Commodities: Buy the dip

• Parts of the commodity complex have pulled back since June, prompting an almost audible sigh of relief from global financial markets 
• Fears of global recession have driven sizeable divestments from commodity positions among investors. Yet, the structural climate-change driven bull case we outlined for commodities here is intact, and commodities remain the most effective inflation hedge 

• We remain bullish and believe the market is complacent about upside risks in commodities 
• While demand worries are understandable, it is structural supply-side constraints, set against a backdrop of very low global inventories, that remain the key bullish driver  
• Investors should also consider that 15% to 25% corrections in commodity markets are completely normal during bullish cycles 

Recession fears have restrained commodity markets in recent months 

Parts of the commodity complex (notably oil, precious and base metals, as well as grains) have pulled back since June, prompting an almost audible sigh of relief from global financial markets. Falling oil prices have coincided with peaking US CPI inflation and declining in forward looking inflation expectations. Brent oil prices are down around 25% from their March highs and down approximately 20% since June. US average gasoline prices have fallen from more than US$5/gallon to currently below $4/gallon, bringing relief to US consumers. Elsewhere, mainstream media headlines on a looming global food crisis coincided with an interim high for grains markets in May. Wheat prices are currently below levels seen just before the Russian invasion of Ukraine. Precious and industrial metals have also had a dismal run since early March. The list goes on.  

Clearly, fears of a global recession have scared investors away from commodities. Selling pressure has been protracted, with declines in positioning since April very stark. Overall (BCOM weighted) net non commercial positioning has moved from significant net long positioning to net short (see exhibit), Concerns around slowing global demand have a firm basis in reality. PMI type indicators point to a synchronized global slowdown. Realized oil demand has indeed disappointed somewhat. Additionally, China’s housing downturn has been deep and remains unresolved, pressuring industrial metals in particular. 

Investor indifference to commodities appears complacent given bullish price risks and the global inflation environment 

Despite the demand concerns discussed above, we remain bullish and believe the market is complacent about upside risks in commodities. While the demand side of commodity balances are providing ample cause for concern, it is the supply side of commodity markets that should make investors sweat, sit-up and take notice. Two examples, both from parts of the commodity complex in which we are bullishly positioned, illustrate this dynamic well.  

Firstly, crude oil. The bearish drumbeat here has been relentless. Yet investors should consider the following factors: 

1. Despite a record Strategic Petroleum Reserve (SPR) release in the US, inventories remain historically low. By October this flow will have likely ceased and US strategic reserves will be the lowest since the 1980s. If, as is stated US government policy, the reserve is rebuilt, the SPR will flip from being a source of net supply to a source of net demand in the oil market 
2. Just at the point the SPR is at the lowest level since the 1980s OPEC is very close to running at maximum capacity and has been consistently unable to meet stated quota levels 
3. Overall capital investment levels into crude oil markets remains very low relative to history and we are  
   not witnessing a surge of capital into the US shale basins on anything like the scale witnessed in the  
   shale boom 
4. Crude oil is extremely cheap compared to the broader fossil fuel complex. While brent crude is trading at c.US$95 per barrel of crude oil (bbl), European natural gas in barrel of oil equivalent terms is trading at more than US$400/bbl 

In summary, with new supply limited and recession fears already high oil prices are likely to increase following the summer correction.  

 Secondly, let’s examine grains markets. 

1. Part of the reason why corn and wheat prices have fallen so much is because the market believes Ukrainian shipments from Black Sea ports can increase significantly post the recently agreed export deal. However, even if all goes smoothly, it will take several months for those exports to increase meaningfully. It is also possible the deal falls apart completely and nothing is priced into wheat markets to reflect this 
2. High natural gas prices mean fertiliser production will continue to be curtailed. That will in turn increase the production costs for corn and wheat where fertilizer (nitrogen fertiliser in particular) is used intensely in the crop production process 
3. We expect India to implement more restrictions on rice exports, in addition to their already-existing  
   wheat export ban, in order to protect against domestic inflation. This will force consumers to buy  
   grain substitutes 
4. At the same time, dependency on foreign supply for top importers in Africa and Asia has increased as food nationalism drives many countries to increase strategic reserves 

In short, while grains prices remain at pre-invasion February levels, global balances are now meaningfully tighter. 

Global inventories remain exceptionally low and commodity market continue to give positive roll returns. 

Looking more broadly, it is very apparent that available inventory in commodity markets remains at distressed levels and significantly below five year averages (chart III). This is why overall curve structure (the price difference between front month contracts and longer dated contracts), which also softened somewhat over recent months, remain in backwardation giving investors positive carry for holding commodities (chart x). We expect this positive roll return to strengthen further over coming months. 

Investors should also note that while no two cycles are the same, it is not abnormal to observe corrections of 15% to 25% that last months within a long-term cycle. The 1970s bull-cycle saw seven such corrections, while the period from 2001 to 2008 saw at least five corrections of more than 10%.