Is A Quick Recovery In Store For Energy And Other Commodities? by Columbia Threadneedle Investments
- Supply is outpacing demand growth for most commodities, putting prices under pressure.
- Despite the boost from lower petroleum prices, global economic growth should continue to be the primary driver for oil demand over the next few years.
- Longer term, the incentive to add new oil supplies to meet demand growth and offset natural production declines will likely require prices considerably higher than current levels.
By Jonathan G. Mogil, CFA, Portfolio Manager and Senior Analyst and Josh Kapp, CFA, Portfolio Manager and Senior Analyst.
In the wake of the August swoon, investors have sorted through the rubble, looking for opportunities that might have emerged. Energy and natural resource shares were particularly hard hit, and the question thus being asked is whether fundamentals justify the declines and whether now is a good time to buy. Answering these questions generally starts with a discussion of supply and demand. For most commodities, production capacity was developed throughout the commodities super-cycle that began roughly a decade ago, much of which has come online just in the last few years. Technology and innovation, which have driven the shale revolution domestically, for example, have also expanded and changed the nature of supply growth. Meanwhile, the anticipated demand from China’s continued growth that was to absorb this supply has also fallen short of most expectations. The result is that supply is outpacing demand growth for most commodities with prices thus under pressure.
Imbalances within the oil markets largely stem from an abundance of supply, which up until very recently has failed to show any signs of moderating, despite the dramatic decline in oil prices over the past 12 months. The combination of a slower response from U.S. shale producers and increased output by OPEC has resulted in global production rising 3.1% YTD versus last year. Over the same period, oil demand continues to grow at a healthy pace (1.9% YTD) as lower petroleum product prices have led to increased consumption in many countries, including the U.S. In fact, a recent report by the IEA predicted demand growth for 2015 at 1.8% is on track to post its highest year-over-year growth in five years. The largest risk on the demand side remains a slowing of global economic growth, particularly in China and other developing markets. Despite the boost from lower petroleum prices, global economic growth should continue to be the primary driver for oil demand over the next few years.
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Given the capital intensive nature and long lead times associated with bringing new conventional supply on stream, oil markets rarely stay in perfect equilibrium, and instead overshoot in both directions, as we saw before and after the global financial crisis. During the current downturn, the hope had been that U.S. shale producers would provide a smoother and faster self-balancing mechanism, taking on the role traditionally held by the OPEC cartel, which has now chosen to increase production in a quest for market share. Earlier this year, U.S. production growth failed to show signs of slowing as producers slashed capital budgets and the U.S. oil rig count proceed to decline by 60% peak to trough. More recently, data by the EIA suggests that U.S. production has already started to roll over on a month-to-month basis. It is our view that volumes will start to decline on a year-over-year basis sometimes during the fourth quarter. The key risk to reaching equilibrium from the supply side remains the speed and magnitude of additional Iranian exports (should sanctions be lifted), as well as how the rest of OPEC responds in the face of additional supply in an already oversupplied market.
Recently, the financial press has been abuzz about a call for $20 per barrel oil by a well-respected commodity analyst. While possible in the near-term, over the next few years we expect oil to trade well above current levels. Prices over the next few months should remain in the $40-$50/bbl range unless supplies build beyond existing storage capacity limits. In that case, producers would require an incentive to curtail production, likely in the form of prices at or below cash production costs. Longer-term, the incentive to add new oil supplies to meet demand growth and offset natural production declines will likely require prices much higher than $20 per barrel, although perhaps not the $100 per barrel producers had gotten used to over the past few years.
Aluminum is somewhat different than most other commodities in that demand growth has remained fairly strong driven by end markets such as aerospace and autos. For example, Alcoa recently estimated global demand growth for aluminum at 6.5% for 2015. However, supply growth is proving even more robust, leading to excess production of roughly 760,000 tons, equivalent to 1.0%-1.5% of consumption. Production curtailments are clearly needed to balance the market, and shutdowns have been occurring at higher-cost smelters. However, new capacity, primarily in China, also continues to come onto the market, suggesting that the market will remain in surplus for the next few years.
China comprises over 40% of global copper consumption, and its demand is thus a key driver of the copper market. China’s copper consumption slowed considerably in 2015 while supply advanced considerably in the last couple of years. As a result, copper is also in surplus, with many forecasts putting the surplus at roughly 500,000 tons, equivalent to 2.0%-2.5% of consumption. However, the supply outlook has improved recently, with Glencore having recently announced production cuts equivalent to roughly 400,000 tons. Thus, the market is moving closer to finding a balance. Even without such significant production cuts, most forecasts assume that copper moves back into deficit in the ‘17/’18 timeframe. Scarcity in future years is expected to support higher long-term prices, making copper one of the more attractive metals despite the current apparent surplus.
China comprises over half the world’s steel production capacity and it imports most of the world’s seaborne iron ore to support this capability. Perhaps nowhere is the global supply response to China’s demand needs more evident than it is in iron ore, with Brazil and Australia growing capacity and exports significantly. Given the low-cost nature of their production, they’ve generally been averse to slowing their expansion even with lower iron ore prices, resulting in forecasts of surplus through 2020.
Ethylene is the basic building block of most plastics. It differs than most other commodities in that it can be made from different inputs, e.g., either derived from oil or natural gas liquids. U.S. producers use natural gas liquids (e.g., ethane) as inputs to a much greater extent than their global peers. The ample supply of such inputs afforded by shale has provided a relatively advantaged cost and margin position. Ethylene margins and the U.S. advantage have compressed significantly in the wake of the oil price declines, but U.S. producers are still generally advantaged vs. their global peers and enjoy margins above the long-term historical average for the industry. In addition, plastics (and ethylene) demand continues to grow at a rate faster than GDP. With this and limited capacity additions to date, industry utilization rates are expected to move higher over the next few years before supply additions begin to impact the market in the 2017-2018 timeframe. Ethylene differs from most other commodities, therefore, given the impact of oil/gas on global cost curves, as well as the likelihood of demand outpacing supply over the next year or two.