In 2017 commodity prices (ex-agriculture) have fallen by close to 6% from their February peak to a recent trough in early March, with crude oil leading the sell-off (Exhibit 1).
The speed and depth of the correction raises important questions about the outlook for cyclical commodities such as crude oil and base metals: what was the key driver of this correction? Is the adjustment temporary or is there more pain to come? What is the cyclical and fundamental outlook underlying crude oil and metals prices? Finally, does this price action merit a change in our asset allocation decisions regarding the asset class? This note seeks to answer these questions.
Source: Bloomberg, BNP Paribas Investment Partners as of 16 March 2017
Reasons for the correction – too much good news priced in
The correction in cyclical commodity prices is better understood when one considers how much ‘good news’ had already been priced in. On the demand side, for instance, commodities and other risky assets were factoring in a robust outlook for economic activity in the developed world, including the prospect of reflationary fiscal stimulus in the US, as well as a revitalised cyclical outlook for the Chinese economy.
On the supply side, crude oil markets had discounted the production cuts agreed by OPEC in November. In the case of base metals, markets were aware of the transition to a more constrained supply outlook following the 2011-2015 bear market. The tipping point is likely to have been the fact that inventories remained high both in crude oil and base metals (notably copper). In particular, investors in crude oil markets have remained sensitive to US inventory levels after the dramatic rise in production from 2010 to 2015. It is perhaps not surprising that it was a further US inventory build-up that accelerated the recent fall in oil prices.
Finally, investors in commodity futures had been positioned heavily on the long side. This historically large number of longs could be seen as a sign of froth in the market and an important reason behind the speedy correction. All of these factors together meant that cyclical commodities had become vulnerable to a correction, in our view.
An upbeat fundamental outlook for cyclical commodities
While a price correction was probably due, we see little evidence of a bearish trend developing. Perhaps the most convincing argument is the robust fundamental outlook for cyclical commodities. On the demand side, there is no reason to drop the reflation proposition yet. Momentum in economic activity is strong in the developed world and fiscal stimulus in the US would add to that.
In China, there is also strong momentum in various economic indicators as a result of the aggressive fiscal and monetary stimulus in recent years. That support should wear off over time, but we think it is by no means imminent. Indeed, a synchronised global manufacturing recovery appears to be in place and this is typically positive for commodity prices (Exhibit 2).
Source: Markit and Bloomberg, as of 16 March 2017
The prospects for supply are perhaps less clear-cut, but there are a few important developments that should support prices. In crude oil markets, OPEC members are so far complying with the agreed production cuts. Exhibit 3 shows that since their agreement in November, production has dropped to close to the new target of 32mn b/d. The main risk here is that compliance will slacken, with Iraq the most likely sources of upside production surprises.
Exhibit 3: So far, OPEC members are complying with agreed production cuts
US crude oil supply is now stabilising following the rapid increase since 2010, but investors are aware that US shale production can rise quickly. However, we are quite confident that given the high level of global demand, even low growth rates will be enough to return the market to balance given reasonable assumptions on supply (such as further expansion in US supply, but more restricted OPEC supply).
This brings us to another important point: commodities are real assets and they tend to post positive returns and outperform other assets (e.g., equities and bonds) when the business cycle is mature, i.e. when growth and inflation are above trend. This is related to the prospects for roll returns (carry). As commodity markets tighten, front-end (near-term) prices rise by more than those at the back end, leading to backward sloping (or backwardated) curves. Roll returns are positive for such backwardated curves and can help boost returns at the mature stages of the business cycle.
Improving fundamentals and the Fed support prices
Perhaps the biggest hurdle to surpass is that inventories remain high both in crude oil and copper markets and commodity investors will feel more confident when they see material drawdowns. This is happening, but very gradually. Indeed, US crude inventories fell in the week ending 17/03/17 for the first time in 2017, following a small build-up in February.
We are aware that the supply curve in the crude oil market is now more elastic than it was in previous years, so while we see scope for upside from current prices, it should prove difficult to breaking the USD 55-58 per barrel range that prevailed in January and February. In the case of copper, the supply outlook is likely more supportive, especially if outages in some big mines persist. The outlook for demand is less clear. The main upside risks are the by-products of China’s monetary policy stimulus such as higher house prices. But Chinese economic growth is also slowing down structurally, so demand for base metals could weaken further out as the effects of policy stimulus fade.
Finally, the US Federal Reserve’s dovish policy rate rise on 15/03/17 can also be seen a bullish factor for commodities in the near term. Monetary policy is unlikely to become an immediate headwind for risk assets. The US dollar rally now looks stretched relative to other major currency and some softness would be good for commodities. Finally, the policymaking FOMC seems to be more tolerant of inflation, which also bodes well for real assets such as commodities.
Asset allocation: commodities underweight closed
We have been underweight commodities since early April 2016. The non-agricultural index that we used to implement the strategy is up by close to 13% since inception of the trade. This means that the position was under water, but adding in the negative carry on oil limited the damage. Nevertheless, we saw the recent sell-off in oil prices as a good opportunity to close this trade. The negative roll returns are still punitive for outright long positions in crude markets. But given our constructive view on commodities we will look for opportunities to add long exposure in due course.
Written on 17 March 2017