ICG Commodity Update – June 2022
The ICG Commodity Update is our monthly published comment on the energy, industrial metals and precious metals market.
Oil headed for a third weekly drop, its longest losing run this year, on concern that a potential recession will cut into energy demand. Oil fell about 8% in June as investors fretted over a potential global slowdown, eroding a rally spurred by the war in Ukraine, interruptions to supplies and rising demand. The jump in prices alarmed President Joe Biden, who’s spearheading efforts to get producers in the Middle East to boost crude output. Even though oil fell in June, the world economy is short all forms of energy, with global natural gas and coal prices also soaring, as a result of improved fundamental conditions, poor policy choices and repercussions from Russia’s invasion of the Ukraine. Moreover, global refining capacity is also constrained, meaning that shortages of refined petroleum products are leading product prices to outperform crude oil prices. Relentless demand for energy has resumed following the COVID interlude, much as it has after any of the temporary downturns over the last 40 years. The world economy began to experience energy shortages in 2021 as demand recovered more quickly than many anticipated and supply growth continued to lag, in part due to the OPEC+ group managing the oil market. Then, seven years of underinvestment in productive capacity and infrastructure collided with the Western World’s pivot away from Russian oil and gas, creating an even bigger problem. Given the immovable force of climate policy and shunning of Russia supply, the only solution appears to be commodity prices that are high enough to weaken future demand growth. According to Analysts, oil is clearly driven by macro-economic developments at the moment, fundamentally, the market is still tight so downside is expected to be more or less limited. North American oil and gas equities have materially outperformed the broader market over the last 18 months. However, investors generally remain underexposed to oil and gas equities, with sector weightings not far off the lows in 1998/99. Somewhat incongruently, the sector’s earnings and free cash flow contribution to the market are more than double its weight in the S&P and TSX, and the sector is in the best financial position in more than 30 years. According to BMO, low investor exposure to oil and gas equities reflects misperceptions about the future of the industry as well as the causes of the sharp increase in crude oil and natural gas prices. Most generalist investors are convinced that oil is the new tobacco and should be avoided. Not surprisingly, oil companies are not taking their cash windfalls and re-investing them in new supply that would ultimately lead to lower oil prices and rather allocate their profits to shareholder returns via dividends and share buybacks.
Base metals booked the worst quarterly slump since the 2008 global financial crisis as China’s economy recovered only gradually and fears of a world recession intensified. Markets have been buffeted by both growth and inflation worries for some time now and are not getting any relief from G-7 central bankers, most of whom are intent on raising interest rates further. Early indicators for China’s economic activity tracked by Bloomberg suggest an improvement during June as Covid-19 restrictions were gradually eased. An overall gauge of the outlook returned to neutral after deteriorating for two straight months, though the recovery remains muted. It’s a dramatic reversal from the past two years, when metals surged on a wave of post-lockdown optimism, inflationary predictions and supply snarls. Inventories remain at critically low levels in several metals markets, setting the stage for potential price spikes. . Both exchange and estimated total stocks on average across the complex are at the lowest levels since at least 2000, leaving supply chains and prices more susceptible to supply and demand shocks, as well as financial market squeezes. Longer term, demand growth will have to be aggressively adjusted to cope with constrained supply across a number of energy transition metals, notably copper & nickel. According to analysts, the commodity bull market is not over, it has hardly just begun. Natural resource related equities experienced three distinct periods of outperformance over the past century. One period was associated with intense inflation (1970s), one period was associated with crippling deflation (1930s), and one period was associated with the China boom in the early 2000s. All of these three periods had one thing in common: commodity prices were extremely cheap relative to the broad market. Comparing the Goldman Sachs Commodity Index today with the Dow Jones Industrial Index, commodities remain still in undervalued territory. Investors have to keep in mind that despite the recent sell-off, almost all of the key commodities are trading well outside of the cost curves and as a results, margins and free cash flow yields of natural resource companies are still robust. Looking at the diversified miners alone, EBITDA expectations for 2022 are US 160bn, up 5% on 2021, with nearly half of the year’s EBITDA already banked. Even with analysts’ expectations of lower commodity prices going forward, they still support strong cash flow, with 2023 EBITDA of US$123 billion still the third highest year in a decade. Further, despite some inflationary pressure to capex and costs, analysts still expect free cash flow yields to be strong for the foreseeable future with solid balance sheets and potential for significant shareholder returns via dividends and share buybacks.
Gold headed for a third straight monthly decline as investors weighed rising interest rates against recession fears, with central bankers warning of a longer-lasting inflation shock. Federal Reserve Chair Jerome Powell and his European counterparts may be forced to tear up their playbook of the last 20 years as they debate how to tackle persistent price pressures and slower growth. Speaking at the European Central Bank’s annual forum, President Christine Lagarde said it’s unlikely that the world will soon go back to a low-inflation environment as a result of the pandemic and geopolitics. According to analysts, the lingering uncertainty on the extent of policy-tightening to curb inflation may still be having a hold on the yellow metal’s prices, with central bankers’ comments continuing to reiterate their resolve in keeping prices down as a priority. Also, although for most market participants symbolic, the European Union is working on new sanctions to target Russian gold, matching a move by the Group of Seven nations aimed at further choking off Moscow’s revenue sources, according to people familiar with the matter. The impact from a ban on Russian gold imports by G-7 nations is likely to be fairly limited, given that the industry already took steps to restrict Russian gold. Looking at gold mining companies, the most important theme for most is inflation. While cost inflation is very real, and was a dominant theme in Q1/22 conference calls, analysts expect that higher-grade deposits, larger deposits, prudent management teams, and robust gold pricing should all act to maintain free cash flow margins. Assuming that the gold price remains robust, and inflation impacts other segments of the market, analysts expect that there is a good chance that investors could come back to the sector. This will be especially true if the companies maintain cost discipline and keeping their focus on dividends or shareholder returns in general. Most companies use a gold price assumption to calculate reserves that is roughly $1,400/oz on average, implying that the companies are retaining a relatively conservative stance in their mine plans. As with base metals miners, despite some inflationary pressure to capex and costs, analysts still expect free cash flow yields to be strong for the foreseeable future with companies being in their best financial health they have ever been – the net debt to equity of the precious metals champions funds portfolio companies is currently negative, meaning companies have more cash on their balance sheets than debt leaving still enough room for more dividend hikes and share buybacks to come, as we have already seen in the last couple of quarters.