In the latest edition of the Investment IQ podcast series, Sree Kochugovindan and Robert Minter discuss surging food and energy prices and the impact these have on the outlook for asset classes, as well as their destabilizing effect on societies.
As usual, Richard Dunbar is your host. This podcast was recorded in May.
We were reminded, rather shockingly, that energy always is and always will be a national security issue.
Transcript
TRANSCRIPT
Richard Dunbar: Hi, my name is Richard Dunbar. Welcome to our latest abrdn Investment IQ podcast. Today I am delighted to be joined by Sree Kochugovindan, abrdn Senior Research Economist, and Bob Minter, Director of ETF investment strategy, both of whom have long research and market experience across the broader commodity complex.
Now, this discussion takes place in May 2022, at a time where commodities have been front of mind across all asset classes, significant moves seen in the commodities themselves, but also driving inflation expectations and therefore bond markets and driving sectors up and down within equity markets. Food and energy prices are driving the cost-of-living debate and both are leading to pressure on politicians and governments. Add the implications of the tragedy in Ukraine and we have a rather complex current cocktail, an opportune time undoubtedly to discuss all of the above with Bob and Sree.
And perhaps starting off with you Sree, there are many opinions as to what are driving the commodity complex prices but to start with, what does pure demand and supply perhaps tell us.
Sree Kochugovindan: Well, thank you, Richard. I guess, even before the Ukraine war broke out, we had a combination of supply and demand factors that were really driving commodity prices higher for a number of months, actually.
So, if we start with the energy complex, there was a combination of seasonal, structural, global and domestic supply and demand imbalances that were already pushing some of the commodity prices higher. So, over the past couple of years climate change has been a key concern and the regulatory requirements there have been changing behaviour across a number of different countries. And we've seen increased demand from Asia, for liquid natural gas or cleaner forms of energy. And that's really led to some stockpiling over the course of last year, and some shortages for other countries that would have been relying on that liquid natural gas in Europe, for example, gas supplies that were a bit lower than would have been expected as a result of that.
We've also seen intermittent supply of renewable power, increased reliance on natural gas as a result of that. But also, there's been a structural underinvestment in coal, again, because of the climate change concerns. That led to a structural decline in supply, as we were heading into the northern hemisphere winter. Now, fortunately, the winter was not as cold or as severe, as we've seen in previous years. But that increase in demand had come at a time when supply was particularly tight across the energy complex. And this left a number of countries quite exposed already. But then, obviously, we have the Ukraine war, which broke out and that just amplified some of these supply constraints. Europe was particularly reliant and exposed to Russian gas supply, we had already elevated raw material prices prior to that, and now the prospect of energy sanctions really weighs on the outlook there. So, we've seen a combination of private sector action, obviously in response to the Russian invasion, and increased public pressure as well, which is allowing governments to act. We're still seeing the flow of gas and oil from Russia to Europe. However, there is the prospect of sanctions still leaning on those prices at the moment. So it’s a combination there, of supply and demand dynamics really playing into the commodity story.
Richard: China I suppose over the past decade, two decades has been a key contributor to the both the supply and the demand story. Is that, is that story waning now? Obviously there's zero COVID strategy is front of mind and nervousness or otherwise in the Chinese economy is also front of mind – is that less part of the story now than it had been?
Sree: Well still is a very important part of the story. At the moment, we're seeing quite a different dynamic that we've seen over the past two years. And previously, it was a number of different countries were affected by the various COVID waves. But at the moment, whereas the rest of the world has seen COVID subsiding somewhat we're seeing reopening in a number of other countries, China has been quite unique with its zero tolerance policy. And what we've seen is the fact that China is so integral to the global supply chain, so it's actually factoring in having spillover impacts on the commodity story in a number of different ways.
So, China's obviously been quite a key driver of commodity demand over the years. And we often look at the relationship between China activity data and the demand for industrial metals in particular, but also for energy complex as well. But now recently, we've seen quite a divergence in that, the price action for commodities are now being pulled between the supply shock of Ukraine war, but we also see the impact of the zero tolerance policy in China. We're seeing that in a couple of ways of seeing that and potentially, you know, the impact on slower growth and demand from China. But also we see the supply chain disruptions, China's quite integral to the global value chain. Port congestion has been increasing, and we are expecting some continued price pressures as a result of that, and disruptions across the supply chain.
So, there are two different drivers here. Supply chain disruptions that would be a supply add to the supply shock and the transportation of commodities. But then the demand side China is so integral, as you say, to the to the demand for industrial metals in particular. And at the moment that there was recently the New York Fed did a decomposition of - it was particularly energy prices. And it looks at the supply side drivers and the demand side drivers and quite recently we've seen not just from China, but softer demand globally. And that's taken a bit of a dive in recent weeks - the demand side impact on energy prices has declined. However, the supply side, drivers are still quite positive and have offset that decline in demand. So, you've got these two opposing forces at the moment really driving and impacting not just energy but across the commodity complex.
Richard: And moving to Bob just on the observations from Sree of the tight demand and supply mix before the war in Ukraine. Do you think we were sufficiently aware of that? Did we realise that? It feels like we've had, you know that the tightening demands we come out of the pandemic and then Ukraine has exacerbated that. Did we realise how precarious this situation was before these two factors are or is have we been surprised?
Bob Minter: Maybe I would put a few data points behind to backup what Sree has said. It really is three factors that got us into where we are right now. One is the decline in inventories and inventories last year dropped by about 2 million barrels a day globally, every single day of last year. So actually, right now we're down to OECD global inventory levels that existed between 2010 and 2014. That's pre shale revolution. And not surprisingly, that's where we are in oil price, around the average of those years in the $92 to $100 a barrel level. So, I would caution that any sanctions against Russia are not in the price right now.
And the second factor is there's been a tremendous lack of investment, capex, both from government pressure and investment pressure. Investors are just not giving capital to the oil companies to invest in future production. And it's important because the average depletion rate is 4- 6% per year. So if you do not invest 500 billion a year in capex globally, in future production, you will not get the same production next year that you have this year. So you sort of build in that, that decline in supply.
And the third thing is, there's a tremendous lack of spare capacity. It's a dirty business, it's a dangerous business. Some producers like Libya and Nigeria are not very reliable, supply, production wise. And so you do need spare capacity that can pick up when things happen. And right now, that's about 2 million barrels a day of spare capacity. It's just not enough. So we kind of booked into this situation, very precarious assumptions. And so right now, we're at a kind of dangerous point and the assumption that the 7 million barrels a day that Russia exports can be taken out of the market is just really, really lacks credibility - 7 million barrels a day is 7% of the global market.
So, if you were to decline to have activity and demand decline by that seven percent, you know, is 7% a lot? How do you put that in perspective and during the global financial crisis, demand dropped by 4%. And during the 2020 COVID lockdowns, demand dropped by 10%. So no one's going to sign up for some sort of a slowdown between global financial crisis and COVID 2020 global lock downs in order to offset the supply.
Richard: And broadening it out Bob, because I suppose we had in the run up to the global financial crisis, probably unarguably, massive over investment in the broader commodity complex and you know the supercycle was talked of etc across I suppose oil and the broader metals complex and that boom turned to bust and then there we have 10 to 12 years of I suppose shareholder desire for retrenchment and lack of investment in mining but rather returning cash to shareholders, rebuilding balance sheets. So is this just a normal cycle that we've hit demand picking up with an under investment and the cycle will go back to normal and shareholders will release purse strings and more investment will result? It would be interesting to get your thoughts on the I suppose the climate transition impacts thinking today perhaps less more so than it did 15 years ago?
Bob: Well, luckily, you don't have to take my word for what's influencing supply decisions right now. The Dallas Fed does a survey of oil and gas CEOs and pretty strong messages came out of those that was just released in March, and some pretty strong words. Some of these comments aren't even okay to repeat on a podcast, but they were frustrated by several things.
One is a lack of labour, there just is not enough experienced labour to run all of these oil rigs. The materials costs have increased, in some cases, 15 - 20%. The services costs have increased dramatically. And one of their main sort of confusion points is what exactly is the US policy towards energy? When President Biden was inaugurated, within several hours, he killed the Keystone XL Pipeline, he attempted to stop federal leases to oil and gas companies, which is actually so radical that a federal judge overturned that in court several months later. So, you know, for oil and gas executives to hear, you know, we're going to make things very difficult for you to produce. And then several months later say, ‘Well, you know, the oil price is high, so now we want you to produce’, and they correctly push back and say these types of investments aren't made for the next six months, these investments are made for 5–10 year type of returns. And so, it's creating a conflict between what would be most expedient to allow the economy to fully express itself and what the reality is on the ground.
And, from my perspective, there's a number of, of takes from that. And I think the wrong take is that we suddenly flipped to forgetting about renewables and forgetting about all the progress that we've made, and just go back to sort of a ‘drill, baby drill’ environment.
We were reminded, rather shockingly, that energy always is and always will be a national security issue. And from my perspective, I think that a lot of the renewables are going to start to take on national security level importance and more money is actually going to get put there. The Austrian Minister of Energy, just last week said something very similar that renewables are now getting a redoubled effort because of the national security implications.
Richard: And Sree, maybe just coming to you on that question. You've looked at the supply demand picture over decades in the work that you've done and published. Is the sort of supply, demand tightness, is that just a normal cycle and we’ll see more investment come in as prices are at or remain high. It's just what you what we've seen over the centuries?
Sree: I think this is a little bit different this time around actually in the sense that we are making, not just responding to price action and investing according to that, we need to also respond to the other variables such as the climate and the regulatory environment.
What we are seeing at the moment in response to this recent supply restrictions, as a result of the pandemic, and now Ukraine war, the immediate short term policies, and what the policy is at the moment are quite short term in the sense that they are we seeing reopening of coal mines and China and some of the other countries as well. There is a shift back towards fossil fuels. However, longer term, we do need a lot more infrastructure investment in renewable sources. And that's been quite, that's just been missing really. We should have started this many years ago. And that's the investment that's required. So when I was talking earlier about, yes, there's underinvestment in coal, but we haven't seen enough investment for replacement sources of energy.
And I think once we move beyond the next couple of years, we'll see a shift in allocation of resources, hopefully, more towards the investment in renewable energy. And we had started to see that, for example, there was quite a big surge in investment capex from China in renewable infrastructure. But obviously the pandemic has put a halt to many of those projects, you know, across a number of different countries. So that, I'd say that’s part of the difference here in that we can't just follow high prices, we need to be thinking much more longer term and much more sustainably in terms of investment decisions.
And I'd also note that some of the government policies to help with the cost-of-living crisis as well. And that can be quite short term as well. So just providing subsidies, that would be helpful. But again, it's this idea of - exactly as Bob said - renewable energy is a national security issue now. And that needs to be where the resources are allocated going forward, once we move out of this, this crisis, but at the moment, it seems to be knee-jerk short-term policies, unfortunately. And that's natural considering how tight supply and demand balances were heading into this, into this crisis.
Richard: And just staying with you Sree, we touched on soft commodities at the at the starter and some of the existing trends - weather trends particularly - were there before the problems we've seen in Ukraine. Obviously, a supply response is in some areas easier in the soft commodity areas and in some of the other broader commodity areas, but should we expect to see that? Or is the supply that we've lost in some of these areas, too great to be replaced in in that timescale?
Sree: Yeah, it's actually a quite a complex picture. We've been looking at this and discussing this in a great deal of detail in recent weeks. And so, you know, going into this recent crisis with the Ukraine war, even before that, we did have weather related issues that were weighing on agricultural prices. So for example, droughts across the US had impacted wheat, we had the impact on South American supply from La Nina which may remain in place until June or July. So this has really impacted soybeans and coffee prices in particular. And so there were a number of weather related issues and this is a constant source of anxiety and uncertainty for the agricultural industry.
Now the impact of the outbreak of the Ukrainian war has obviously amplified price pressures within agricultural complex as well. And we're all very well aware of the impact of the size of the global supply of grains that are coming from Ukraine and from Russia. But also, in particular, fertiliser supply as well, that's been hit quite hard as well, because of the outbreak of the war. And I think we need to look at the various channels through which this can impact the outlook for agricultural prices.
So first of all, Europe has been quite heavily reliant on Ukraine for the wheat and grain supply, there are discussions about transporting grains from other countries. But for example, take the example of India, they could transport exports grains to Europe, but there is also concerns about their domestic consumption, as well, being able to provide for, you know, the domestic demand. So we could start to see some more protectionist policies there with regards to exporting food, food items, and grains, and so on. So there's that side of the protectionist side of it, but also then the logistical side of the story as well. So just trying to transport grains from the US through to Europe is much further away. So the shipping costs, transportation costs of logistics are much more expensive. And again, as Bob mentioned, you know, we have the issue of labour suppliers shortages as well. All of this is impacting the overall supply of prices, the overall price direction.
And in terms of fertilisers, there are concerns that perhaps the shortage that we're seeing today could lead to impacting crop yields over the course of the coming months. Now, the estimates there are quite varied. And there is a great deal of uncertainty there. But what we have seen, even before the Ukraine war, was the fact that higher energy costs, were pushing up prices for fertilisers as well. So there is this sort of feedback loop that was already in place, even before the shortages kicked in.
Richard: And Bob, how do you see the soft commodity side from your side of the pond? Obviously if some of your farmers will be prospering in some of these prices, but you hide how are they seeing things?
Bob: I think the La Nina point is a really valid one. And just kind of the backup La Nina means cold ocean temperatures on the surface of the Pacific Ocean west of South America. And what that tends to do is, it tends to pull moisture off the land and send it over the ocean making the land dry. So obviously you get lower crop yields when the land is dry. And that has proven, there's a tremendous amount of US, North America and South America growing regions which are under drought.
An important point though, is that this is the second consecutive year of La Nina conditions. And that's really important because La Nina is like the Chicago commodity grain traders Mardi Gras, they love it, because of what it does to prices. The last time we saw a year on year, La Nina condition was in 2010 and 2011. And not surprisingly, that's where grain prices are right now, they're back to 2010, 2011 prices. So I think it really kind of helps underline what we're saying here is that, some of the Russia Ukraine story is not yet in prices. And if you, if you really get anything out of this, you should understand that the fundamental basis for where prices are right now, is, a slight amount of risk of disruption in supply from the Russia Ukraine war, but really there are very large fundamentals that have backed up and put prices where they are now.
Richard: You both talked about the politics of alternative energy it feels like the politics of food could be as important in the short term, we're already seeing some of that in Sri Lanka and other areas of the developing world but I suspect we'll see that more broadly. Is that Is that a fair expectation?
Sree: I think that is a key concern at the moment, you know how, across a number of different countries how this combination of food and energy price, squeezing household incomes and living standards, and it really varies across countries. But this is a common theme for the politicians and policymakers to try and manage the impact of this.
I mean, a few weeks ago, we were looking at just the growth impact of the increase in energy prices. And what you can see is even though during the pandemic, we've seen, you know, savings have increased, there's a bit of a buffer there. But even before the war we had seen, in some countries, there were surveys that were suggesting that households had already started changing their behaviour, they'd already started to shift their consumption patterns and started easing into their savings buffers. And that was even before the war and I think this is a, you know, this constant concern that that we're hearing about that that's likely to persist for the next at least until the end of this year.
Richard: Bob, do you concur with that? It does feel like it if ever there was - along with the politics of alternative energy the politics of food - it does require a sort of global solution and it feels that the global solutions are in short supply at the moment but does that sound also fair?
Bob: So, you know, Europe is more attuned to these price pressures just because of the way that natural gas price rise has played out, it's roughly 500% price gain in the last couple years on natural gas, which flowed into electricity prices. But even in the US, you know, you're looking at 250% increases over the last couple of years in natural gas, and we're starting to see those type figures flow into the CPI numbers. However, you know, whether you're in Europe, the UK or the US, you have a number of ways to substitute behaviours to avoid taking all of that price increase into your family budget. But people in some of these countries with lower per capita GDP, you know they don't have the same flexibility in food sources and energy sources. And that's really where I think more of my attention is.
Additionally, we need to be cognizant of ESG pushes because, there was a chemical pesticide that was banned in a southeast East Asian country, and it dropped crop yields in half, immediately causing food scarcity and civil unrest. So, we need to be careful and almost it's almost like you want a global policy but the ability to adapt it locally so that you don't you can foresee these kinds of problems before they occur and not inflict pain on some of the world's most vulnerable people.
Richard: I suppose we've seen as we've touched on throughout this discussion, high prices, but we’ve also seen extremely high volatility in markets in the hard and soft commodity markets. Bob, it would be quite interesting to get your perspective on who are the players and some of the markets themselves who are trading some of these commodities obviously on the London Metal Exchange that's with a particular reference of the past few months, and nickel, some traders have been caught out. Is it right to feel that there might be a likelihood of more vulnerability in some of the players in this market given the volatility we're seeing?
Bob: So we know what high interest rates do to stocks, right, the future earnings the present value of future earnings is less, because you're using a higher discount rate. You also have a lower multiple, they tend to have a lower price to earnings multiple. So, we know what happens to stocks. And what happens to bonds is pretty obvious. But how do commodity markets react, and what we've seen is a tremendous uptick in price volatility in commodity markets. And we've seen a tremendous uptick in financing costs for physical commodity markets.
You know, you're trying to book a shipment of a commodity from Saudi Arabia to Houston or something of a sort. And volatility plays a factor in that cost. Interest rates play a factor in that cost. And so, both of these recent trends tend to lower the physical supply and ability of these physical commodity trading houses, to actually supply the physical demand to meet the demand.
And so, this is a really important factor. And a few of these trading houses have gone to central banks of Europe and the UK and asked for help in this financing. And it's just not something that's that the central banks can even consider - the optics of it are just, you know, ‘let's help the big commodity trading companies make money off of the higher prices’ is just it would be all over the headlines. So, there's, there's a political tension in there as well.
If you look at the visible inventories of most industrial metals, with the exception of copper, so aluminium, nickel, zinc, all of these, you can see the physical inventory levels on the exchanges. And they're all very, very low. And the reason for that is that the physical demand is actually pulling that inventory off the exchanges to use. Obviously, energy prices are very high. Some of these metals are very energy intensive to produce. So, in some cases, European smelters have stopped producing them because they're just not competitive on a global market. And so, it's a very complicated situation, and it's something that we need to be very careful of because there will be no energy transition without industrial metals. Copper is in every single thing electric; aluminium is absolutely crucial for electric vehicles to offset the heavy weights of the batteries. Elon Musk called his aluminium frame for the Tesla his unique selling proposition, not the battery, it's the aluminium frame. Nickels and batteries and zinc, galvanizes steel for all sorts of wind turbines and other projects. So, just to call these metals crucial to the energy transition is a really big understatement.
Richard: And presumably free from a long term perspective, notwithstanding the views on short, shorter term volatility, high prices, high interest rates, the problems that the traders might have, presumably demand supply will out in the end and the data that will set the price and the volatility will be will be less remembered over time, but that's what your work would suggest over time.
Sree: Yes, that's very true. I mean, we have done a bit of work about a year ago or so, you know, everyone's talking about the commodity supercycle. And we wanted to drill into that in a bit more detail and as Bob has highlighted, it's the energy transition that's really going to drive that. So I wouldn't say it's a broad based commodity cycle in our view, but I think there are key metals and key materials that are going to be affected. And exactly as Bob has said, copper, aluminium, you know, these are metals that are going to be quite critical in terms of that green infrastructure. And I think there'll be in it's really sort of picking out what are the materials that are going to be affected the most and where they begin to see the greatest demand in terms of that transition.
So I wouldn't say this is a we're seeing a lot of volatility across the whole, across the board for commodities, but longer term, it's really the structural drivers that we need to be really focusing on.
Richard: Okay, well listen sadly, on that note, that's all we have time for today. I'm conscious we’ve ranged across quite a lot in the last half an hour. Sree, Bob, I appreciate your time, your insights and your candour. We've touched on the fundamentals - however, one describes them - the oil market, soft commodities market, the technical side of these markets. Importantly the politics of these markets and the increasing importance of these, these assets and the politicians that can sit on top of them. It's been a fascinating conversation. I look forward to speaking again, but in the meantime, thank you both.
IMPORTANT INFORMATION
Trading in commodities entails a substantial risk of loss. Commodities generally are volatile and are not suitable for all investors. The commodities markets and the prices of various commodities may fluctuate widely based on a variety of factors.
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