From the Economist's Chair: The pros and cons of super-cycling

Author David Fyfe, Argus Chief Economist

Commodity prices have moved sharply higher since November amid disrupted supply, healthy Chinese import demand and vaccine successes, with imminent demand recovery and broader inflation concerns now stoking expectations of a commodity super-cycle. However, persistent economic risks and divergent trends between key commodities make a cross-commodity bull run in 2021 unlikely just yet.

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Prompt commodity prices have surged since November, following the US election, successful deployment of Covid-19 vaccines and more recently as daily virus caseloads worldwide have fallen. Renewed risk appetite has spilled over from equities into crude oil, metals and cereals. Speculative net length in crude has regained pre-pandemic highs. Buoyant Chinese demand, tight commodity supply and ample liquidity have pushed commodity prices 20%-50% higher since October. Plummeting winter temperatures and voluntary Saudi Arabian supply restraint have further bolstered oil and energy prices in early-2021.

Nymex WTI futures

In contrast, the safe havens of gold and the USD, go-to assets amid 2020 market turmoil, have faded, with ongoing dollar weakness only amplifying the bullish commodity narrative. Benchmark energy, metals and agricultural futures are now firmly in backwardation as surplus inventories built early last year have drawn more quickly than expected. Some see a looming global commodity super-cycle, barely a decade after the last one ended.

With bumper fiscal stimulus planned to continue in 2021, and monetary policy from the US Federal Reserve unlikely to tighten in the next 12-24 months, the spectre of broader price inflation again looms. Runaway inflation seems unlikely, given the uncertainties that still surround Covid-19, but the fact that inflation is again on asset managers’ radar suggests commodities’ historical role as an inflation hedge could re-emerge.

Modest energy price gains going forward could also tempt equity investors back into a sector that slumped from 13% of global portfolios in 2011 to barely 3% now. If significant inflationary pressures were to re-emerge, equity markets might weaken overall, but also rebalance, with higher-value stocks like technology suffering, while hitherto cheaper equities including financials and energy potentially recover.

Annual real commodity prices

China has helped fuel price increases, with industrial and services sector recovery post-1Q20 encouraging 10% annual growth in major commodity imports in 2020. Chinese demand should remain robust in 2021, even amid an investment re-orientation from infrastructure and real estate towards industry and personal consumption. The People’s Bank of China is expected to allow further modest strengthening in the Chinese currency, something that would also be supportive of commodity imports overall.

Supply constraints augment the bullish prognoses

In the metals complex, copper and iron ore production from Brazil, Chile and Peru fell in 2020, while 2021 supply is threatened by stubbornly elevated regional virus levels, ongoing economic fragility and threats of strike action (raising concerns too over Latin America’s agricultural exports). Suppressed mine investment may also limit metals exports from mid-decade, potentially coinciding with an expected uptick in global copper demand as electrification and decarbonisation gather pace.

The impact of extreme weather on natural gas supplies and prices was evident in January and February in North Asia and the southern US states respectively. Prices have since returned close to pre-winter levels as natural gas markets appear well-supplied on an underlying basis. Nonetheless, the rapid price increases played into a broader commodity bull narrative.

Unlike these involuntary supply impacts, Opec+ producers voluntarily curtailed crude oil output last April by nearly 10mb/d, with tapering production cuts running until April 2022. Signs of fraying discipline by Russia and others this January were quickly offset by a Saudi Arabian pledge to cut an additional 1 mb/d of supply in February and March. Although tacitly an acknowledgement of precarious oil demand recovery, the Saudi action was interpreted bullishly, on assumptions Opec+ would indeed adhere to supply restraint until 2022.

The 2020 oil demand collapse has accelerated consolidation in the US shale sector, with US crude production still 2 mb/d below pre-Covid levels, 2020 capital spending down by 40% and surviving producers now reciting a “value, not volume” mantra. Shale’s recovery depends on prices high enough to generate positive net cash flow. Nonetheless, the days of 1mb/d-plus annual growth in US supply are long gone. More broadly for oil, Total’s Head of Strategy and Innovation recently warned of a 10 mb/d oil supply crunch by mid-decade if last year’s 30% cuts in global upstream capex are not quickly reversed.

Mitigating factors for 2021

Despite these bullish supply-side signals, and the rebound across the commodity complex since 2Q 2020, calling a 2021 super-cycle still looks premature. Uncertainties remain over virus suppression, so too trajectories for 2021 economic activity and commodity demand. The following factors could, to varying degrees, undermine the super-cycle story in 2021:

1) Patchy progress on Covid-19 and uneven economic recovery

Robust economic recovery represents the consensus 2021 outlook (circa +5% year-on-year vs. -4% contraction in 2020), assuming Covid-19 cases continue to decline as vaccines deploy more widely. However, with daily global Covid deaths near 10,000 in February (+40% vs. October 2020 levels), widespread relaxation of lockdowns remains a way off. A tapering of restrictions looks more likely than a sudden global re-opening. The WHO expects it will take until mid-2022 before widespread global vaccination coverage is achieved. A full recovery in long-haul travel might also be two to three years away.

Overall economic expansion will likely be volatile and uneven between sectors and geographies, with China leading the recovery, as it has since second quarter 2020. But high levels of global unemployment will persist, notwithstanding ongoing government financial support.

2) Inflation fears may be overdone

Inflation fears assume pent-up consumer demand, unleashed as lockdowns ease, coincides with supply-side constraints to drive prices higher. Large global government stimulus and historically low interest rates re-enforce a likelihood of upward price pressures. So too an expectation that the economy’s supply capacity has been impaired during the pandemic, and that a focus on industrial supply chain resilience will further raise costs.

These factors may drive inflation over time but elevated unemployment, particularly in services, could provide an offset. Moreover, expectations for accelerated de-globalisation have receded since the early days of the pandemic, and so too the risk of global supply chain cost inflation. China and others may selectively prioritise local manufacture and diversify supply chains, but with potentially less inflationary impact than previously believed.

Similar fears of accelerating inflation followed the Great Recession a decade ago, amid exceptional fiscal and monetary policy too, but subsequent inflation remained subdued. Moreover, governments today retain ample adjustment levers if the pace of price rises risks undermining recovery. The ECB, US Fed and IMF recently suggested that temporary spikes in inflation should not be confused with more gradual, sustained price rises, noting also that inflation risks themselves are a lesser risk to the global economy than premature withdrawal of stimulus. Positive inflation near government targets seems more likely in 2021 than sharp increases that would spur a massive asset reallocation into commodities.

3) China’s import demand increasing but not evenly between all commodities

With China’s economy expected to grow by 8%-plus this year, commodity imports will rise further. However, commodity import growth may be less widespread than in 2021.

Expansions in oil refining, petrochemical capacity and oil storage will underpin strong crude oil and gas imports. The metals sector looks more nuanced. The 2021-2025 Five-Year Plan will likely accelerate electrification of the Chinese economy. This provides a structural underpinning for copper demand, which may also benefit cyclically as investment in 2021 rotates towards the industrial sector and away from infrastructure and real estate, which dominated investment growth in 2020.

Reduced infrastructure investment should moderate iron ore imports, a trend likely to be re-enforced by government mandates for steel mills to curb supply in 2021 for environmental reasons and to progressively shift towards electric arc furnaces and away from blast furnaces.

Growth in agricultural imports seen in 2019 and 2020 after the decimation of the Chinese herd due to African swine fever may also ease as the herd is now nearing replenishment.

4) Oil market rebalancing assumes supply-side restraint

Oil demand in 2021 could reclaim 5-6 mb/d of the 9 mb/d lost in 2020, assuming steady economic recovery focused in the second half of the year. Despite a return to modest non-Opec supply growth at $50-$60 prices, ongoing Opec+ discipline could drain surplus inventory by the end of the year.

Uncertainties around Covid-19 and the economy apply equally for crude as other commodities, although demand-side risks are magnified by the 60% share of oil demand concentrated within transportation. Arguably for crude oil though, fault lines in the Super-Cycle theory lie more on the supply side of the equation.

Foremost is Opec’s current 5-6 mb/d of spare capacity, plus any upside from current Libyan supply. In addition, the Biden Administration’s pledge to revitalise the JCPOA Iran nuclear agreement could partially reinstate 2 mb/d of shuttered exports. Few expect fully recovered Iranian supply before late-2021 or early-2022, but progress in negotiations could weigh on prices later this year.

Moscow and Riyadh will be aware this timeline coincides with Opec+ negotiations on renewal of their supply restraint deal ahead of its April 2022 expiry. Signs of discord before then could further dampen crude’s recent price recovery. And while US shale now appears a chastened shadow of its former self, don’t discount either that prices above $50 WTI may start to fuel more modest production growth from 2022 onwards.

Conclusion

Individual commodities, regions and sources of supply confront divergent prospects in 2021, suggesting a commodity-wide bull run is unlikely this early in the cycle. Cyclical demand recovery is expected but could be diluted by more structural policy shifts from the incoming Biden Administration, and after the COP-26 Summit in November, aimed at accelerating the energy transition/de-carbonisation agenda.

Notably, while metals confront ongoing supply-side tightness, demand-side shifts in these markets may undermine the more bullish expectations for 2021. In contrast, for oil it is incremental supply that risks spoiling the party for the year ahead. All told, commodity prices should strengthen year-on-year in 2021, but there may be bumps in the road before we return to super-cycle territory.

Uneven commodity recovery since 2Q 2020

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