So far I will score my battle with Goldman over the nature and form of today’s commodity bull market at a draw. They have been right so far on metals and oil. I have been right on iron ore and other materials.
The most pressing disagreement between us is whether or not strong price action to date is evidence of a structural or cyclical bull market. This matters a lot to investors in terms of how long high prices can last which flows into notions of stagflation and equity factors.
My contention is that there is no underlying scarcity in anything. The China supercycle built that out for decades. In energy, metals and softs, the China supercycle delivered immense worldwide excess capacity in ports, shipping, rail, mines, processing. You name it. So any apparent scarcity will be brief.
On the other hand, Goldman contends this:
Last month we argued that markets had moved from pricing demand recovery to pricing supply scarcity. This scarcity pricing is the result of a severely stretched global supply chain, with demand being actively constrained by the lack of supply in many markets. While gas and coal are already at critical inventory coverage (India has 3 days of coal inventory), we believe that oil and base metals will reach such critical levels before year-end. Although they appear unconnected, one-off shocks are driving prices today – from low wind in Europe to tighter Chinese coal regulations – it is the system that causes their impact on prices making commodity inflation more persistent. Depleted systems see a bigger effect from a smaller shock – it no longer takes ‘tail’ events like COVID to generate large price pressures. In fact, previously unnoticed shocks – a 1 std deviation move in European weather, for example – now can break incredibly tight markets. More importantly, all the supply chains are connected, leaving shortages in one area generating system stress in another. Reduced coal output in China hits aluminum smelting capacity, creating shortages in aluminum. Reduced gas availability forcesgas-to-oil substitution, generating shortages in oil. The rolling impact of smaller, frequent shocks on a stretched system generates the emergent phenomenon of persistent physical price inflation – the start of which we are seeing today.
The problem with this analysis is the notion that it is a “stretched system” in commodity supply. That implies structural shortages. What we have are temporary shortages resulting from COVID crimped supply and stimulus pumped demand. Neither will last.
On the supply side, coal and gas supply will rebound fast as Chinese coal output booms and Russian geopolitics with Europe settles down. An incredible amount of LNG is still in the pipeline as well. Supply discipline in oil has been strong so far but will break as prices rise.
Crucially, there is NO shortage in infrastructure for any of it. Choices have been made to limit extant supplies. Those choices are now being unmade very fast. So supply constraints are temporary:
Note that China has been just as short of coal (and gas) on otehr occasions in recent years but has swiftly rebuilt inventories. The same will happen this time as it reopens mines. Most importantly, note that “reopening” supply is very much easier and faster than building new.
The associated European gas shortage is a political, not a physical issue. Europe and Russia will find a way to agree on Nord Stream 2 and will be the end of it. Otherwise, why build it!
On excess demand, Goldman makes two critical assumptions. First, it argues goods demand will remain elevated:
Does it seem likely to you that as economies reopen and we move on from COVID that goods spending will remain elevated in the extreme? Or, will services rebound and goods consumption fall back to trend? My money is on the latter. This is why this argument matters:
With the power crisis threatening industrial production in both China and the EU, and the majority of the post-COVID fiscal impulse behind us, the global growth outlook has weakened from its record levels in early 2021. While some investors might expect this slowdown in growth to ease price pressures, it is important to remember that physical inflation as measured by commodity prices is a dynamic driven by volume – the level of activity – rather than the growth of activity.
I expect actual physical activity to fall back as more money shifts to services.
Goldman’s second assumption about demand is this:
…a resolution of these power issues can provide some respite to global markets and downside to prices – higher Chinese coal output could ease the gas, ali and steel shortages. This is why we remain more bullish on those commodities less exposed to a resolution of those constraints – oil and copper. Case in point, our gas and coal price forecasts are below market forwards in 2022 but oil and copper are well above. Moreover, we remain bullish on copper, as the expected (GSe) sharp decline in new starts (-15% yoy) hits steel, but the momentum from the large pipeline of current works keeps completions up +10% yoy (GSe).
Steel shortages? I guess that’s a joke. Goldman did forecast ferrous shortages and endless high prices but they’ve collapsed as China slammed the breaks on construction. Steel prices have been held up by immense output cuts but those are not “shortages”. Inventories are fine and latent capacity huge.
For the purposes, of copper. Note the short-term supply disruptions now resolving in Goldman’s chart. Plus, the Chinese construction chart relative to copper demand is very dubious. Construction starts have been collapsing since January:
The year-to-date growth rate crossed negative in July:
Infrastructure funding has likewise been hammered all of this year:
So, the notion that there is a huge hump ahead in copper demand all of next year from Chinese construction is highly questionable. The example of steel is useful given the demand for it has already collapsed in China owing to construction retrenchment:
It is true that copper is used a little later in the construction process than steel but not by that much, and certainly well before completion dates. Builders don’t lay the plumbing the day before realtors move in to sell!
In short, Chinese construction – the titan of all commodity demand – is already in deep contraction and the tail for base metals is much shorter than Goldman makes out.
On inventories, yes, they are low at this juncture thanks to the temporary distortions we have seen. Even iron ore isn’t excessive. But base metal inventories are notoriously easy to manipulate (often it is simply a matter of moving pallets of ingots from one side of a warehouse to another). So hoarding can heavily influence perceived inventories if enough sentiment is generated around a commodity.
In short, it’s not hard to corner a market in base metals if a mania takes hold, which is why it is so important for metals bulls to keep markets in a state of panic about alleged shortages.
Finally, there is this peach of an argument:
While we have often said and continue to believe that commodities remain the best hedge for inflation, they remain one of the only hedges for stagflation. Should supply-side constraints become so severe many companies have to cut back production, margins could become squeezed and traditional pro-cyclical assets can underperform. Equally, after a 30-year bull market, bond yields remain only just above record lows, with substantial downside in total return should yields rise further. Amid the requisite central bank rate rises, designed to curb demand and take stress out of the system, long-duration assets tend to get hit further,while TIPS only protect against moves in inflation, not against the rate rises themselves. Commodities however, can provide outperformance even in stagflating markets, precisely because price rises are required to re-balance supply with demand. As a result, commodities should remain a hedge for both reflation and stagflation risks.
In short, buy commodities to hedge buying commodites. The question we must ask at this point is was the 70s stagflation that this thesis is based upon the same as today? Was there a pandemic and global distortions? Strong unions and booming wages? Rising demographics? Globalisation? Monopsony corporations? A disinflationary technology superboom? No.
Yes, there were some commodity shortages for a bit as Japan developed. And there was an energy panic stoked by OPEC, which turned out to be fallacious. Today is mildly reminiscent, at best.
So, does it make sense to buy commodities to protect yourself from stagflation arising solely from commodity inflation? If you think so then I have a bridge you might be interested in buying!
My best guess for what happens from here is this:
- The volume of global goods demand peaks and begins to fall into 2022 as we move post-COVID and services recover.
- Chinese coal output booms into new year and inventories spike for thermal and coking.
- Europe finds accommodation with Russia on Nord Stream 2 in the next six months and gas inventories normalise.
- US shale oil production booms and US oil inventory drawdowns end, though this may require a higher ongoing oil price than the last cycle.
- As the energy bubble bursts, Chinese metals processing ramps and current base metals shortages normalise.
- As the underlying surplus of everything becomes apparent and prices begin to fall, a panicked unwind of hoarding crashes prices through H1, 22. Much like iron ore and lumber this year.
All that stands between us and this outcome is a cold northern winter and possible La Nina.
So the real question you need to ask yourself about the duration of this commodity bull market is are you in the business of betting on the weather?