Cautious and defensive trading with a few exceptions. That is the best way to describe the early 2023 price action across the commodity sector. Hopefully, this year will provide less drama and volatility than last, when the Bloomberg Commodity Total Return (BCTR) Index surged to record a first-quarter gain of 38% before spending the rest of the year drifting lower and closing at 16%, which was still a very respectable return considering the stronger dollar and market participants spending the second half increasingly worrying about a recession.
Such a pessimistic focus helped drive financial deleveraging across the commodity sector and physical destocking to the point some markets have ended up being ill-prepared for a strong recovery in China – even less so, should the most widely anticipated recession in history turn out to be a shallow one.
Tight market conditions across most commodities in 2022 saw forward curves swing into backwardation, a structure that rewards long positions through the positive carry from selling an expiring contract at a higher price than the next is bought. Backwardation helped drive the mentioned 16% return on a passive long investment in the BCTR Index, almost 9% above the return signalled through changes in spot prices.
The key macroeconomic event that will drive developments in 2023 has, in our opinion, already occurred: The abrupt change in direction from the Chinese Government – away from its failed zero-Covid tolerance toward reopening and kickstarting its economy – will have a major impact on commodity demand at a time where supply of several key commodities from energy to metals and agriculture remains tight. In addition, risk sentiment will likely also be supported by a continued and broad drop in the dollar as US inflation continues to ease, thereby supporting a further downshift in the Fed’s rate hike trajectory.
Furthermore, an increased likelihood of an incoming recession either not materialising or becoming weaker than anticipated may also trigger a response from financial and physical traders as positions and stock levels are rebuilt in anticipation of stronger demand. In such a scenario, the structural underinvestment thesis, mostly impacting energy and mining, will likely attract fresh attention and support prices.
Crude oil demand will, according to the International Energy Agency, rise by 1.9 million barrels per day in 2023, bringing the total to a record high. The main engine behind that price supportive call is a strong recovery in China as the country moves away from lockdowns towards a growth-focused recovery that is driven not only by increased mobility on the ground, but also a post-pandemic recovery in jet fuel consumption as pent-up demand is unleashed.
What it will do to prices very much depends on producers’ ability and willingness to bump up supply to meet that increase in demand. We expect multiple challenges will emerge on that front to support higher crude oil prices later in the year once demand in China increases, especially as sanctions on Russian crude and fuel products continue to bite and OPEC shows limited willingness to increase production.
The theme for our quarterly outlook – The Model is Broken – has very much been felt and seen across the energy sector this past year. Russia’s attempt to stifle a sovereign nation and the western world’s push back against Putin’s aggressions in Ukraine remains a sad and unresolved situation that continues to upset the normal flow of prices for key commodities such as industrial metals and key crops to gas, fuel products, and not least crude oil.
EU and G7 sanctions against Russian oil from December last year have created several new price tiers of oil where quality control and geographical distance to the end-user are no longer the only drivers of price differentials between crude grades. Seaborne crude oil flows from Russia have held up but will increasingly be challenged in the coming months as the EU’s product embargo is introduced in February.
Developments have also forced Russia to accept a deep discount on its crude sales to customers not involved in sanctions – especially China and India. The second wave reaction to this development is strong refinery margins in China, a country with capacity beyond what is required for the domestic market. Depending on the strength of the economic rebound in China, we are likely to see an increase in product flows from China to the rest of the world. These flows, together with the US and the Middle East, which is an emerging refining powerhouse, will likely make up the short fall in Europe from the removal of supply from Russia.
Crude oil’s trajectory during the first quarter primarily depends on the speed with which demand appears set to recover in China. We believe the recovery will be felt stronger later in the year, and not during the first quarter, which seasonally tends to be a weak period for demand. With that in mind, we see Brent continue to trade near the lower end of the established range this quarter, mostly in the 80s before recovering later in the year once recession risks begin to fade, China picks up speed, and Russian sanctions bite even harder.
OPEC meanwhile has increasingly managed to rein back some price control, not least considering the level of market share it controls together with members of the OPEC+ group. Through their actions, they have been able to create a soft floor under the market and the question remains how they will respond to a renewed pickup in demand – not least considering their frustrations with Western energy companies and what they see as political interference in global oil flows, particularly last year’s decision by the White House to release crude oil from its Strategic Reserves.
Overall, we see another year where multiple developments will continue to impact both supply and demand, thereby raising the risk of another volatile year that at times may lead to reduced liquidity and with that fundamentally unwarranted peaks and troughs in the market. Following a relatively weak first quarter where Brent should trade predominately in the $80s, a demand recovery thereafter combined with supply uncertainties should see Brent recover to trade in the $90s with the risk of temporary spikes taking it above $100.
