Commodities’ Summer of Discontent: Limited Supply Flexibility Poses Material Risks
Heading into 2022, the commodity markets were broadly strengthening as demand recovery collided with several years of underinvestment in production. Events in Ukraine have accelerated these trends and exposed a need to embark on a significant investment cycle to meet future energy needs and address climate and security concerns.
Given previous poor governance and environmental considerations, the supply response has been more muted than would have been expected pre-COVID-19. Our concern now is that additional energy supply disruptions or a poor growing season in the North American agricultural harvest will require demand rationing, since there is so little capacity to increase supply in the short term. Simply put, many commodity markets face a very fine balance this summer, with potential for price spikes should anything go wrong with harvests or additional energy supply losses.
Supply-side considerations drive energy outlook
Just a few years ago, $80 per barrel of crude oil (bbl) would have spurred North American production sufficient to keep up with trend demand growth. In 2022, with prices north of $100/bbl, we expect capex to remain about 15% below 2018 levels and production growth roughly half previous rates.
The factors behind slower growth and lower supply elasticity are multifold: 1) poor governance has led investors to prioritize return on investment and return of investment over production growth, and companies are responding; 2) state and local environmental opposition has been very effective in constraining production growth, particularly in the wet gas-heavy central Appalachia region; 3) climate-related concerns are increasing uncertainty of demand over the next decade or two, reducing willingness to deploy capital in long-lived projects. In addition, underinvestment the past few years is a global phenomenon that has significantly reduced productive capacity in OPEC and OPEC+ countries – and this was before Russian supplies were impaired. In short, limited spare capacity due to previous underinvestment and a constrained investment response is making today’s energy crunch that much more challenging to resolve. Nowhere are these supply considerations more acute than in Europe, where lack of supply flexibility in power and gas sectors is contributing to record prices.
Critical growing season is ahead
Similar to energy, even before the war in Ukraine, global and U.S. agricultural inventories had been tightening due to a broad-based demand recovery, rising production costs, and production shortfalls in key growing regions due to adverse weather. Against this backdrop, the sudden loss of Ukrainian exportable supplies – which are especially acute in wheat, corn and vegetable oils – and a large cut in Russian exports owing to war-related trade finance, banking and logistical issues, have induced significant additional price volatility.
Unfortunately, there are few obvious mechanisms to balance markets apart from price-driven demand rationing. The prospects for demand rationing this year appear especially uncertain given the rise in trade protectionism driven by declining inventories in many major agricultural/food-importing countries; although explicable from a domestic security standpoint, export bans and proposals to build strategic agricultural reserves may only exacerbate near-term inventory stresses.
Given the annual agricultural production cycle is relatively short and the production base is highly disaggregated, historic supply shocks have usually been relatively transitory as weather patterns returned to normal and high prices were met with expanded planting interest. It is entirely possible that weather during the balance of this year (and into next) will be far less challenging than the global scale of issues witnessed in 2021 and thus far in 2022, alleviating some stress in the market. However, historically high costs of production, limited scope for easily tapped additional farmland in many countries, and rising trade protectionism will likely keep agriculture prices higher than in the past decade, and volatility in the sector appears likely to remain elevated amid what are becoming increasingly fatter-tailed weather and geopolitical risks.
Demand slowdown concerns are real, but manageable
While crude oil prices are not at records in real or nominal terms, prices of gasoline and diesel are. In addition, for nearly all non-U.S. dollar-denominated consumers, the cost of fuel is well above previous records. The same can be said for the cost of food. Together, real incomes are declining and the commodity basket burden as a share of GDP is approaching a record. Against this backdrop, we do expect demand to decelerate. However, while little help to the Global South, savings today should help provide an offset to the income drag for services and travel, which support key transport fuel usage. In addition, we would expect food and energy vulnerabilities will likely lead to some hoarding of critical goods, compounding problems. Last, although Europe does appear finally awakened to the risks to their natural gas supplies, too many policymakers globally are cutting taxes and offering subsidies when and where possible to help consumers, which reduces the price signal effect needed to change behaviors. As the world undergoes a transition unparalleled in our lifetime, largely due to various implications of COVID on the economic landscape, it’s an open question just how much demand will be lost.
Commodity prices pose key risk to inflation and broader asset prices
This set up certainly creates a challenging backdrop for investors, particularly those concerned about both inflation and being too late to invest in the commodity cycle. We have sympathy for this latter concern given many commodity investors’ checkered experiences over past 20 years.
However, given the importance of inflation to asset prices over the next few years, as well as considerable supply risks associated with weather and geopolitics that could precipitate price spikes to reduce demand, we view an allocation to commodities or a multi-asset inflation solution as a useful complement to traditional equity/fixed income portfolios. In addition, commodity indices today offer a nearly 15% positive carry (one-year forward commodity prices are 15% lower than spot), greatly reducing the hurdles for such a commodity allocation. In many respects, investors are being paid to hedge a key risk to asset markets.
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