(Words by Ole Hansen, Head of Commodity Strategy at Saxo Bank)
The direction of many major commodities will continue to be influenced by the decisions taken in Washington during the past six months. Apart from the weather, which has delivered challenges as well as opportunities across the agriculture sector, President Donald Trump’s trade war with China and sanctions against Iran will keep setting the tone for the rest of the year.
The trade war, especially with China, shows no signs of easing. At least not before the November midterm elections, with Democrats generally favouring Trump’s tough stance towards China. Accepting this fact, China has shown little interest in trying to find a solution before the US elections.
(Image: Ole Hansen)
While growth and demand-dependent commodities, such as industrial metals, have been left reeling, energy prices have risen sharply in response to the November introduction of US sanctions on Iran’s oil trade.
With the risk of a prolonged trade war and rising oil prices due to sanctions, the global economy may struggle to maintain its long-held positive momentum. The combination of rising energy prices and the hitherto strong dollar, not least against many emerging market currencies, will act as an unwelcome tax on consumers.
Adding to this we have rising interest rates in the US as the Federal Reserve continues to normalise its monetary policy. The combination of high external dollar debt, rising interest rates, a strong dollar, and rising oil prices carries the risk of slowing down growth prospects, especially in EM economies.
With this outlook in mind, we try to gauge the direction of crude oil and metal prices heading into the final quarter. While China’s promises to cut taxes and increase (infrastructure) spending have supported a bounce in industrial metals, the outlook for oil is troubling.
At this stage, we simply do not know the full impact of sanctions on Iran, and whether the production cut ends up closer to 0.5 million or 2 million barrels/day will determine if oil costs closer to $70/barrel or $100/b by year-end.
While the negative impact of rising crude oil prices has yet to affect the 2019 demand outlook, there is no doubt that it will have an impact sooner rather than later. EMs led by China and India represent close to 90% of global demand growth, and the table below shows how much a barrel of Brent crude has risen during the past year in local currency.
India, which is on track one day to overtake China as the country with the highest demand growth, has seen the cost of Brent crude in rupees return to a level that prevailed between 2011 and 2014. During that time, the price in dollars averaged $110/b, some 33% higher than today. The potential spike above $90/b that some expect over the coming months would only accelerate the demand destruction, which ultimately would see oil turn lower again.
In the short term, however, falling supply from Iran and to a certain extent also Venezuela will continue to tighten the market. This development will increase the pressure on producers with spare capacity to produce more. Inadvertently, a drop in spare capacity would be viewed as price-positive given the reduced ability to react to an unforeseen future disruption.
However, given the negative impact of the current dollar strength, rising US interest rates and trade wars, we believe that the global economy is not able to cope with runaway oil prices. Although the US Energy Secretary has ruled out tapping into the country’s Strategic Petroleum Reserves, an embattled Trump will not be pleased with the prospect of having to fight a midterm election with domestic gasoline prices up by one-third since his election victory in November 2016.
After cutting bullish oil bets by 41% from a record back in February until August, hedge funds have plenty of room to increase their oil exposure as long the technical and fundamental outlook supports it.
With normal supply-and-demand mechanisms being replaced by political interference, we refrain from issuing an end-of-year forecast for crude oil. We understand the reasons for the bullish sentiment, however, as the oil market reacts first and asks questions only later.
Brent crude oil – Source: Saxo Bank