Commodities have achieved strong price gains recently, prompting speculation that we could be in the early stages of a so-called super-cycle; a sustained period of growing demand exceeding supply. Global commodity prices have moved higher in the past few months, partly due to geopolitical issues such as Russia’s invasion of Ukraine. A mismatch of demand and supply has also affected prices.
However, despite robust demand for commodities, producers have been reluctant to increase supply, adding further pressure on prices. We spoke to James Luke, a commodities specialist at Schroders, to find out what’s behind the supply and demand changes in the commodity market, in particular the effects of China’s demand weakness, and what impact a global recession could have on the market.
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Where are we in the commodity cycle?
James Luke said: “Structurally, we’re still in the early stages of a multi-year cycle. When we talk about commodity cycles, we must talk about long-cycle and short-cycle impacts. Over the past weeks, we’ve seen some significant jitters push through various parts of the commodity complex. Oil prices are down, metals prices have been selling off their highs, and there’s some clear cyclical worries around that.”
“Most notably, we’ve had China struggling through rolling Covid-19 lockdowns in various cities. At the same time, we’ve seen the first signs of potentially peaking manufacturing indexes in developed markets. And add to that, significant worries about what tightening liquidity is going to do to all markets, in general.
“As commodity analysts, we focus on fundamentals. Firstly, if we look at balances for 2022 and into 2023, we still see very constrained markets. We see close to record low inventories in agriculture, very low inventories in oil and oil product markets, which are still in deficit, even assuming you get a demand slowdown from here. Ultimately, we think the issues that we’re seeing in China from a Covid perspective are transitory.
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“Then if you talk about the actual structural underlying drivers, we are not seeing a high supply response to higher prices, and that ultimately is what gives this cycle longevity. One of the absolute core reasons for that is the extent to which investment in commodities has become persona non grata because of its negative ESG characteristics.”
Why are companies so afraid to add supply in an environment where prices have risen so dramatically?
James Luke said: “In a nutshell, the returns environment is very uncertain. Commodity investments, particularly in the energy and the metal space, are very long-cycle, because you’re essentially investing for 15 to 20 years. Most observers and government officials are telling you that oil demand is going to collapse in five years as the world transitions to clean energy. So, would you want to make multi-billion-dollar investments into something which could well be a stranded asset less than halfway through the life of the asset?
“Huge quantities of base metals are required to enable the energy transition and yet the production of that metal is, on the whole, carbon intensive and the ability to add ’clean‘ supply is limited. This is an unresolved paradox, and it is an important part of the reason capital investment remains low despite the increase in prices.”
How do the sanctions against Russia impact supply?
James Luke said: “Our view is that we have not yet felt the impact of sanctions on Russian supply to the global market. We think the embargo Europeans have launched will fully start at the end of this year with some concessions to consumers like Hungary. That is going to significantly reduce global oil supply. There is no way, in our view, that you can divert even half of that supply into the Far East. “
How has the reduced demand from China affected commodities markets?
James Luke said “Chinese demand is indeed extremely weak, but I would say we’ve already absorbed a significant property market retrenchment in China. We’re absorbing a significant shock to oil demand, and yet oil inventories globally remain low. Metals inventories globally remain low, particularly in Shanghai, which is very striking.
“It comes down to the view of whether the Covid-19 stress is a permanent feature of the Chinese market, or is it something that is creating a short-term headwind to demand. Ultimately, the Chinese government will force their way through it, and the end result, ultimately, will be further stimulus to the economy.
“China’s role in commodity markets today is very different from when they were the nascent kind of super-cycle consumer of 2002 until 2005. This was when China was suddenly changing from being a net exporter of almost all commodities in the 1990s to being a massive importer of metals and slowly increasing their oil imports too. Clearly, the construction cycle is much, much later stage. Anyone expecting Chinese metal imports to surge like they have in the past, is clearly going to be brutally wrong.
“While China is not going to go through another inflection point like we saw in the 2000s for metals markets, it might well be going through an inflection point of similar magnitude in agricultural markets. The reasons for that are clear; we’ve got very difficult domestic production trends and increased per-capita consumption. We believe the government is laser-like focused on the stockpiling of agricultural and broader commodities because they are quite worried about the external environment.”
How do factors such as deglobalisation and decarbonisation favour a commodity supercycle?
James Luke said: “Deglobalisation would create much more stressed supply lines and chains across commodities, meaning it’s going to be harder for some companies to bring on new projects in different parts of the world. Indeed, one of the consequences of the Russian-Ukraine crisis is that it is a wake-up call to governments that have become overly reliant on specific regions.
“Decarbonisation feeds directly into the concept of ‘greenflation’, the sharp rise in the price of materials used in the creation of renewable technologies. From an ESG perspective, decarbonisation in the commodity sector also presents some challenges, unless you have the absolute greenest source of power, or access to hydro resources for aluminum smelting, to get bank financing for this type of project.
“In general, decarbonisation presents a dilemma. As demand for the metals needed for electric vehicles or wind turbines explodes, production of these materials is getting harder due to the rising costs of carbon permits.”
If the US Federal Reserve engineers a recession, how would this affect the case for a commodity super-cycle?
James Luke said: “If you manage to engineer a global recession, then clearly that has to impact demand calculations. You would see further destruction, ultimately, of oil product demands. Aggregate metals demands would be lower than previously forecast.
“But you have to put in very substantial declines in oil demand this year to get the market into surplus. In a global recession environment, you probably would see looser balances, higher ending points for inventories, but does it derail the overall thesis? Absolutely not.”
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