To The Moon

Numerous commodities have seen their prices explode higher over the last year. What drove the rally in commodity prices in 2021 was the pandemic induced supply shortage coupled with the global economic recovery spurring demand. In essence, this backdrop created a supply-demand imbalance in the equation.This year, we witnessed yet another rally in commodity prices as the Russian invasion of Ukraine added additional stress to supplies that are already struggling to meet demand.

Russia and Ukraine are both exporters of commodities. The former is among the largest global oil producers with a market share of 12% and the second-largest producer of natural gas. Additionally, it also has a decent market share for copper, steel, and nickel. Ukraine on the other hand is an exporter of food sources – wheat is the commodity widely exported.

While the US and its allies have thus far stopped short of imposing direct sanctions on Russian oil and gas, it has become increasingly clear that Russian exports are being ostracised – US has signalled that it will ban imports of Russian oil and economies in the Euro-area have pledged to reduce dependence on Russian energy exports, banning coal for a start, which will take place in mid-August 2022.

Hence, with so much uncertainty surrounding the supply side of the equation and demand has been growing as global economies continue to ease restrictions, market participants have begun to price in a supply shock as they await further news developments.

Chart 1: Commodities started the year on the front foot. Source: Bloomberg

Amidst the prevailing macro environment, we believe that the pertinent question investors have in mind is: ‘Will commodities prices experience a sustained rally?’. Our short answer is yes. Commodity prices will be driven higher in our view, bolstered by 1) low oil inventories, 2) market participants looking to commodities as an inflation hedge and 3) robust demand in the years to come, albeit with risks.

Oil inventories are low

The rise in energy prices is no stranger to market participants and the reason behind the ferocious rally is well telegraphed on various news sites – the sharp synchronous rebound in economic activity around the world created a surge in demand that outpaced supply even before the military conflict between Russia and Ukraine broke out.

Chart 2: Consumption has risen back to pre-pandemic levels. Source: Bloomberg

Putting the military conflict aside, the greatest factor behind the shortage of supply is the lack of capital expenditure from companies in the oil and gas sector – the oil and gas sector has largely been starved of capital which resulted in underinvestment over the years. This comes on the back of producers placing emphasis on capital discipline and responding to ESG-related activism by shareholders. Hence, in the absence of a faster ramp-up in production, we now note that oil inventories are depleting rapidly – according to IEA, at the end of January, OECD inventories were 335mb below their five-year average and at an eight year low.

Further aggravating the issue of supply constrains is the fact that the OPEC+ has decided to stick to its strategy of gradually reopening the taps – OPEC+ is slated to raise its output targets by a modest 432,000 barrels per day from May despite sustained pressure from top consumers calling for the group to increase output rapidly to cool oil prices and aid the economic recovery.

No doubt, some may argue that OPEC countries have the ability to ease supply constraints but in our view, we think that OPEC+ output capacity is insufficient to make up for the loss of Russian energy should sanctions hit the oil and gas sector even if they increased supplies into the market nor is Saudi Arabia and its allies willing to put in jeopardy the relationship with Russia which has allowed the cartel to take back control of the oil market.

Lastly, even if a nuclear deal that paves the way for sanction relief falls through for Iran, additional supplies coming from Iran will only act as a plaster over the wound. Therefore, we believe that supply constraints will only ease when the issue of underinvestment is resolved – the time frame for resolving underinvestment remains unclear and could possibly take years. Therefore, the lack of supply in the marketplace will keep prices of energy, more specifically oil on the high side.

Chart 3: Oil inventories are depleting rapidly. Source: Bloomberg

Commodities act as an inflation hedge

Investors’ concerns over elevated inflation which have rippled through global economies continue to be at the crux of the topic in the investment world – market-based inflation expectations have pushed higher and, in some cases to all-time highs while real yields remain near their lows. In the midst of such a market terrain, nominal asset classes such as equities and fixed income have repriced sharpy while commodities on the flip side of the coin have stood to gain.

Chart 4: Five-year forward inflation expectations continue to inch higher. Source: Bloomberg

The strong performance of commodities does not come as a surprise to us given that history suggests that commodities outperformance during periods of rising and high inflation and the only exception was during the 2018 central bank hiking cycle as gleaned from chart 5 – material outperformance comes during the middle and late stages of business cycles.

Chart 5: Periods of high inflation spell positive for commodities. Source: Bloomberg

Hence, we believe that flows into commodities will remain high given that the asset class will provide critical diversifications for investors at the current juncture – real yields are near their lows and the broader equity and fixed income market are instilled with fears on the back of Central Banks’ policy path to tame price pressures

Demand for commodities to remain robust

China has signalled a willingness to deploy extra policy support to ensure stable economic performance ahead of an important party leadership congress later this year. The initiative sets the prospect for higher commodity prices due to the nation’s position as a dominant buyer of metals – the fiscal policy will loosen to accommodate this year’s growth objective, which includes infrastructure spending that requires a large number of metals such as steel, iron, and copper ores.

Chart 6: China’s credit growth leads to higher commodity prices. Source: Bloomberg

Outside of China, demand is expected to rise as well. For example, the European Union (“EU”) has committed to huge fiscal spending over the next few years, with a sizeable portion of the EU Nextgen fund tilted towards climate-specific spending – the transition to green energy will unleash an unprecedented demand for metals in the coming decades.

Moving to the supply front, commodity supply was already tight and was going to lag demand due to structural under-investment, weather, and labour. However, with the war in Ukraine, supply chain issues have been magnified as sanctions are affecting Russia’s ability to export key base metals which is crucial to meet the burgeoning demand from various nations in the years to come.

Riding on the commodity upcycle

For investors who wish to have a slice of the pie, you can look to the $Threadneedle (Lux) Enhanced Commodities AU USD(LU0515768298.USD)$. The fundis managed by David Donora and Nicolas Robin who combines more than 50 years of experience in the industry with an investment objective to seek capital appreciation that is directly and indirectly linked to commodity markets.

Investment philosophy wise, the team’s fundamentally driven investment process which aims to generate outperformance, implements both active weights (two-thirds of the alpha is generated via active weighting decisions such as rebalancing of weights driven by the investment process) and curve positions (one-third of the alpha is generated by capturing volatility and movement in the term structure) as it seeks to maximize performance outcome within the tracking error budget constraint.

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