Commodity Rally Slows on China Lockdowns and Fed Angst
Commodity Markets Fundamental Analysis
The commodity sector rally has unsurprisingly slowed down during the past couple of weeks as the market continues to digest a whole host of developments impacting the sector. During the first quarter, war and sanctions turbocharged an already strong performing sector, resulting in the Bloomberg Commodity Spot Index registering a 24% gain, its best quarter in living memory, thereby almost eclipsing the 2021 gain of 26.5%, the best annual performance since 2000.
The war in Ukraine and increasingly tough sanctions against Russia have uprooted multiple supply channels from crude oil and gas to key industrial metals as well as food commodities such as wheat, corn, and sunflower oil. All developments that have created logistical challenges and elevated input costs for many industries to the extent that some heavy energy consuming industries have started to scale back production, thereby supporting the painful and potentially long route towards stabilising prices through lower demand.
As the war drags on and hostilities temporarily slow down, the market attentions have turned to the lower demand theme which is currently being driven by some short and other more long-term developments. Crude oil is the most noticeable in this context, having shed most of its invasion-driven gains with the focus turning to China’s worsening covid outbreaks, the release of strategic reserves and a hawkish turn by the US Federal Reserve raising growth and demand concerns.
The possibility of the U.S. tumbling into a recession next year was an outcome suggested by some analysts this week after the Federal Reserve raised the prospect of faster pace rate hikes to combat high and widening inflation. The market has almost priced in ten 25 basis points rate hikes during the next ten months, with the Fed’s Bullard looking for an even faster pace. In addition, the Fed will start to aggressively trim its balance sheet from May and the reduction of liquidity will have the same impact of three or four additional 25 basis point hikes.
Inflation remains a key concern for the market and while it was talked about in 2021, it is now increasingly being felt by consumers and businesses around the world. The impact of EU gas prices trading six times above their long-term average on heating bills and energy intensive production from cucumbers to steel and fertilizer is being felt and the economic fallout can increasingly be seen.
Global food prices meanwhile remain a key concern as highlighted by the FAO Food Price Index. In March it jumped 12.6% to a record after the war wreaked havoc on supply chains in the crucial Black Sea breadbasket region, a key supplier to the global market of wheat, corn and vegetable oils.
While the index was 33% higher than the same time last year, the latest increase reflected new all-time highs for vegetable oils (23.2% MoM, 56.1% YoY), cereals (17.1%, 37.3%) and meat sub-indices, while those of sugar (6.7%, 22.6%) and dairy products also rose significantly.
The prospect of continued supply disruptions from Ukraine this year together with US and South American weather concerns as well as the mentioned rise in the cost of fuel and fertilizers will likely led to another year of tightening supply.
In Ukraine, according to UkrAgroConsult, military actions in some key production regions, closed supply lines and lack of fuel could result in a 38% y/y reduction in the wheat harvest to 19.8 million tons and 55% reduction in the corn harvest to 19 million tons. In the US, the conditions of the winter wheat crop have slumped to the worst level in a decade amid dry soil conditions while surging cost of fertiliser may negatively impact crop production in South America.
Gold traded unchanged on the week as it continued to find buyers despite a stronger dollar and Treasury yields reaching a fresh cycle high after the Federal Reserve signaled a more aggressive trajectory for rate hikes and quantitative tightening. We maintain a bullish outlook for gold, a view that has been strengthened recently by the yellow metal’s ability to find fresh buying interest despite an increasingly hawkish Fed and the breakdown in the normal strong inverse relation with US real yields.
Overall, however, the yellow metal remains stuck in a wide $1890 to $1950 range with selling attempts in the futures market being offset by asset managers and long-term focused investors seeking protection through gold ETFs against the risk of slowing growth, elevated inflation as well as continued volatility in bonds and equity markets. A fresh upside attempt remains difficult to achieve without renewed support for silver and platinum, both currently struggling on a relative basis with the XAUXAG ratio above 78 and platinum’s discount to gold at a 17-month high at 967 dollars per ounce.
Copper, the so-called king of green metals, continues to enjoy some tailwind from other industrial metals. Most recently zinc, where the threat of shortages, especially in Europe where LME stocks are critically low, has seen the price move higher. Copper did trade near a one-month high earlier in the week after Chile, the world’s largest producer of the metal, reported a 7% year-on-year decline to 399,817 tons in February, this following a drop of 7.5% year-on-year in January.
While a tight supply outlook and the green transformation will continue to underpin prices over the coming months, the market currently must deal with negative developments in China where draconian lockdown measures to combat covid outbreaks are likely to weaken the growth outlook by more than the government had originally forecast.
Once the covid cloud has lifted, the Chinese government is likely to step in with additional measures to stimulate growth and that should help off-set the impact of lower growth elsewhere caused by soaring prices and accelerated tightening from the US Federal Reserve.
After reaching a record high above $5 per pound last month, HG copper traded back to $4.5 per pound before moving higher again. The outlook for copper remains supportive with tight supply offsetting the risk of an economic slowdown. We maintain this bullish view to take prices to a fresh record high later this year. In the short term, a break below the 200-day moving average, currently at $4.41 per pound, will not ruin our bullish view, only prolong the period of range bound trading.
US and EU gas markets
US and EU gas markets went in opposite directions thereby supporting a long-awaited convergence between the two. US Henry Hub reached a 2008 high near $6.50/mmbtu, driven by robust domestic demand due to unseasonal cold weather and strong export demand for LNG. Natural gas inventories shrank by 33 billion cubic feet last week, with inventories now some 17% below the five-year average, the widest gap since 2019.
In Europe meanwhile, a reluctance to ban Russian gas, together with milder weather and record LNG imports have seen the price of Dutch TTF gas traded lower but at €108/MWh or $34.5/mmbtu it remains very elevated and at levels that will continue to negatively impact demand. Europe and especially Germany’s U-turn on Russian gas dependency will require high prices during the coming months in order to attract record oversea supplies of LNG.
Crude oil has drifted lower following weeks of extreme turbulence and near record prices and this week it managed to retrace most of the invasion-driven gains after breaking below the uptrend from the December low. There are several reasons why the market focus has, at least for now, turned away from the loss of Russian barrels.
The four major factor, some of which are temporary, being 1) EU avoiding adding Russia crude to its growing list of sanctioned products, 2) China’s worsening covid outbreak and extended lockdowns driving a temporary contraction in fuel demand, especially for diesel and jet fuel, 3) slowing US gasoline demand in response to high prices and the prospect of an economic slowdown as the FOMC steps up its battle against inflation, thereby hurting demand, and finally 4) the release of millions of barrels of crude oil from strategic reserves held by the US and other members of the International Energy Agency.
With the war ongoing and the risk of additional sanctions or actions by Russia the downside risk to crude oil remains, in our view, limited. In our recently published Quarterly Outlook we highlighted the reasons why oil may trade within a $90 to $120 range this quarter and why structural issues, most importantly the continued level of underinvestment, will continue to support prices over the coming years.