subsequent negative impact on bonds, often the biggest component in a diversified portfolio.
The Bloomberg Commodity Index reached its highest level since 2015 this past week and is currently up by around 4% year-to-date. This means that it is still some distance behind the energy-heavy S&P GSCI index which has clocked up a 12% return so far.
This is primarily due to crude oil’s surge to a 3½-year high on supply worries related to Venezuela and Iran.
This past week, however, it was not crude oil and products that provided the gains. Instead, the grains sector and natural gas both found support from hot weather across the US. This development has been raising demand for natural gas from power plants to meet increased demand for cooling. Already dry weather conditions in the US and around the world has fuelled concerns about a price supportive reduced crop production this year.
Precious metals recovered following a few weeks of headwinds caused by rising yields and a stronger dollar. The geopolitical focus provided renewed support after President Trump cancelled his June meeting with North Korea’s Kim Jong Un. A sell-off in emerging market currencies, not least Turkey, together with political developments in Italy and Spain also helped give gold a boost.
Precious metals, led by gold, have recently been caught in the crosshairs of a rising dollar and US 10-year bond yields climbing through the psychological 3% level. After dropping below $1,300/oz on May 15 gold has since managed to find support at $1,286/oz, a key technical support level. The return to relative safety above $1,300/oz has been supported by renewed focus on geopolitical developments. Adding to this the Federal Open Market Committee signaling that they’re in no hurry to hike rates more aggressively, despite the prospect of rising inflation.
Faced with a deteriorating short-term price outlook, hedge funds, which are often more sensitive to adverse price changes than longer term investors, have been cutting bullish futures bets to a ten-month low at 31,000 lots, well below the five-year average of 105,000 lots. Longer-term investors meanwhile, who often use exchange-traded funds, have shown a great deal of resilience.
Throughout the recent weakness they have maintain a total holding close to a five-year high. It confirms our view that while funds must react to short-term price developments the limited exposure seen now could act as the engine that takes gold higher once the technical outlook improves enough to warrant buyers to return.
Gold has managed to stabilise and climb higher after finding support at the important level of $1,286/oz. The return above $1,300/oz and more importantly a weekly close above $1,307/oz, the 200-day moving average is likely to set the stage for additional gains.
The extension of the crude oil rally following Trump’s decision last month of unilaterally abandoning the Iran nuclear deal has begun to run out of steam. This after Brent crude oil reached and found resistance at $80/b, a level last seen in late 2014. Faced with emerging signs of consumer unease about the rapid rise in recent months Saudi Arabia and Russia have both begun talking about rolling back some of the production cuts that during the past year successfully have supported a rebalancing of the global oil market.
The need to supply additional barrels to maintain a stable market has also become more apparent with the ongoing drop in Venezuelan production and the so far unquantifiable future impact of US sanctions on Iran’s export ability.
In Venezuela the pace of decline of oil production is accelerating and following last week’s sham election which saw Maduro regain power the outlook for the country looks incredible dire. Adding additional sanctions from the US there is a risk that production could slump to just 1 million b/d, from 1.5 million currently.
When sanctions hit Iran back in 2012 its exports fell by more than 1 million barrels. Without the support from Europe, Russia and China the impact of Trump’s new sanctions which will take effect before yearend is very difficult to quantify at this stage. Considering US ‘friends’ from Europe to Japan and South Korea currently buy around one-third of Iran’s export some impact on global supply cannot be avoided.
On that basis Opec and Russia which have kept 1.7 million barrels/day away from the market since early 2017 are likely to step in sooner than expected to stabilise the market and prevent it from rallying to levels where global demand begins to be negatively impacted. At first the least controversial decision could be for the group to raise production by 300-500,000 barrels/day to meet the shortfall from Venezuela thereby bring the compliance back to 100% from the +150% seen in recent months.
The short-term focus will center on the June 22 Opec meeting in Vienna. The following day the cartel will meet with the non-Opec group, especially Russia, who have supported the production curbs.
Watch what they do, not what they say, has been a very good description of hedge funds’ behaviour during the past four weeks. Since Trump’s Iran announcement hedge funds and money managers have been actively selling into the rally thereby cutting what a few months ago was a record combined long in Brent and WTI crude oil. In the week to May 15 the combined net-long dropped below one million lots to a five-months low.
The price behaviour this past week further strengthened the belief that the crude oil rally, at least for now, was running out of steam and needed consolidation. Two consecutive attempts to drive Brent crude oil above $80/b failed quite spectacularly as sellers emerged. News that both Saudi Arabia and Russia both suggested easing production cuts further added to the sense that the focus for now has turned to one of consolidation.
From a technical perspective Brent crude oil is currently consolidating more than its correcting. However, a break below $75.40/b could change this perception and help attract additional long liquidation.