2016 was the year when the commodities bear market ended. It capitulated in January when crude oil fell below $30 a barrel and a number of commodity-producing companies in the energy and metals sectors were in a battle for survival, selling off assets and desperately restructuring their balance sheets.
As commodity prices fell below the cost of production, these companies were losing money at a rapid rate. If oil stayed below $40, then 20 per cent of global capacity would have gone out of business. Similarly, major mining companies Glencore and Anglo American were forced to liquidate significant parts of their overall businesses to reduce debt and to shore up their balance sheets.
The market recognised that prices were unsustainably low and there was a small bounceback. As we enter January 2017, prices are rising further. This is because, although prices fell in 2015 and the beginning of 2016, demand for commodities continued to increase; not at an extremely strong rate but fairly consistently. And so the requirement for increased production over the medium term remained. The question for 2017 is whether the market bounces along the bottom or prices increase significantly. My view for 2017 is that we will have significantly higher prices.
Performance of Bloomberg Commodities index over 2016
Source: FE Analytics
The Bloomberg Commodities Index rose 11.8 per cent in 2016. That does not signal a bull market. In my view, a commodity bull market is when we experience a doubling or tripling of commodity prices. In the bull market of 2000-2008, the index tripled in value. That was a full commodity bull market. 2016’s rise is just bouncing along the bottom.
So, prices have risen, significantly in base metals and in energy. In oil, OPEC countries and a number of non-OPEC countries led by Russia have agreed to take 1.8 million barrels per day of production off the market to reduce excess inventories more quickly than they would otherwise have been depleted.
Performance of Brent crude over 2016
Source: FE Analytics
Demand outstrips supply
The question for 2017 is whether the market bounces along the bottom or prices increase significantly. My view for 2017 is that we will have significantly higher prices for a number of reasons.
Firstly, the supply side is not in a position to respond to significant demand growth. While commodity producers have spent the last three years dealing with very low prices, focusing on balance sheet restructuring and saving cash, they have not brought on new projects. Also, in mining they have been ‘high grading’ (only producing the highest grade ore) to just stay cash-neutral or cash-positive. After commodity prices bottomed in early 2016, demand is outstripping supply once again, suggesting the next bull market may be approaching.
Secondly, I expect there will be significant demand growth. Emerging markets demand will be greater than the market expects, especially in Asia. China has been going through economic restructuring for a number of years. We believe that it is coming through that and there will be stronger consumer-led demand from China and all Asian emerging markets.
Thirdly, we think that in the developed and emerging markets, consumers have enjoyed low food and energy prices for two years, and that has shored up their finances and now they are also receiving higher wages. So, we expect consumer demand for commodities to increase. For example, for two years the oil price has been around $50 rather than $110. That halving in the price of oil was worth $2tn per year to the benefit of consumers, at the expense of oil-producing companies and countries. Longer term we are bullish about precious metals as well.
Gold is likely in the short term to continue to be weak while bond yields are rising. Commodities, in general, are negatively correlated with bonds but gold at the moment is behaving more like a low-yield reserve currency and less like a commodity.
Fourthly, governments of both developed and emerging countries are signalling a shift in focus from monetary policy to fiscal policy and fiscal stimulus. They recognise that quantitative easing has not materially helped consumers and consider that fiscal stimulus is more likely to do so. We expect to see the US, Europe and Japan turning to fiscal stimulus, while China continues to deploy it. That will increase demand for commodities.
A widespread trend
The increase in demand is likely to be most acute in base metals. Copper, zinc, nickel and aluminium should benefit from a substantial increase in consumer demand for metals.
We think the growth rate for oil demand will continue to be strong in 2017. The return of supply discipline will keep the oil price on an upward trajectory. It is worth noting that there is very little spare capacity globally.
If the OPEC agreement holds and 1.8 million barrels are taken off the table globally, that accounts for almost all surplus inventory, leaving the world vulnerable to a supply disruption. We have concerns about this given the security situation in the Middle East. The new US administration is unlikely to want to be the region’s peacekeeper. And while the Russians have become more involved, it is not clear whether this will contribute to stability or not. It is likely that the boundaries drawn up in the Sykes-Picot Agreement 100 years ago will be redrawn.
Longer term we are bullish about precious metals as well. Gold is likely in the short term to continue to be weak while bond yields are rising. Commodities, in general, are negatively correlated with bonds but gold at the moment is behaving more like a low-yield reserve currency and less like a commodity. Gold will be weak when bond yields are going up and bond yields have some way to go. Once bond yields plateau we would expect to see gold strengthen again.
Performance of LBMA Gold Price PM in 2016
Source: FE Analytics
Turning to agricultural commodities, there have been two years of abundant harvests as the El Niño weather cycle’s stable weather pattern has prevailed. But this has ended, so weather is likely to be more variable in growing regions and so crop yields are likely to fall. Our view is that despite having two great years to rebuild stocks, they are only adequate. If the next Northern Hemisphere harvest is compromised, we will see upward pressure on agricultural prices.
Start of the bull market?
Across the commodity markets as a whole, we expect 2017 to be another positive year. Inventories are tightening. Commodity curves are flattening, which supports prices and returns for investors. Producers are likely to have difficulty keeping up with demand over the next couple of years. We have had the end of the bear market, after which there is normally a period of bouncing along the bottom. While this historically has persisted for two to five years, we think that a focus on improving the lot of consumers could bring this forward to 2017.
David Donora is head of commodities at Columbia Threadneedle Investments. All views are his own and should not be taken as investment advice.