Long Commodity Cycle Continues Momentum
By TRG Advisors on January 25, 2023
Metal Prices Have Risen, Reflecting Macro Momentum and Structural Supply Challenges
Gold futures are up +19% since its November lows, reaching the highest levels since April. Gold tends to be a hedge against economic uncertainty and a safe-haven asset as traders price-in the idea that we may be near a peak fed funds rate. But it’s not just gold exhibiting these trends; copper futures are up +33% since its July lows, silver and platinum futures are up +35% and +32%, respectively, since their September lows, and iron ore is up +57% since its October lows.
Many metals, particularly copper and iron ore, are central to a global economy that is seeking to expand its infrastructure. The rise in metals prices reflects a reopening in China; a better-than-anticipated European economy; strength in the property market, particularly multifamily housing; and U.S. onshoring capex trends.
Other metal futures, like silver and gold, gain global demand as the dollar weakens – making U.S. dollarbacked gold and silver futures more affordable with a more favorable foreign exchange rate. U.S. Q4 GDP will be released later this week and, if better-than-expected, will continue to underscore these trends. GDP growth expectations have trended upward recently across key markets, including U.S., China and Europe. This is supportive for cyclical metals.
Chart 1: Gold Futures Chart Mirrors GDP Expectations1
Undersupply of copper and iron ore is expected to keep prices high in a positive economic growth environment. There is a structural deficit for many of these metals – consider the long-run demand for
semiconductors or electric vehicles or 5G broadband, and then consider the lack of supply growth in the metals industry.
The structural supply issues are linked to a variety of factors, including the Russia/Ukraine war limiting steel exports from the region, no new aluminum capacity outside of China, and underinvestment in energy, which increases heavy-metal production costs and contributes to a disciplined capex cycle across commodity industries.
Energy Cycle Supported by Decade of Underinvestment
The Fed’s tools have great influence over economic demand. It has limited influence on supply-side economics. Energy commodities outperformed all other asset classes in 2022 because there had been
an extended period of underinvestment, limited supply and significant pent-up demand. While demand may be hindered by the recent Fed action, supply-side investments have remained limited.
Large, institutional banks continue to divest or limit contributions to the sector because of ESG concerns. Without investment support from outside institutions, the industry is reluctant to spend free
cash flow on long-term, capital-intensive projects. Instead, with pressure from long-term investors, they prefer to engage in growing share buybacks and dividends. Further, it can be argued that the Fed’s action to raise rates and increase borrowing costs has made investing in risky long-term capital projects even less attractive for fossil fuel companies.
Chart 2: Energy Capex Increased in 2022, Following Contraction During the Prior Decade2
We think economic growth will slow and remain modest, but this does not represent a sharp downturn in demand, which would drag cyclical commodity prices much lower. Modest economic growth,
supported by China reopening, coupled with limited supply-side investment, is the basis for conviction in a long-run energy commodity cycle. Until we experience a sustained period (years) of capex, notwithstanding an outside chance for severe recession, we think the undersupply and healthy demand will support the upward commodity cycle.
We heard last week from energy services company, SLB (SLB), which said during its earnings call, “the combination of long-cycle oil capacity expansion projects, offshore deep water resurgence and strong gas development activity will be a key driver for the multiyear duration of this cycle.” SLB – and demand for their innovative technology – has benefitted from a tight energy services environment as industry-wide capacity remains limited. Today, diesel inventories are 15% below the five-year average and gasoline inventories are 7% below the five-year average.
It’s worth mentioning that most major energy companies are leaders in renewable investing and carbon-capture technologies. Along with underinvestment in traditional fossil fuel capacity, there’s been a similar underinvestment in important alternatives. To keep up with net-zero pledges, the world is (perhaps dangerously) extending the lifespan of existing nuclear power plants. Limited investment in new nuclear power plants has led to aging fleets that operate with lower efficiency and require greater subsidies to maintain. Interestingly, nuclear generation represented 18% of the world’s electricity in the mid-1990s and now represents roughly 10%.3 The inelastic demand for fossil fuels and associated technology reflects the broader undersupply in supportive energy infrastructure.
Capex, Currency and GDP in Focus
Three key factors that will influence the long-run cycle in commodities include the level of industry capex, U.S. dollar strength and global economic growth.
Capital investment supports supply growth, while underinvestment supports commodity inflation. Capex is dependent on broader support – both politically and across the investment landscape.
The U.S. dollar has weakened, following its steep rise amid Fed rate hikes and global macro uncertainty (incl. Russia/Ukraine war). A weaker U.S. dollar supports investments in U.S.-denominated commodity futures.
Lastly, upcoming GDP figures and forward-estimates will impact commodity prices. A stronger economy supports demand, particularly for base metals used across industries, many of which are pricing supply deficits.
1 Source: FactSet (chart). As of January 24, 2023.
2 Source: FactSet (chart). As of January 24, 2023.