Commodities: are low prices here to stay?
5 minute read
Recent forecasts show global growth strengthening in 2017, but the outlook for commodities remains mixed.
Forecasting the price of oil and other commodities with any certainty is notoriously difficult. Goldman Sachs famously predicted in 2008 that the price of crude would reach $200 per barrel. Within months, prices had dived towards $40 per barrel following the onset of the global financial crisis1.
Nevertheless, a number of global supply and demand trends suggest that oil prices are likely to remain under pressure for decades. Many giants in the oil industry subscribe to this view2 for two main reasons:
First, there is an abundance of oil resources: current known resources dwarf the world’s likely consumption of oil to 2050 and beyond. Global proven oil reserves have more than doubled over the past 35 years: for every barrel of oil consumed, more than two new barrels have been discovered.
Second, at the same time demand growth for oil is slowing. As one leading energy firm put it, “cumulative oil demand out to 2035 is expected to be around 0.7 trillion barrels, significantly less than recoverable oil in the Middle East alone”. The company also predicts demand is likely to peak around the mid-2040s, but that point could arrive sooner if alternative technology progresses faster than expected.
The oil glut reflects advances in technology, which have allowed for the exploitation of additional supply sources, such as from shale rock. This trend is particularly evident in the US, with the US Energy Information Administration forecasting that US crude oil production could hit a record 10 million barrels per day (bpd) in 2018, up from the current 9.3 million bpd, putting it almost on a par with top exporter Saudi Arabia3&4. The surging US oil supply is undermining the Organization of Petroleum Exporting Countries’ (OPEC) ability to influence prices.
For example, a Russian energy firm anticipates shale oil output will increase by about 1.5 million bpd in 2018, close to the entire cut targeted by OPEC and its allies, including Russia5. Certainly OPEC’s production cuts announced last September failed to encourage a recovery in prices, with output from US shale producers surging on the back of reduced operating costs.
Meanwhile, the slowdown in demand for oil reflects a number of factors, primarily increased energy efficiency in advanced economies. One oil company noted “virtually all the growth in energy demand is expected to come from outside the developed world” over its forecast period to 2035. In addition, oil’s relative importance will decrease as the contribution of renewables and gas increases.
The combination of oversupply and slowing demand is likely to result in “quite significant pressures to dampen long-run prices”6.
Figure 1: Oil prices in US dollars, 2007-17
Oil’s impact on other commodities
Commodity prices can be volatile and influenced by a variety of factors. However, the forecast for low oil prices over the long term has significant implications for other commodities where oil is a major input. Mining is energy-intensive, with energy accounting for between 20–25% of operating costs7. Oil also has a significant effect on agricultural commodities. It is used to power farm equipment, provides the energy for greenhouses, and is a significant input in many agricultural chemicals.
Fuel is the biggest cost for the global shipping industry, suggesting that fuel savings should lead to lower international freight rates. By increasing the distance a product can be moved at a set cost, this exposes all producers to greater competition, creating further downward pressure on commodity prices8.
In addition, the prospect of increasing US shale oil and gas output should continue to put upward pressure on the dollar. Given that commodities tend to be priced in dollars, the greenback’s strength could also weigh on commodity prices more broadly. This is because when the dollar goes up in value, commodities become more expensive for non-dollar buyers and this usually causes demand and hence the price of commodities to fall.
US oil imports have fallen from US$400 billion in 2008 to US$146.5 billion in 20169. This suggests shale production growth may be a principal driver of dollar appreciation, according to the consultancy Princeton Energy Advisors10.
Winners and losers from low oil prices
Various industries should benefit from the outlook of low oil prices, including the automotive and airline sectors, says Alessandro Rovelli*, Senior Corporate Research Analyst at Aviva Investors.
“Cars and aircraft have high energy inputs and make wide use of plastics or rubber, which also use a lot of oil. As a result, manufacturing costs should fall, while airlines and drivers will enjoy relatively low fuel costs,” Rovelli explains.
Major oil exporting countries, which lack a diversified economy, will likely be losers. Examples include Russia, Venezuela, Nigeria and Saudi Arabia. One company research report stated countries that are low-cost producers, such as Russia and Saudi Arabia, may seek to offset the impact of lower prices by increasing market share. The majority of the lowest cost resources are located in large, conventional onshore oilfields, particularly in the Middle East and Russia, followed by “the best US tight oil plays”. The company forecasts that the abundance of oil resources may prompt a change in behavior with production from the Middle East, OPEC, Russia and the US increasing disproportionately and anticipates the share of these low cost-producers should grow from 56% today to 63% in 203511. That could also weigh on oil prices long term.
The oil majors have responded to the sharp slump in prices by cutting costs, selling assets and adding debt, but there are question marks over their ability to maintain dividends at current levels. James Balfour*, UK Equities Fund Manager at Aviva Investors, believes even the biggest energy firms “may struggle if oil prices remain below $50 for a sustained period”.
Energy utilities could be another casualty. The price of gas, a major cost for utility companies, is tied to oil. “Lower prices could have a deflationary impact on the rates they are able to charge their consumers”, says Rovelli.
Falling oil prices could also apply deflationary pressures to the wider economy. This might appear illogical given that oil is sometimes described as the lifeblood of the global economy and lower prices effectively provide a boost to consumers.
Rovelli notes that the low oil price appears to have forced down all price indices in the US and Europe in recent years, suggesting that the impact has been deflationary rather than reflationary. The IMF made the same point in its Article IV consultation on the US published in July 201612. It argued that “since November 2014, the drop in oil prices has provided a 1% of GDP windfall to U.S. households” but while this would once have boosted consumer spending significantly, this no longer seems to be the case.
Palladium and gold: bucking the trend?
While the long term outlook for oil is negative, the opposite is true for palladium. Metals such as palladium, which have a specific electron structure that make them appropriate industrial catalysts, are in short supply. In particular, the metal can help transform nitrogen compounds and carbon monoxide produced from combustion into elements that are not detrimental to human health.
With global car sales up around 30% in the last decade - reaching 82 million vehicles in 201613 - demand for metals like palladium has also accelerated. Platinum was often the “catalyst of choice” in diesel engines and palladium has benefited from the backlash against diesel as a “dirty fuel”. Around 75% of palladium demand derives from auto catalyst demand and a move away from diesel should boost demand for the metal14. Certainly the metal’s spot price has soared in the past two years, rising from $484.95 in February 2016 to $885.57 by June 201715.
In addition to its role as a catalyst, palladium has a number of other useful physical characteristics which have boosted demand. It is durable, malleable, an effective conductor, does not rust and has a high melting point16. Applications in the electronics industry, as a conductor in integrated circuits, in dedicated military applications and consumer products are diverse. Materials scientists see a possible future role in hydrogen-driven fuel cells as well17.
Figure 2: Palladium: Net demand is rising (‘000 ounces)
The price of gold, meanwhile, is subject to a variety of influences, including US interest rates and the dollar, as well as geopolitical risk. Given gold provides no yield, higher US interest rates or the prospect of higher rates can adversely affects the price of gold. Indeed, Cailin Birch, Senior Commodities Analyst at the Economist Intelligence Unit (EIU) believes that the prospect of higher US interest rates is currently weighing on the price of gold. However, Birch believes gold could still rise to around $1,300 an ounce by the end of 2018 (from around $1,250 currently). “This is a relatively strong level in comparison with the preceding five years and reflects a wave of safe haven-buying, driven by emerging market buyers”.
Demand for gold
Birch believes that geopolitical risk will remain at high levels, partly because of “erratic policymaking in the US”. This should underpin demand, while supply constraints could also support the gold price in the longer term. While overall levels of mine production have grown significantly over the last decade, substantial new discoveries are rare and production levels are constrained, according to the World Gold Council, the market development organization for the gold industry18.
* Investment professionals are members of AIA/AIC's Participating Affiliate, Aviva Investors Global Services Limited ("AIGSL").
 The Daily Telegraph May 7, 2008. http://www.telegraph.co.uk/finance/newsbysector/energy/11339595/Oil-hits-six-year-low-as-Goldman-Sachs-slashes-price-forecast.html
 BP Energy Outlook 2017 edition. https://www.bp.com/content/dam/bp/pdf/energy-economics/energy-outlook-2017/bp-energy-outlook-2017.pdf
 US Energy Information Administration Short-term Energy Outlook. July 11, 2017. https://www.eia.gov/outlooks/steo/report/us_oil.cfm
 International Energy Agency, Key World Energy Statistics 2016, Producers, net exporters and net importers of crude oil, Page 11. https://www.iea.org/publications/freepublications/publication/KeyWorld2016.pdf
 “Russia's Top Oil Producer Sees Risk of Shale Neutering OPEC Deal”, Bloomberg, June 2, 2017. https://www.bloomberg.com/news/articles/2017-06-02/russia-s-top-oil-producer-sees-risk-of-shale-neutering-opec-deal
 Financial Times, January 25 2017. https://www.ft.com/content/28607ed2-e305-11e6-8405-9e5580d6e5fb
 World Coal, March 11, 2016. https://www.worldcoal.com/mining/11032016/low-oil-prices-continue-to-be-good-for-mining-companies-2016-382/
 Agriculture and Horticulture Development Boad (AHDB), Beef and Lamb: The far-reaching effects of low oil prices on agriculture, February 12, 2015. http://beefandlamb.ahdb.org.uk/market-intelligence-news/far-reaching-effects-low-oil-prices-agriculture/
 US Census Bureau, Annual Trade Highlights 2016, Press Highlights. https://www.census.gov/foreign-trade/statistics/highlights/annual.html
 Princeton Energy Advisors, “Shales, the US Trade Deficit, and Dollar Appreciation”, September 15, 2015 http://www.prienga.com/blog/2015/9/15/impact-of-shales-on-the-us-trade-deficit
 BP Energy Outlook 2017 edition. https://www.bp.com/content/dam/bp/pdf/energy-economics/energy-outlook-2017/bp-energy-outlook-2017.pdf
 IMF 2017 Article IV Consultation with USA, June 27, 2017. https://www.imf.org/en/News/Articles/2017/06/27/ms062717-2017-article-iv-consultation-with-the-united-states-of-america
 Business Insider Australia, January 19 2017. http://uk.businessinsider.com/2016-was-a-record-breaking-year-for-global-car-sales-and-it-was-almost-entirely-driven-by-china-2017-1?r=US&IR=T
 Mining.com, “Dieselgate: Palladium the big winner”, September 25, 2015. http://www.mining.com/dieselgate-palladium-the-big-winner/
 Bloomberg, Palladium Spot price. July 19, 2017. https://www.bloomberg.com/quote/XPDUSD:CUR
 Electronic Components: Johnson Matthey. http://www.platinum.matthey.com/about-pgm/applications/industrial/electronic-components
 “The role of palladium in a hydrogen economy.” Brian D. Adams. Materials Today. Volume 14. Issue 6. p282-289. http://www.sciencedirect.com/science/article/pii/S1369702111701432
 World Gold Council http://www.gold.org/about-gold/gold-supply/gold-mining
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