- The 2016 commodities rally is likely to extend in 2017
- Energy, precious metals and potentially also farm commodities may gain
- Risks include new US policies, USD direction, US interest rates, China growth etc.
- Inflationary pressures could make commodities attractive as a hedge
- Major Opec producers have taken steps signalling commitment to November deal
- Some high-cost oil production already returning, curbing pace of rebalancing
- Record long oil position probably oil’s biggest challenge in short term
- If global demand stays strong, year-end oil price could be close to $60/b
- Chinese demand will continue to support commodities
- Grain challenged by supply overhang; coffee, sugar, soybeans supported
Compliance with Opec's end-November agreement on production
cuts holds the key to crude oil prices. Photo: iStock
By Ole Hansen
[This article is adapted from an interview with the Greek business paper Naftemporiki.]
The 2016 recovery in commodities from a five-year bear market is likely to extend in 2017 for a number of reasons, not least of which is that oil producers seem to be taking significant steps to implement the November Opec production cut.
Many uncertainties remain, however, including the policies of the new US administration, the direction of the US dollar, the path of US interest rates and the pace of economic growth in China.
The Bloomberg Commodity Index gained around 13% in a fairly broad-based rally last year, and drivers are in place for that rally to continue in the energy sector, precious metals and potentially also agricultural commodities, which have been under pressure for a good few years.
In general, we believe the energy sector slowly will make its way higher. It will be a bumpy road, even a rollercoaster ride, but the energy sector is bound to move higher.
In precious metals, we could see a revival similar to what we saw last year, some of that depending on the US dollar. The jury is still out on the dollar at the moment. Quite a big camp still expects the dollar to go higher for many reasons. There is also speculation that it could weaken, and recent comments from new US president Donald Trump tend to support that view.
A weaker dollar would be generally good for commodities.
Inflation rears its head
One of the themes that is going to come back in 2017 is inflation. We are seeing inflationary pressure starting to build in China, and, if that theme endures, then then commodities will attract some interest as an inflation hedge.
Chinese growth moderating
China will continue to support demand for commodities, but we should not expect the growth rate seen in the past. It will be a different kind of demand – more towards commodities required for consumer-based development than for heavy industrial commodities. A sudden slowdown in China seems unlikely, but a key question still is how much more additional stimulus the Chinese government can provide without creating an even bigger debt bubble, which is a concern.
Some uncertainties hinge on the currency. Chinese producer prices are rising, and in response to that we have seen the currency come under pressure in order for China to remain competitive on the international markets. But there will continue to be increased demand in China for energy because of the rising middle class, which is reflected also in continued big demand for automobiles. Some uncertainty surrounds the heavy industrial commodities, steel, iron ore, where we saw a big rally in 2016. Some of that rally was speculative-driven, but also driven by initiatives taken by the government which could be faded out during 2017.
We have a generally positive outlook for China, but the relationship between the US and China is a key factor, and only the coming months will tell how that is to develop.
Monetary tightening by the US Federal Reserve is on paper dollar-supportive because it raises interest rate differentials between dollar and other currencies, with the Fed almost being the only central bank now in tightening mode as most others are on either stand-by or still in easing mode.
Based on the assumption that Fed tightening will lead to a stronger dollar, that could have a negative impact on commodities. The rising cost of funding at the same time as the dollar strengthens is not what emerging economies need. A lot of their debt is in US dollars, and a rising debt burden would reduce the ability to service the economy in other areas.
Political risks abound in 2017, the biggest being whether Trump’s protectionist and isolationist policies have a significant impact. But Europe also faces elections later this year in the Netherlands, France and Germany, and these will be important to watch because the UK’s Brexit referendum last year has clearly raised concerns about the future of Europe and the Eurozone as we know it.
We’ve seen some of that sentiment already reflected since mid-December in quite a decent recovery in precious metals, and the uncertainty related to Trump’s presidency has been mentioned as one of the reasons for the rally.
Oil market rebalancing
The Opec-led production cut agreed at the end of November will work, but it’s probably going to take longer than currently expected. There is no doubt that the major Opec producers have already taken significant steps to signal that they have cut production, some by even more than they initially stated . They have done that to send a clear signal to the market that they mean it seriously, which is also required because of poor compliance with production cuts in recent history. It is also necessary to signal such a strong commitment to ensure that Russia gets on board with its 300,000 barrels/day reduction, which is a key dimension to this process.
Meanwhile, we are seeing a pick-up now in production from what was formally known as high-cost producers, especially in the US shale industry. The high cost there is not so high anymore. Most of those producers are now producing at a profit, and that has triggered a revival in the number of rigs and is also causing a recovery in production.
The unknowns and the speed at which the oil market rebalances will clearly depend on production levels above all in the US, but also — and probably as importantly — in two volatile producers, Libya and Nigeria. Both are producing well below capacity, and as long as they see consistent improvement, such as in Libya in the past few months where security on the ground is starting to improve, then they will be able to increase production further. That will pose a major challenge to Opec because each barrel that these countries add will have to be cut by someone else to keep the market re-balancing on track.
In short, Opec has the right remedy. It is sending a signal to the market, and the market has bought into it strongly.
Some positive early signs of compliance with Opec's agreed production cut
have supported oil prices in early 2017. Image: iStock
But a record long position in the oil market held speculatively at the moment is probably oil’s biggest challenge in the short term. Oil prices have rallied 20% from the lows back in November, and so far this month prices are settling into a relatively tight range. That indicates that the buying interest has dried up and, at this stage, considering there is such a big position in the market, those holding on to their positions need to be fed positive news to avoid the temptation to take profits. That raises the risk of profit-taking, at least in the short term.
Looking over the year, in the short term we see the risk of $50/barrel before $60/b as the greatest risk. When we move deeper into 2017, as long as global demand growth remains as strong as currently expected, which is in the region of 1.5 million barrels/day this year, then the market will continue its rebalancing process, and that leaves it open for a year-end price close to $60/b.
As long as oil stays within its current relatively low range, where the upside potential above $60/b remains reasonably limited, then it will not have a significant impact on the European economy. We are not seeing any spikes in the market — spikes will only be driven by unforeseeable geopolitical events. But based on how the market is developing and how demand growth appears going forward, the current expectation is that the oil price will generally rise by $5/barrel over the coming couple of years, ending up towards the end of the decade probably closer to the $70 to $80/b area.
Having seen oil prices averaging $110/b for three years from 2011 to 2014, that is something the market has seen in the past and it shouldn’t create much of a challenge.
Weather-dependent farm commodities
Weather, supply and demand and to a certain extent the dollar are key factors for agricultural commodities. An overhang of supply, especially in grains, has been built up following four good crop years, and is clearly a challenge to the potential for grain prices to move higher. But having seen low prices most of last year, there will be some speculation once spring arrives whether we are going to see changes in the mix of what farmers are planting, especially in the US. That could add some support to the likes of wheat.
Soy beans have picked up recently as weather concerns in South America, especially in Argentina, supported the market. That shows that any weather upset, whether shorter or longer-term, has the potential to turn the market around.
In soft commodities, there is a fundamentally bullish case for both coffee and sugar. We are seeing a supply deficit again this year. Coffee production in Brazil is likely to be lower than we’ve seen over the past couple of years, and that lends support to solid prices there.
Four good crop years have resulted in an overhang
of supply in the grain market. Photo: iStock
— Edited by John Acher
Ole Hansen is head of commodity strategy at Saxo Bank