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Why Commodities May Defy the Odds in 2023

Why Commodities May Defy the Odds in 2023

Nearly every time I strayed from the herd, I've made a lot of money.  Wandering away from the action is the way to find the new action.

Jim Rogers

Issues to be addressed in this research paper

Commodity prices usually move in well-defined patterns defined by economic activity.  As you can see below (Exhibit 1), the Bloomberg Commodity Total Return Index (BCOMTR) has been through three major bull markets and two major bear markets since its inception in November 2001.  The last bull market peaked in early June last year at 292.50, following which it has given up about 20%.  (BCOMTR closed at 233.65 on the 6th of February 2023, down from 245.89 at the end of December last year).

Exhibit 1: Bloomberg Commodity Index, total returns since index inception
Source: J.P. Morgan Asset Management

More often than not, commodity prices peak at about the same time as central banks’ interest rate hiking cycles peak, and the last cycle was no exception to that.  Last summer, when the Fed began to talk about reducing the pace of its hiking programme (from 75 bps to 25-50 bps per hike), BCOMTR peaked as well.  Looking forward, if that logic is applied, commodity prices should continue to weaken until the economic data starts to improve again.  Britain is probably already in a recession which could last a couple of years; the EU is on the edge of one, and the US is facing a few quarters of slower economic growth but probably not a full-blown recession – at least not this year.

Therefore, all logic suggests a difficult year ahead for commodity prices, and that is precisely the logic that I intend to challenge in this paper.  There are several reasons why 2023 could turn out to be a pretty good year for BCOMTR.  In other words, there are good reasons why you should be exposed to BCOMTR in the months to come.  Furthermore, as I think performance will vary considerably across the commodity complex, you can probably do even better by being selective in your choice of commodities but more on that below.

The bear market of 2H22

As is evident when looking at Exhibit 2, almost all commodities delivered a negative return in the second half of last year; however, over the whole year, most commodity prices were up.  That said, as you can also see, the divergence across the commodity complex was huge.  The most negative sub-indices were industrial metals (with the exception of nickel), whereas energy prices enjoyed a superb year.  The former was probably due to the problems the Chinese had getting COVID-19 under control, and the latter due to the war in Ukraine.

Exhibit 2: BCOMTR index constituents
Note: * The peak of the last bull market
Source: J.P. Morgan Asset Management

Why the outlook is better than perceived

I can think of at least five reasons why commodities may perform better this year than what economic fundamentals in Europe and the US would suggest.  In no particular order, the five reasons are:

1. The warmer than normal winter this year.

2. The re-opening of the Chinese economy.

3. A US dollar that looks to have peaked.

4. Exaggerated economic growth concerns.

5. The green transition.

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Let’s go through them one by one.

1. The warmer than normal winter the year

Although January was quite warm, a cold December has led some commentators to argue that, so far, it has been an average winter, temperature-wise.  That is not correct, though – at least not in Europe (Exhibit 3).  January was so much warmer than normal in Europe (about 2 standard deviations above average according to Goldman Sachs) that the demand for winter fuels was well below average.

Exhibit 3: Average heating degree days in NW Europe for Oct-Jan since 1970 ranked from coldest to warmest year on record
Source: Goldman Sachs Global Investment Research

That has had a negative impact on oil and gas prices, both directly and indirectly.  More recently, the gas price has collapsed on either side of the Atlantic and now trades below the level it was, the day Russia invaded Ukraine.  Oil demand has also been hit, partially because of lower heating oil demand and partially because of the lost gas-to-oil substitution in Europe.

Weaker energy prices then started to pull down grain prices, i.e. the warm weather began to affect the commodity complex more broadly.  From an investment point-of-view, it should be noted, though, that the warm weather is masking some underlying, and much more positive, changes that are likely to have a significant, and positive, effect on BCOMTR in 2023.

Most importantly, as we move further into 2023, Europe could, and probably will, suffer from a significant lack of refinery capacity.  That alone could drive Brent oil above $100 again. If you add to that the re-opening of China (more on that below) and a few other factors discussed below, one should expect oil prices to rise as the year unfolds.

2. The re-opening of the Chinese economy.

The headwinds which came from China in 2022 are about to turn into tailwinds.  According to the research team at Goldman Sachs, the rolling lockdowns in China last year had a negative impact on many commodity prices.  More specifically, had the Chinese economy grown at the trend rate last year, the GS team estimate that BCOM (a cousin of BCOMTR)  would be 7% higher than it is today (Exhibit 4).

Exhibit 4: Simulated price path under a constant dollar and a constant Chinese industrial activity level (assumed to be March 2022)
Source: Goldman Sachs Global Investment Research

Commodity prices stand to benefit pretty much across the board from the re-opening of the Chinese economy, but two commodity groups stand out – industrial metals and energy.  According to Goldman Sachs, the re-opening of China alone will be worth about $5/bbl to the oil price this year.

3. A US dollar that looks to have peaked

A strong US dollar is notoriously bad for commodity prices, and 2022 was no exception.  According to Goldman Sachs’ model, BCOM would be about 15% higher today, had the US dollar not rallied so much last year (Exhibit 4).

The early signs are that the US dollar has now peaked (Exhibit 5).  On a trade-weighted basis, it is down 7-8% from its highs last autumn.  Therefore, the worst of the headwinds of last year has probably blown over now and may even turn into tailwinds, should the US dollar continue to weaken.

Exhibit 5: Trade weighted US$ index (broad, goods and services)

4. Exaggerated economic growth concerns

For a while, I have been of the opinion that (i) the British economy is probably already in a recession, (ii) the EU economy is on the edge of one, and (iii) the US economy will slow meaningfully this year, although an outright recession may be avoided.  All that points towards lower commodity prices in 2023.

As you can see in Exhibit 6 below, JP Morgan Asset Management have reached largely the same conclusion.  (For those of you not familiar with the Purchasing Managers’ Index (PMI), a read below 50 is indicative of economic contraction.)  As you can see, across the DM world, the green colours are rapidly turning yellow or orange, meaning that economic growth is slowing.  However, more recently, economic data coming out of the EU suggests that a recession there may just be avoided.  Likewise, in the US, recent economic data is pointing towards respectable economic growth in 2023 despite the aggressive hiking programme established by the Fed.

Exhibit 6: Quarterly PMI
Source: J.P. Morgan Asset Management

On the basis of that, I think it is fair to conclude that a (near) global recession in 2023 looks less likely today than it did only a few months ago and the numbers in JP Morgan’s chart above suggest.  And, for that reason, commodity prices may actually do better than expected this year.

5. The green transition

Earlier this month, the European Commission published a draft proposal to legalise state aid to companies in the EU that play an important role in the green transition.  The proposal is now in consultation with all 27 member states and is effectively the EU’s response to President Biden’s ambitious climate programme.  Biden’s army of political aids have been roaming the corridors of corporate Europe for a while, trying to convince the European climate heavyweights to give up on Europe and instead focus on the opportunity set in the US.  The European Commission responded by opening the door to state aid (which is already permitted in the US).

Exhibit 7: Amount needed for first generation renewable infrastructure vs. proven reserves

Essentially, a climate trade war is about to break out.  No government wants to fall behind the curve, but the corporate expertise and resources are limited, i.e. governments all over the world are competing for the attention of the top guns.  The problem is not only that the expertise is limited, though.  Potentially an even bigger problems is that certain industrial metals that are key to the green transition are in seriously short supply.  This has been largely ignored by government officials all over the world.  A handful of them will be in such short supply that a full green transition is in reality impossible, unless (until) new technologies are developed (Exhibit 7).

The three most obvious conclusions I can draw from that observation are that:

1. fossil fuels will be with us for much longer than our political leadership is prepared to admit;

2. certain industrial (green) metals are about to enter a supercycle of potentially unfathomable proportions; and

3. neither is bad for BCOMTR.

Final comments

I shall stop here but, as you have probably gathered, I expect 2023 to offer plenty of opportunities in the commodity complex.  Absolute Return Partners is a signatory of UN PRI.  As a consequence, we have decided not to invest in fossil fuels.  Having said that, given the limited level of investments going into exploration these years, before long, the world could be seriously short of fossil fuels.

It hurts me when I see how little reality there is behind all the fine words coming from our political leadership.  Fossil fuels will not go away any time soon.  It is quite simply an impossibility.   Certain countries (mostly the smaller ones) may successfully alter the fuel mix but, as long as the world’s largest countries have no desire to do so, it won’t make one iota of difference.  And, as you are probably aware, CO2 has not heard of borders between countries.

Ignoring the fossil fuel complex, I believe the biggest opportunity is to be found in those green metals that will be in the shortest supply in the years to come (see Exhibit 7 again).  We already have meaningful investments in copper and lithium but not the other metals referred to in Exhibit 7.

Niels C. Jensen

7 February 2023

About the Author

Niels Clemen Jensen founded Absolute Return Partners in 2002 and is Chief Investment Officer. He has over 30 years of investment banking and investment management experience and is author of The Absolute Return Letter.

In 2018, Harriman House published The End of Indexing, Niels' first book.