IAUM - Commodity Markets Face Tug-Of-War Between Tight Supply And Demand Concerns

Summary

• Physical commodity markets remain very finely balanced.
• Part of the reason for high inflation is commodity prices have been strong.
• There are signs from OPEC that they would be willing to adjust their production to accommodate Iranian barrels back onto the market.
• Longer term, copper has one of the stronger demand profiles because of the demand for electrification.
• If some of the uncertainty in the world were to subside and the market were to refocus on the real yield, that could be a headwind for the gold price.

Global commodities continue to face increasing volatility amid the battle between tight supply dynamics against a potential economic slowdown. Jennifer Nowski, Portfolio Manager at TD Asset Management looks at how that tug-of-war is playing out in the energy, copper and gold markets.

Transcript

Greg Bonnell: As investors weigh the risk of a recession, the commodities market's been a bit of a tug-of-war between worries about slowing concerns and those growth concerns versus tight supply for oils and metals. Joining us now to discuss is Jennifer Nowski portfolio manager at TD Asset Management. Jennifer, great to have you on the program. Welcome.

Jennifer Nowski: Thank you.

Greg Bonnell: Well, let's jump into the conversation. Let's talk about this theme that we've been watching. We're talking about tight supply and balanced on growth worries. What are you seeing out there?

Jennifer Nowski: So in general, when we look across physical commodity markets, they do remain very finely balanced. Starting on the supply side, there's been years of under-investment, so near-term supply growth in many areas is very limited. We still have risks and uncertainties associated with exports out of Russia. Inventories are very low. And more recently, the very high power prices and natural gas prices have resulted in some production being taken offline.

The supply side was certainly the focus in the first part of the year. And that's part of the reason that many commodities started hitting highs that we haven't seen in nearly a decade. Now, to your point, prices have backed off a bit. And part of that is due to growing concerns over demand and slowing macroeconomic growth.

Greg Bonnell: So there's a lot of concerns there. Of course, inflation has been another big theme for investors so far this year. What does that mean for companies in the commodity space?

Jennifer Nowski: So higher -- part of the reason we're having high inflation right now is because commodity prices have been strong. So that's good for producer revenue. However, like everyone else, they are feeling the impact that is having on their cost base. So for the past couple of quarters, we've seen operating expenses amongst producers start to rise. Higher commodity prices also mean higher royalty payments, potentially higher cash taxes, and higher demands for more royalties. As we also look at the CapEx side, inflation has been creeping into CapEx, and that has been feeling the impact as well.

But if we take a step back and look more broadly at the fundamentals amongst the producers, they're in a very strong financial condition right now. So the producers have spent the past few years, when commodity prices were lower -- they've been really cutting spending, cutting CapEx, being a lot more disciplined on M&A. And that has left them -- and deleveraging, importantly -- and that has left them in great financial shape. Leverage is very low. And at current prices, free cash flow yields are very high. So it varies by company, but amongst energy producers, you can see free cash flow yields in the high teens at current prices. Diversified miners would also be double digits. Now, the risk, of course, to those free cash flow figures is if prices weaken, or if CapEx starts to rise.

Greg Bonnell: All right. You mentioned the oil and gas industry there. I know commodities is a big space. You do a lot of coverage. Let's get into some of the specific commodities you cover. And let's talk about what's happening with oil, because this has been a bumpy ride from day to day.

Jennifer Nowski: Yeah. So the oil market is fairly finely balanced. Some of the price volatility we've seen in recent months has been to that growing concern about demand and weakening economic growth. However, supply is fairly limited. So if you look at OPEC's effective spare capacity, what they can easily bring to market, that is at low levels. Now, the US has been growing their production. To date, demand has been robust enough to absorb it. But also, we have disruptions elsewhere. You see some in Libya, due to geopolitical events there, and also Russia. So as we go into the end of the year, the EU is expected to reduce their imports of Russian oil, and it will remain to be seen if Russia can continue to place the amount of barrels it has been placing into the market.

Now, one of the bigger near-term concerns has been the rekindling of the Iranian negotiations. Now, it's still very uncertain what the outcome of this will be. But there has been signs out of OPEC that they would be willing to adjust their production to accommodate Iranian barrels back onto the market.

Greg Bonnell: Fascinating thing about commodities -- it can tell us so much about geopolitics. It can tell us so much about an outlook and fears of an economic slowdown. So we talked about this theme of slowing growth -- fears about that. What does it mean for copper?

Jennifer Nowski: So copper is one of the commodities -- it's used in so many different industrial manufacturing applications, electrical transmission infrastructure. Because it's so broad-based, it's viewed as a proxy on global economic growth, hence why it sometimes gets the name, Dr. Copper. So its price has been weakening as well due to the near-term demand concerns. And particularly for copper, one area to watch is China.

So China is a massive consumer of metals. They're roughly 1/2 of copper demand. So as we go through the rest of the year, when looking at China, you look at what their COVID policies will be, how they're handling their property situation, and whether some of the stimulus measures they're starting to put in place will actually have a positive impact on economic growth.

Turning to the supply side of copper, there is some supply growth this year. There's a few new mines ramping up -- Grasberg expansion, Kamoa-Kakula, as well as Quellaveco, to name a few. This is at times offset by disruptions. Some mines have struggled with COVID absenteeism. You sometimes have strikes. But when we look at the longer term for copper, that's when it could become more interesting. So longer term, copper has one of the stronger demand profiles. And that's because of the demand for electrification. So its use in transmission and infrastructure -- EVs, EV charging stations, renewables, all growth areas. As well, if you look out a few more years, the new sources of copper supply become less clear.

Greg Bonnell: What fascinates me -- and there was a time I thought perhaps I understood why gold would do what it would do in different conditions. What is the outlook for gold? What is going on with gold?

Jennifer Nowski: Yeah, so gold is a bit different, because it's both a commodity and a financial asset. So its price is driven by three main things -- real yields, the US dollar, and safe haven demand. And if we think about gold, it's been kind of tending rather rangebound for the past year and a bit. And that's because the outlook for these three factors has been more mixed. So starting with a tailwind that it's seen -- and that's all this uncertainty, so geopolitical uncertainty, as well as uncertainty being the really high inflation, what the Fed's next move is going to be. That promotes some demand for gold as a hedge or safe haven. And I feel like we've seen some of that this year.

Turning to the second point on the US dollar -- so the US dollar and gold are actually negatively correlated most of the time. However, during times of stress, they both get that flight to safety bid. And we saw this immediately around the Russian invasion. However, lately, the US dollar has remained very strong, and the gold price has been kind of lackluster. So I think it's been more of a headwind.

Now, the third is real yields. And the reason this is important is because gold pays no income. So the opportunity cost of holding gold is what you could earn somewhere else. So the US 10-year real yield was about -1% at the beginning of the year. It's now about 56 basis points. So plus-56 basis points -- that is a really big move for fixed income. And it's a headwind for gold. And if, say, some of the uncertainty in the world were to subside a bit and the market were to refocus on the real yield, that could be a further headwind for the gold price.

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