Growing Demand, Tight Supply Support Commodities in 2023

Investors may be wondering how long commodities markets can sustain the rally they’ve been on since the spring of 2020. Higher interest rates and decelerating growth (and potential recession) in key developed markets are likely headwinds in 2023. However, China’s rapid reopening alongside post-pandemic demand growth globally, plus supply-side factors including persistent low inventories and the uncertainty around the Russia-Ukraine war, bolster the case for continued high commodity prices over the coming year.

Looking longer term, a prolonged period of limited supply-side investment along with the secular transition toward renewable energy sources could further support commodity prices, and energy in particular.

Market drivers for 2023: Continued tightness, China’s reopened economy

A key factor underpinning commodity market strength in recent years is significantly tight supply across many sectors, which we expect to continue. This trend is driven partially by a recovery in global demand and by adverse weather affecting important crops, but primarily by underinvestment in supply. The net result is low inventories in base metals, agriculture, and petroleum.

The market impact can be seen in the shape of the forward pricing curve. Low inventories and tight balances have led to a state of positive carry, where front-end (spot) futures prices are higher than longer-term (forward) futures prices. Positive carry is evident in the majority of the constituents in the Bloomberg Commodity Index, elevating the fully collateralized return to an attractive 6%–7% level. Undoubtedly the Russia-Ukraine war exacerbated commodities tightness and pushed carry higher in the past year, but the impact of underinvestment was already evident prior to the invasion in February 2022.

Russia is a source of volatility and uncertainty, but in our base case Russia will likely remain a catalyst for higher commodities prices overall. For example, the European Union’s ban on imports of Russian oil products, effective in February 2023, could put upward pressure on prices for refined products, though this has been partially tempered by Europe’s relatively warm winter. The impact is already being felt, as evidenced by record refinery margins and historically high premiums for prompt delivery of many refined products.

The macro environment should broadly support commodities in 2023. Although central bank rate hikes have curtailed growth in developed markets, China’s reopening offers the potential for a large offset – China has an outsize influence given the commodity intensity of its economy. The effects of China’s reopening alongside continued low inventories provide a broad fundamental tailwind, but individual commodity sectors are likely to experience varying price impacts:

• Energy, especially refined oil products: Early signs suggest travel to, from, and within China is likely to rebound in 2023, though not yet to pre-pandemic levels. Over time, this should spur higher demand for gasoline, diesel, and jet fuel, bolstering prices.
• Agriculture: We generally favor agriculture, where supply-side issues have underpinned higher prices and likely won’t abate much in 2023. Several years of disruptive weather have damaged crops in many regions, and this is compounded by the war in Ukraine, a major producer. Inventories are lean across much of the supply chain, despite the pandemic years when China hasn’t been a big buyer, suggesting potential vulnerability as China’s economy picks up. Much will hinge on the weather in the Northern Hemisphere this coming summer. Given poor initial soil conditions, prices will likely be more vulnerable to any adverse weather developments.
• Industrial metals: Reported inventories are quite low. Although we don’t expect a Chinese manufacturing surge -- the lockdowns had hurt services more than manufacturing, and export demand remains weak – a revival of the real estate sector should help metals demand. That said, much of the metals complex has already priced in China reopening.
• Gold: Historically, China has been a major buyer of gold, and it could provide a tailwind to prices in 2023. However, given strong recent performance, we view gold as rich at current levels, and we expect higher real yields may weigh on gold prices this year.

The secular story: Underinvestment in energy production capability

History suggests that this sustained period of high prices should encourage supply-side investment that in turn boosts production, balances demand, and reins in prices over time. Today, however, the supply response has been much less than in past periods of comparably high prices – and lower than what may be needed to meet expected future demand. To motivate sufficient investment, we believe even higher price levels are needed than current forward curves for many commodities indicate.

While this could be a convincing argument for commodities’ long-term prospects, investors may be understandably skittish. Within recent memory (2012–2013, 2017–2018), similar periods of high prices amid limited supply sparked excitement but ended poorly: Rampant increases in investment created supply that outpaced demand and drove prices down. The specific catalyst in both of those periods was a surge in North American production – a surge so substantial that U.S. production growth alone exceeded global demand growth.

Today, however, we are seeing the opposite: lower investment growth despite higher prices. U.S. companies are spending a significantly lower share of revenue on upstream investment than during prior periods of high prices. Companies are also returning more money to investors and investing an increasing share of revenue in energy transition technologies. (The long-term transition toward green energy could be another driver of higher and more volatile energy prices – for details, please read our February 2022 Viewpoint, “Energy Transition A Jarring Path to Green.”) When rising costs are factored in alongside the general slowdown in efficiencies, over the next few years we expect U.S. energy output will grow at a fraction of the rates previously observed when prices were elevated.

With OPEC spare capacity near historical lows, the lack of upstream investment globally is likely to be supportive for prices – and potentially disruptive for the global economy should there be another supply shock.

Key takeaways for investors

In any environment, an allocation to commodities may provide diversification and a potent inflation hedge within an investment portfolio. As we have seen over the past two years, traditional investment portfolios can be vulnerable to unexpected increases in inflation. Commodities can offer a potent hedge to inflation. Given the level of positive carry and our overall constructive outlook on the sector – particularly in energy and agriculture – we see a compelling case for owning commodities and, at the very least, the expected “cost” of hedging inflation risk via a commodities allocation appears low.