By: James Luke, Malcolm Melville, John Mensack, CFA
In a June 20th podcast episode of The Investor Download, Senior Investment Director John Mensack consults Commodities Portfolio Managers Jim Luke and Malcolm Melville to learn the effects of the 3D Reset on commodities. For your convenience, we have extracted the most salient insights.
Listen to the full podcast here.
John Mensack: The 3D Reset encompasses major global economic and financial changes stemming from trends in decarbonization, deglobalization and demographics, the three Ds. We believe the results of the 3D Reset will be higher and more durable inflation, increased fiscal policy, challenges to globalization, more robust responses to climate change and labor shortages that drive technology investment. We advise investors to consider what they’ve done during the last ten years and now do the opposite. This podcast focuses on the implications of the 3D Reset for commodities.
Rates are now off their generational lows across the globe and in the US we’ve had the largest and sharpest increase in interest rates since the early 1980s. Central bankers have prioritized inflation over growth. One of the most consequential points of debate is what will happen if the cyclical elements of the economy, particularly employment and financial stability, clash more explicitly with the inflation target.
Jim Luke: I doubt developed markets like the US will reach an inflation target of 2%. Given the early signs of stress in the US economy, in order to meet the 2% target, there will likely be pronounced increases in unemployment and the knock-on effect of that into the broader policy picture.
John Mensack: If we use gold as a proxy for all commodities in general and say we’re going to be running at a higher level of inflation, what is the impact for goldbar?
Jim Luke: Traditionally the US dollar and especially real interest rates have driven the price of gold but these relationships are changing. In 2022 when real rates in the US went from negative 100 to positive 150 on the ten-year Treasury bond, gold performed resiliently. I think the way to frame the macroeconomic argument for gold is through the lens of normalization. If all of your faith lies with the Federal Reserve and its ability to normalize monetary policy and return to a world where it regulates business cycles, the outlook for gold is not too rosy.
We think that fundamentally some of those macro pressures that stand behind current policymakers, particularly the current state of US fiscal affairs and the elevated levels of public debt, push policymakers toward unconventional policy responses, such as direct monetization of debt, the resumption of quantitative easing and perhaps, in a downturn, the resumption of fiscal programs. This type of environment is potentially better for gold.
Gold is to some extent a barometer of the credibility of central banks and it is becoming apparent that the expansion of central bank balance sheets, particularly at the Fed, is not a temporary measure. What do we think would happen to that balance sheet in the event of another downturn? What just happened to the balance sheet in response to a regional banking crisis? It went straight back up again. There are underlying systemic stresses here that make some of these short-term issues a sideshow; the debt ceiling is the most obvious one. If you’re a bit skeptical of the return to a normalized monetary policy regime like we are, then gold has a place, as do broad commodities.
John Mensack: Let’s drill down to oil now. The rise of the petrodollar in the 1970s was based upon implicit US security guarantees in the Middle East. They seem to be wavering right now.
Malcolm Melville: Yes, that system was built on the guarantee that the US would provide security to those in the Middle East in return for oil being priced in dollars and then those dollars getting recycled into US assets to help fund US deficits. But I think there’s a number of reasons why that relationship and that kind of system where oil was primarily priced in dollars is going to be challenged. The US’s need for this system is reduced somewhat, given that the US is now the number one producer of oil in the world. The other reason is that the Middle East wants to build strategic relationships with India and China.
Those economies are very important now in the global context. We see that developing strategic relationships with them is increasingly important to the Middle East, especially Saudi Arabia. Then there is Russia. Moreso since the invasion of Ukraine, Russia wants to avoid anything to do with the dollar and there is pressure for Russia to deal and transact in oil in a different currency from the dollar. That feeds the narrative of countries moving away from using dollars in the commodity space. In fact, China, which consumes 15-16 million barrels a day, 15% of global oil, wants to make its currency more international and is pushing for oil to be priced where possible in the renminbi. I think we can see that petrodollar system being eroded in years going forward and oil trading in other currencies apart from just the US dollar.
John Mensack: So, 15 months ago, when Putin’s tanks rolled into Ukraine, there was some speculation that Russia would have a real problem exporting its oil but that ended up being a bit of a naive take.
Malcolm Melville: It was. The main buyers we’ve seen are India and China because Russian oil trades at a $25 discount to international oil. And cheap oil is too good to miss. If you look at the western sanctions regime, it is set up to reduce the flow of capital back to Russia while ensuring Russian oil flows onto the market to depress inflation. The last thing the West wanted through the sanctions regime on Russia was to restrict the oil supply and see inflation and energy prices spike. The sanctions have worked. Russia’s oil trades at a $25, $30 discount, but it continues to flow at roughly the same rate, putting a cap on oil prices. This explains some of the weakness we’ve seen in the oil price over the last twelve months.
John Mensack: So Russia is earning revenue but not a ton of profit; the West wanted to keep the taps on but keep profits down. No one wants to fund the war machine. What do those recent OPEC+ production cuts mean for crude’s risk premium going forward?
Malcolm Melville: I think the price you see on the screen of oil should have a risk premium in the sense that OPEC+ is the major dominant supplier to the oil market. And its cuts, which were decided on between regular meetings, suggest that it has the ability to change the supply of an absolutely key commodity as and when it sees fit. I don’t think anyone outside that core group can predict its decisions. Therefore the price of oil should reflect that risk premium. Additionally, the OPEC+ cuts put a floor under the oil price. I think if oil prices fall materially below where we are and get into the 60s, you would see another supply response.
John Mensack: When it comes to climate transition, all roads lead through commodities. And we’re going to focus specifically on copper, a key metal in energy transition.
Jim Luke: Copper is key because of its role as an irreplaceable conductor of electricity that offers increased usage per unit. So increased intensity of usage in things like electric vehicles, but also increased intensity of usage per megawatts of installed capacity. From an energy transition perspective, if you were to shift around the composition of electric vehicle batteries, so you use a bit more manganese, a bit less nickel, for example, you’re not going to be able to get away from using a significant amount of copper in vehicles.
John Mensack: We’ve heard a lot this year about supply disruptions. Can you give us a sense of whether this is to be expected going forward or have we seen the worst of things?
Jim Luke: I think we can confidently say there is enough copper to satisfy the needs of the energy transition worldwide. Supply and demand of any commodity comes down to price. I think what history shows is that at a given price, there will always be a way for the market to balance. We can go back to the early 2000s and prove over and over again that the theoretical peak in copper supply is always two to three years out. And that is no different today than it was in 2010 or 2015.
The question then is how healthy is the supply pipeline that we have in front of us? And what copper price would we need to actually incentivize producers to bring that stuff to market against a backdrop of significant ESG constraints, geopolitical constraints, grade constraints and geological constraints? There is a very credible argument to be made that copper prices need to be substantially higher in order to incentivize supply into the market. But are we going to be facing a critical shortage or a geopolitically destabilizing shortage of copper? On that point I would stay a bit cynical. Here I am a cynical bull in terms of the cooper supply.
John Mensack: So I guess any of these energy transition metals falls along the same lines?
Jim Luke: The supply picture varies by metal; the bottlenecks are in different places. But broadly speaking, one contrast you could draw would be that production, particularly the refined production of some metals, is more concentrated than others. For example, 95%+ of rare earth materials are still processed and refined in China. There are clearly some strategic issues. You can see with the raft of legislation from the EU and with the Inflation Reduction Act in the US that this is something that is becoming much more highly prioritized as the global geopolitical situation becomes more fraught.
John Mensack: And there is always a chance for certain countries to strategically stockpile inventories and for the world to stop running as smoothly going forward. Is that correct?
Jim Luke: You would think that if you had your eyes on the future and you had the view that US-China relations were going to worsen, you would hope that policymakers would look at the supply of things like rare earths and some of these base metals and think it would probably be good both from an industrial complex perspective and from the military industrial complex perspective to have a decent buffer on hand. So I wouldn’t be surprised to see governments move in that direction at all and I would be slightly worried if they don’t from a security perspective.
John Mensack: Malcolm, Jim, thank you for your time.
The full podcast is available here.
Originally Posted July 18, 2023 – Commodities in the age of the 3D Reset: Podcast Highlights
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