multi-asset
In this late-cycle phase, how high could commodity prices fly?
We are probably at the end of an economic cycle. Several quarters before some form of ’landing', a number of market mechanisms typically activate, including the relative outperformance of emerging-market assets, a rise in long-term interest rates and an increase in commodity prices. In this weekly instalment of Simply put, we focus on the future growth potential of commodity prices.
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Soaring energy prices
Commodity prices, and energy prices in particular, have soared recently, despite the rise in the US dollar. While this situation is not inconsistent with our view of a late-cycle phase, it does raise questions about the potential for price increases in these markets.
Prices were generally higher in the aftermath of the pandemic, attracting increasingly less-efficient producers to the market and boosting their overall breakeven thresholds. At the same time, we are experiencing one of the lowest decades of capital expenditure (capex) in this sector, which is constraining supply.
Today, our nowcasting signals show signs that demand is improving in the US and stabilising in China: a situation which could well see prices surge in the face of these two supply-side phenomena. This is a key consideration today, especially considering it is starting to look like inflation is being brought under control.
So, if commodity prices are likely to rise further, how high could they fly?
Oil has room to grow
Let’s start with oil. There are a limited number of macro variables that are pivotal in determining barrel prices: production costs, inventory levels and industrial demand. Many other micro factors are also usually in play, including OPEC production cuts. But let’s start by assessing the impact of the macro factors.
With the data we have today, these three factors lead to a fundamental value of USD 72 per barrel (see figure 1), up from about USD 45 at the end of the pandemic. What's happened?
The factors have overlapped: demand has drained inventories, pushing up prices and accommodating less-efficient producers in the market, raising average production costs. This situation is reminiscent of the 2007-2008 period, when the fundamental price rose from USD 42 to USD 76 for the same reasons.
Until recently, an increase beyond USD 100 seemed unrealistic but has now become more likely. Historically, the price of a barrel rises to around 40% above this fundamental value, which would correspond to USD 104 a barrel on today's figures. But that's not all: we're currently in an extremely weak commodity capex cycle, and this is likely to be reflected in prices.
Figure 1: The price of West Texas Intermediate compared with its fundamental value
Based on production costs, inventories and industrial demand
Source: Bloomberg, LOIM as at September 2023. For illustrative purposes only. Past performance is not a reliable indicator of future results.
Capex collapse
The current situation shares few similarities with that of 2008, but there is one aspect that cannot have escaped the reader's attention.
We've just come through a cycle in which capex in the commodities sector has collapsed. From 2009 to 2015, the industrial metals sector saw investments approaching 0.2% of global GDP, but this percentage has fallen to 0.1% over the last three years. The same applies to the energy market: from 2009 to 2015, no less than 0.4% of global GDP was invested in the sector, although this figure has recently fallen to 0.25%. What happens when less is invested in developing production in these markets?
The answer is shown in figure 2. As capex declines, returns on these markets tend to increase the following year. It could well be that, with industrial activity increasing in the US and stabilising in China, this surge in demand will meet limited supply for a few quarters. In this scenario, higher cyclical commodity prices could surprise investors and central bankers alike.
Let's not forget that energy inflation does not concern central bankers if it is temporary. But in the 2008 tightening cycle, recall that the European Central Bank’s (ECB) final hike was spurred by energy inflation. Investors should keep watch on commodities – especially the energy and industrial metals sectors.
Simply put, commodities could continue on their upward trajectory, boosted by higher equilibrium prices and inelastic production.
FIG 2. Capex correlation?
The relationship between capex (as a ratio of GDP) and commodity returns one year later
Source: LOIM, Bloomberg as of September 2023. For illustrative purposes only. Past performance is not a reliable indicator of future results.
Nowcasting corner
The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises designed to track the recent progression of macroeconomic factors driving the markets.
Our nowcasting indicators currently show:
- Growth remains low but is improving
- Inflation pressures continue to build, notably in the US
- Surprise monetary-policy moves could be in order – notably in the US, where recent macro data could force the Federal Reserve’s hand
World growth nowcaster: long-term (left) and recent evolution (right)
World inflation nowcaster: long-term (left) and recent evolution (right)
World monetary policy nowcaster: long-term (left) and recent evolution (right)
LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).
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