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The global commodities complex continued to receive strong investor support over the past month as the world economy entered unfamiliar territory. After more than a decade of worries about inadequate demand and spending power in the aftermath of the global financial crisis, signs of insufficient supply are now emerging in commodity markets and supply chains driven by a post-pandemic surge in demand.
Amid upbeat economic data, there is now strong demand for construction and manufactured goods around the world aided in part by the hopeful pace of COVID-19 vaccination in major economic centres, translating into more demand for basic commodities. Demand growth is robust because it started at relatively low levels due to the pandemic, which also led to some curtailment of capacity, explaining why consumers have seen shortages of lumber and other key products recently. Additionally, both consumer and wholesale materials are experiencing supply chain disruptions around the world.
All forms of transportation are experiencing delays (some intermittently), including ocean freight, air freight, trucking and rail. These factors have been driving prices higher with lumber, iron ore, steel, copper and palladium prices all touching all-time highs in May, while corn and soybeans traded near their highest levels since 2012.1 Backorders have multiplied as plastics, cotton, palm oil, coffee, pigs, chickens, paper products, packaging, chemicals and other items were also facing shortages tied to the release of pent-up demand and a global supply chain crunch. A recent analysis of commodity trade networks revealed inadequate supplies of numerous rare minerals crucial to the manufacture of mobile phones, electronics and medical equipment were also upsetting the global marketplace.
Although the world was not running out of commodities, there were signs that supply bottlenecks may lead to unwelcome surprises that could upset the post-pandemic recovery as the logistics system cannot handle such a spike in (previously pent-up) demand in a short period of time. Nowhere were shortages more acute than in America, where a boom is underway: US consumer spending is growing by over 10% at an annual rate, as people put to work the estimated US$2 trillion-plus of extra savings accumulated in the past year, while more stimulus is still being doled out.2
Rising inflation expectations and a subsequent boost in investor demand for assets with inflation-hedging capabilities, like commodities, also provided a market lift. Expectations for further global growth and a greater need to compensate for inflation risk—along with excess liquidity, historically low real interest rates, fiscal stimulus, and a weaker trade-weighted US dollar—have underpinned the commodities’ rally year to date.
A Look at Key Commodity Moves in May
With the demand picture showing clear signs of improvement, crude oil prices reached their highest levels in 2-1/2 years as oil analysts and the OPEC+ alliance (The Organization of Petroleum Exporting Countries and select major oil producers outside the cartel) forecasted a tightening global crude oil market. Crude and refined-product inventories have been gradually eroding throughout the spring with the robust recovery in the United States and Europe, so that the oil glut built up during the COVID-19 pandemic was almost eliminated and stockpiles were projected to ebb rapidly in the latter half of 2021. By mid-May, US gasoline prices averaged above US$3 a gallon for the first time in more than six years. The surge followed severe weather disruptions in Texas and the 7 May shutdown of the Colonial Pipeline, North America’s largest petroleum conduit, after a cyberattack.
US natural gas futures rose in May on strong liquefied natural gas (LNG) exports and warm weather forecasts that signaled the onset of potentially higher cooling demand for the power-plant fuel. Supply constraints also bolstered natural gas as late-May US inventories of 2.215 trillion cubic feet were 14.7% lower than a year earlier and 2.8% under their five-year average.3 Fundamentals remained supportive heading into June: demand has rebounded as more businesses reopen, while supply has not yet fully responded.
Precious and Industrial Metals
Momentum in the gold market has been strong this spring with inflation risks in sharper focus, though demand was also stoked by US dollar depreciation and the potentially uneven economic recovery due to the resurgence of COVID-19 in some countries. Investor flows into gold bullion-backed exchange-traded funds—a major driver of 2020’s gold rally—accelerated in May following several months of relative stagnation. Gold erased its 2021 losses as spot prices rose 7.8% (to US$1,907 per troy ounce) in May, the biggest monthly advance since July 2020.4
Industrial metals rebounded toward the end of May after a volatile month dominated by concerns over inflation, credit tightening in China and new coronavirus outbreaks. Copper and all five other primary base metals tracked by the London Metal Exchange (LME)—nickel, aluminium, zinc, tin and lead—traded higher, underpinning the LME Index’s 4.1% gain for the month. Copper was also up sharply in the past year as the metal’s price has essentially doubled from a post-COVID low.5 Copper supplies, already tight as the global economy recovers, could be further strained by a predicted fivefold rise in green energy demand in the current decade, leading to significant shortages starting in the mid-2020s, according to some industry analysts.6
Despite ongoing concerns about supply risks amid unprecedented Chinese demand, major crop prices cooled off in May following strong recent gains. Corn and wheat futures did, however, bounce back near month-end due to increased risks to crop progress and yields associated with persistently dry US and Canadian weather. Russia also downgraded its 2021 wheat crop forecast. Corn prices are still up approximately 36% in 2021, while soybeans and wheat are up roughly 16% and 4%, respectively. Rising corn, soybean and wheat prices reflect increases in exports and lower inventories compared with previous years. Plus, drivers are returning to the road as the pandemic subsides, and the recovery in demand for gasoline and ethanol, a blend stock, was good news for corn growers.
Commodity Volatility Looks Likely to Continue
Natural resources equities have been caught in a tug of war between the positive aspects of reopening trends in the United States and Europe and the dire circumstances related to resurgent COVID-19 cases in countries such as India and Brazil. While the latter factor weighed on the group in March and April, the improving demand narrative was ascendant in May and early June when the stocks rebounded strongly. We expect this volatility to continue as investors and traders assess the magnitude and sustainability of the demand recovery, which is complicated by the potential for shorter-term effects such as pent-up travel demand and consumers flush with cash.
Among the important questions are whether shifts in consumer behaviour are temporary, permanent, or something in between, and how might they shift fuel consumption in the future? Consumers also shifted towards consumption of goods during periods of mobility restrictions and now appear to be shifting back towards services-oriented consumption, which may weaken demand for the hard goods that boosted consumption of metals and other materials. However, this effect may be offset by government infrastructure spending, which could maintain robust demand trends that have driven some commodity prices to all-time highs.
While the impact of these trends can be nearly impossible to estimate with precision, what we do know is that expectations call for strong US economic growth for the rest of this year and likely into 2022 as government spending and other stimulus efforts course through the economy. And though some countries continue to suffer from additional waves of COVID-19, mass inoculation appears to be having a profound impact in regions where vaccinations have been widely available, a trend that should be repeated throughout the world by the first half of next year, which could further fuel the reopening growth trajectory.
We think these demand trends, when combined with the kind of spending discipline we have seen from large commodity producers, are likely to maintain a healthy price environment and allow natural resources sector companies to generate significant free cash flow. Moreover, the demand uncertainties mentioned above, in addition to stakeholder pressure, have the potential to prolong the cycle as companies’ lack of response to price signals has continued to limit supply.
This last point—stakeholder pressure—is becoming an increasingly important topic, particularly given events during the last week of May when an activist shareholder succeeded in promoting the election of three directors to Exxon’s board and Chevron shareholders passed a resolution calling for a report on the potential impact of net-zero emissions policies. Meanwhile, Royal Dutch Shell lost a court case in The Hague, Netherlands, requiring the company to reduce its emissions more aggressively despite the company’s front-foot efforts related to energy transition.
On the resource nationalism front, countries in South America and Africa have been moving towards higher production taxes as they seek to extract larger economic rents. We believe all of these are manifestly positive for longer-term supply trends and prices as investors, activists and governments more aggressively pursue their agendas.
The Post-Pandemic Inflation Factor
Investors have become increasingly concerned that persistent inflation may be on the rise given a perfect storm of tight commodity markets, widespread price increases, labour shortages and government stimulus, present and future. While some factors may be temporary, others such as commodity supply constraints are likely to be longer-lived and have yet to be fully reflected in finished goods prices. This factor, combined with workers requiring incentives to return to the labour force, seem to be potent ingredients for inflation, which has been relatively tame in the United States for the last 30 years.
Commodity-linked industries, such as oil and gas production and mining, often perform well in inflationary environments primarily because the price elasticity of demand and supply are relatively low, particularly in the short term, due to a lack of substitutes and the time required to develop resources. It may be folly to make bold claims about persistent inflation after 30 years of minor price increases and it may once again prove to be a false alarm, but if there were ever a time when it made sense to have some inflation protection, this would seem to be it.
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1. Source: Bloomberg, LP.
3.> Source: Energy Information Administration (US Dept. of Energy).
4. Source: Bloomberg, L.P.
5. Source: London Metals Exchange.
6. Source: Bloomberg, L.P.