Prior boom and bust commodity cycles have been predicated by an over-build period just before a demand decline. This is not the case this time as producer capital discipline has remained strong since 2015, in part due to shareholder pressure for dividends and buybacks, but also given increased environmental, social and governance (ESG) pressures and regulatory burden from host nations. These periods of uncertainty are further deferring investment decisions.
Alongside inflation and tight labour markets, which increase the construction costs for any new project development, this only acts to extend the cycle – something that already involves long lead times as it can take a decade to bring on large copper or oil and gas projects.
Even relative to the recent history of a global pandemic and a war on the borders of Europe, there is an uncertain macro backdrop to markets today. The primary ‘known unknown’ is inflation and what this means for interest rate policy as central banks look to quell inflation, even if that means higher unemployment and sending the global economy into recession. Inflation is devaluing savings and the energy crisis has squeezed household balance sheets, leaving wealth preservation a key focus.
The IMF, which is far from a leading edge on predictions, expects one-third of the global economy to be in recession in 2023. The implications for a recession, typically viewed as two negative quarters of growth, may vary in implications.
While two negative quarters of -0.1% growth would be no big deal, a more significant decline would be more detrimental to markets that continue to imply a ‘soft landing’ to the economic fallout of higher interest rates.
Inflation prints have notably softened over the past few months, adding to a bullish sentiment towards commodities, but driven by certain aspects such as the vehicle and energy price spike unwinding.
Whether the inflation genie is fully back in the bottle is unclear and central banks will remain cautious on easing too soon, especially if labour markets remain strong, as this feeds through inputs such as shelter/housing. A quick return to the low-rate environment of the prior 15 years may prove optimistic.
Even against this backdrop there are opportunities in the resources sector. The energy crisis of last year has eased due to one of the warmest winters on record so far. That has left gas starved Europe with full inventories and awash with previously contracted liquified natural gas (LNG) imports, causing gas prices to fall 80% from their mid 2022 peak.
Nevertheless, that is still 300% higher than the price at the end of 2019. Gas supply tightness won’t end until significant LNG export capacity additions from US and Qatar occur from late 2025 onwards, in the meantime leaving Europe exposed to weather and capacity reductions in heavy industrial demand.
While the energy crisis has eased, it may rear its head again later in the year should European temperatures return to seasonal norms. Europe will be short of Russian gas for the summer restock period and Asian demand is expected to pick back up, competing for LNG flows.
Oil and gas equities trade at historically low earnings multiples with solid balance sheets, whilst energy use is far less discretionary than, for example copper demand, which is used in white goods or increasingly eletric cars. Not only has the Russian-Ukrainian conflict become a prolonged war of attrition but sanctions and price caps will continue to impact supply.
Since early November, China has unofficially removed its zero-Covid policy that saw entire districts locked down for just a few alleged cases. The pace of this shift has been surprising and has led to the majority of those in urban centres having been infected and now suggesting herd immunity is possible, where vaccine efficacy and general uptake has been low, especially amongst the old.
This should lead to a pickup in general economic activity as well as travel which should be supportive for commodities, especially oil. China’s focus is returning to growth with economic stimulus plans reported by the PBOC, although those measures for the property sector appear to be aimed at dampening the effects of the property crisis and aiding completion of current projects rather than encouraging a surge in new building.
The supply of global commodities looks wholly under prepared for even moderate demand growth. In oil markets, OPEC have limited spare capacity and the quicker response shale producers simply aren’t ramping-up activity significantly.
In copper, we are barely seeing enough investment to maintain production, never mind meet the large deficit expected over the next decade. Broadly speaking, ESG policies that have focused on emissions reduction rather than production growth from the likes of Rio Tinto to Shell have broken the supply response function which may sustain higher prices for longer than expected.
With long lead times of around a decade for large oil and copper projects, there is limited ability for a quick supply response. With current macro uncertainty, rising project build costs, an uncertain regulatory backdrop (as highlighted by the UK’s energy windfall tax) there is further discouragement to investment into new supply from the major producers.
China’s post-Covid economic reopening and renewed focus on a return to growth remains important to the commodity demand outlook. This should help offset the more fragile economic outlook in Western economies, which are far less material to incremental commodity demand than China given high recycling levels in metals and a lower demand sensitivity to pricing.
Commodity cycles are driven by shifts in the balance of supply and demand. Current prospects for a prolonged high prices environment look likely to be supported more by constrained supply of our own making.
Stronger pricing should enhance producers over the next decade. Oil and gas producers trade at low historic earnings multiples, so look attractive on both a top-down and bottom-up view, though given the macro uncertainty a basket approach including some haven precious metal and base metal exposure may help reduce volatility.
Rob Crayfourd is a portfolio manager at New City Investment Managers. The views expressed above should not be taken as investment advice.