The commodity sector remains on the backfoot this month after a supportive focus on China’s reopening was replaced by fresh growth and demand concerns, not least in the US where recent economic reports have shown continued strength in the labor market while inflationary pressures have eased by less than expected. Continued strength in these numbers has forced the Fed to turn up the hawkish rhetoric, and the market has responded by raising the expected terminal Fed funds rate while at the same time sending bond yields and the dollar higher, thereby hurting risk sentiment across stock and commodity markets.
Meanwhile, geopolitical risks remain elevated, which may further speed up the transition to regionalisation following two decades of unconstrained globalization. Reshoring and friend sharing may push up prices, thereby supporting our view that inflation is unlikely to drop to the levels that are being targeted by central banks, and currently priced in by the market. In addition to a commodity-intensive green transformation, and continued growth in China and India, we see limited downside to the sector beyond the current weakness which is driven more by a lack of market confidence than an actual slowdown in demand.
This week also marks the tragic one-year anniversary of Putin’s so-called special operation, which was only expected to last for a few days. The attack on February 24 last year was a major miscalculation on Putin’s part, with Russia having suffered one military and economic defeat after another. Part of the miscalculation was Putin’s belief that the rest of the world would roll over just as they did following the annexation of Crimea in 2014. However, attacking a sovereign nation with an elected government on Europe’s doorstep was not going to be tolerated and, in the weeks and months that followed, Russia was increasingly targeted by sanctions.
Russia and Ukraine are both major suppliers of raw materials to the global economy and, faced with the risk of supply being disrupted, the weeks that followed the invasion saw several key commodities—from crude oil and natural gas to wheat and some industrial metals—rally sharply. Ukraine, a major supplier of grains to the global market, saw its supply lines being attacked and disrupted, thereby temporarily sending wheat futures in Chicago to a record last March before reversing lower after a UN-sponsored grain export corridor was opened.
Russia was hit by very severe sanctions resulting in a voluntary buyers’ strike which, for a brief period, saw Brent crude oil spike to near $140 a barrel while the gasoil (diesel) futures in Europe at one point hit $223 a barrel. The London Metal Exchange index meanwhile surged to a record high, led by nickel and aluminum—the latter a very energy intensive metal to produce—while nitrogen fertilizer produced from natural gas also went on a tear.
An attempt to reduce the resolve of Europeans through higher gas prices remains Putin’s biggest economic miscalculation. Gas and power prices did initially surge higher last summer when Gazprom successively turned off the taps on three of its five major gas pipelines to Europe, thereby reducing its pipeline exports by around 75%. While a period of market panic followed, the timing of the reduction in flows during the low summer demand season provided Europe with more time to source gas from other suppliers while also putting in place initiatives that would help reduce demand during the winter period.
One year on and the Dutch TTF benchmark gas contract is trading more than 40% below pre-invasion levels. This has been driven by a combination of mild winter weather and, in most cases, a voluntary reduction in demand from consumers and industry.
Earlier this week, Eurostat wrote on its website that EU consumption of natural gas had dropped 19.3% between August and January, compared with the five-year average consumption for this period. Adding up total gas flows from rising LNG imports, stable supply from Norway and the trickle from Russia, we find a year-on-year drop of 20%. These developments have preserved gas in storage to the extent that EU gas storage sites are currently 63% full compared with a pre-invasion level of 31%. Apart from a strong pick up in gas demand from China, these developments should see Europe comfortably through next winter as well.
Crude oil, rangebound since November, continues to lack the directional input that may see it break out of established ranges, for Brent between $80 and $89, and for WTI between $73 and $83. The recent weakness has, as mentioned, primarily been driven by a lower investment appetite with a supportive pickup in demand from China and India being more than offset by macroeconomic developments, not least the prospect of US interest rates moving higher and staying there for longer.
Following its longest losing streak this year, crude oil saw fresh buying as prices approached the lower end of the current range. Bids emerged despite a ninth straight week of rising US crude inventories—taking total stocks to 479 million barrels and their highest since May 2021. Refinery demand for crude oil towards production of fuel products such as diesel and gasoline has taken a hit, along with demand for gas, both in Europe and not least in the US, following warmer than expected weather across the Northern Hemisphere this winter.
Despite strong exports, especially to Europe, rising US crude stocks are likely to weigh on the market and investor sentiment, especially WTI which has seen the front end of the forward curve trade in contango for a while now. The opposite remains the case for Brent, the global benchmark, where a backwardation has been supported by sanctions against Russian oil, Opec+ production restraint and the mentioned demand recovery in China. The impact on investment returns between these two different curve structures are clearly visible in the chart below which shows the one-year total return in Brent and WTI. Taking the roll into account, an ETF tracking Brent crude has returned 10.4% during the past year while a similar investment in WTI would have led to a 5% loss.
Ole S. Hansen, Head of Commodity Strategy, Saxo Bank
Oman Observer is now on the WhatsApp channel. Click here
