By Ole Hansen, Head of Commodity Strategy at Saxo
 Ole Hansen |
A year-long commodity sector correction showing signs of reversing
The commodity sector looks set to start the third quarter on a firmer footing after months of weakness saw a partial reversal during June. Multiple developments, some based on expectations and some on actual developments, have all contributed to the gains last month, one of them being renewed and broad dollar weakness, the exceptions being against the Japanese yen and Chinese Renminbi, OPEC’s active management of oil production and prices, the not-yet-realised prospect for the Chinese government stepping up its support for the economy and, not least, the risk of higher food prices into the autumn, as several key growing regions battle with hot and dry weather conditions.
Despite continued demand worries led by recession concerns in the US and Europe, the energy sector is holding up – supported by Saudi Arabia’s unilateral production cut, rising refinery margins into the peak summer demand season and speculative traders’ and investors’ belief in higher prices being near the weakest in more than ten years, thereby reducing the risk of additional aggressive macroeconomic-related selling. Elsewhere, we are seeing a returning El Niño raising concerns across the agriculture sector.
The precious metal rally ran out of steam during the second quarter, as surging stock markets reduced the need for alternative investments while central banks continued to hike rates in order get inflation under control. Inflation may fall further but we increasingly see the risk of long-term inflation staying well above the 2% to 2.5% target area, and together with a growing bubble risk in stocks, continued strong demand from central banks, and the eventual peak in short-term rates as the FOMC shifts its focus, we see further upside for precious metals into the second half of the year.
The recent performance across the different commodity sectors could be the first signs of markets bottoming out, with current levels already pricing in some of the worst-case growth scenarios. Data on the US economy is still showing economic activity below trend growth but is also not showing recession dynamics, and earnings estimates have increased substantially, especially in Europe, since the Q1 earnings season started in mid-April.
The potential for additional gains from here, however, will primarily depend on whether China can deliver additional stimulus, thereby supporting demand for key commodities from crude oil to copper and iron ore. Avoiding a recession elsewhere could see the focus among commodity consuming industries switch from destocking – a process that has played a key part in sending prices lower in recent months – to restocking in order to meet an eventual pick-up in demand. Weather developments across the coming weeks across the Northern Hemisphere and their impact on crop production will also be key.
Gold pausing but a fresh record high remains the target
Following a strong run-up in prices since November, gold spent most of the second quarter consolidating after briefly reaching a fresh record high. Sentiment is currently challenged by the recent stock market rally and surging US bond yields amid the prospect for additional US rate hikes, the latter delaying the timing of a gold supportive peak in rates. So while the short-term outlook points to further consolidation below 2,000 dollars per ounce as we await incoming economic data, we keep an overall bullish outlook for gold and silver, driven among others by: continued dollar weakness; an economic slowdown, making current stock market gains untenable, leading to fresh safe-haven demand for precious metals; continued central bank demand providing a soft floor under the market; sticky US inflation struggling to reach the 2.5% long-term target set out by the US Federal Reserve (and if realised, it will likely to trigger a gold-supportive repricing of real yields lower), and a multipolar world raising the geopolitical temperature.
In addition, silver may benefit from additional industrial metal strength, which could see it outperform gold. Overall, and based on the expectations and assumptions mentioned, we see the potential for gold reaching a fresh record high above $2100 once the market gets confirmation a peak in rates has been reached.
Dr Copper: building a foundation
Copper spent most of the second quarter on the defensive, after a less commodity-intensive recovery in China upset expectations for a strong rebound in demand of key industrial metals. However, during June, the prospect of additional China economic stimulus and falling inventories at exchange-monitored warehouses to a five-month low helped trigger a change in sentiment from hedge funds who, up until then, had traded copper with a short bias.
Additional China stimulus or not, we view the current copper weakness as temporary, as the green transformation theme in the coming years will continue to provide strong tailwinds for so-called green metals, the king of which is copper – the best electrical-conducting metal needed in batteries, electrical traction motors, renewable power generation, energy storage and grid upgrades. Adding to a challenged production outlook as miners see lower ore grades, rising production costs, climate change and government intervention, as well as the ESG focus which reduces the available investment pool provided by banks and funds.
From its current level well below $4 we see the High Grade contract eventually move higher and reach a fresh record high, potentially not until the new year when the global growth outlook and the central bank rate focus turns to cuts from hiking.
Crude oil: FOMC versus OPEC
WTI and Brent crude oil’s sideway trading action since May looks set to continue into July with global economic growth concerns continuing to be offset by the willingness of key OPEC+ members to sacrifice revenues and market share to support the price. Overall, we believe prices are near a cycle low, but a few more challenging months cannot be ruled out, primarily because of worries that a robust pickup in demand, as forecast by OPEC and the IEA, will fail to materialise. The latter is potentially the reason Saudi Arabia took the unprecedented step of announcing a unilateral production cut shortly after the group announced production cutbacks.
It all adds up to what could become a challenging few months for OPEC, especially if demand should fail to recover with Saudi Arabia, then raising the pressure on other producers to curb production. For now, the de facto leader of OPEC has managed to send a signal of support which may help prevent a deeper correction, while an eventual price recovery, which we believe will occur, could be limited given the elevated level of spare capacity that sits ready to meet any pickup in demand, especially from key Middle East producers, which following the latest 1 million barrel a day production cut from Saudi Arabia now sits on an approximate 6 million barrels a day of spare production capacity.
Until then, the crude oil market will be focusing on the tug-of-war between a broader risk off sentiment, driven by rising yields amid the prospect of further Fed rate hikes being offset by signs of tightness in the physical market where the front of the curve in both Brent and WTI have returned to backwardation. Brent will likely remain stuck in the $70’s before eventually breaking back above to the psychologically important $80 level, thereby shifting the current 70-80 range higher by 5-10 dollars, where it may be trading ahead of year-end.
Crop production risks downgrade amid rising weather concerns,/h3>
The agriculture sector remains on high alert for the potential impact of a returning El Niño. A weather phenomenon that strongly tilts Australia towards drier and warmer conditions, with northern countries in South America — Brazil, Colombia, and Venezuela — likely to be drier and Southeast Argentina and parts of Chile likely to be wetter. India and Indonesia also tend to be dry through August in El Niños.
Even before seeing an increased El Niño impact, the three major crops of corn, soybeans and wheat have already experienced a very volatile period which during the past five weeks has seen the new crop futures contracts of soybeans jump 18% and CBOT wheat 8%. Meanwhile corn trades down 4% following a recent top to bottom slump of more than 20%. These developments have been driven by an alternating focus between drought and beneficial rains, and a surprise change in acreage allocations, especially between corn and soybeans. In addition, Ukraine’s grain export deal expires on July 17 and the market is once again worried Russia will refuse to accept an extension that may impact the peak export months from August to October.
