Commodity Markets in Disarray
Commodities have been soaring since the second half of 2020, and they continued to do so in response to Russia’s invasion of Ukraine since the former is a major exporter of crude oil, natural gas, nickel, aluminium, palladium and other commodities, while the latter is a major exporter of wheat and corn foremost. Events in Europe were seen as boosting global inflationary pressures and complicating supply chain disruptions.
The escalation of the Russia-Ukraine conflict led to the imposition of retaliatory sanctions by Western nations against Russia, translating into major supply disruptions—and the creation of stopgap measures among commodity buyers. Commodity markets were thrown into disarray by the move as Ukrainian grain-handling ports shut down and select metals refineries were idled. In Russia, liquefied natural gas (LNG) orders were paused, finance for the country’s raw materials trade evaporated and Black Sea wheat sales froze.
European natural gas prices spiked nearly 40% on the news as the wartime restrictions sparked concerns about potential energy shortages. As it pertains to oil, Russia produces over 10 million barrels per day (mb/d) of crude, about the same as Saudi Arabia. At an oil price of US$100 per barrel, Russia’s oil revenues are around US$365 billion at an annual rate currently. The European Union (EU) is Russia’s largest trading partner, accounting for 37% of its global trade in 2020. On average, the EU receives nearly 40% of its natural gas and more than a quarter of its oil from Russia.
US crude oil prices rose nearly 9% in February, while the international benchmark (Brent crude futures) surged above US$100 per barrel as supply—already stretched by rebounding demand and limited supply increases—was seen as tightening further as Russian flows were slated to be disrupted and buyers preemptively looked to secure less-contentious supplies elsewhere. The associated geopolitical risk premium pushed up current and forecasted 2022 crude oil prices throughout the month, culminating with a spike to the highest levels since 2008 as war broke out in Ukraine and as sanctions were drawn up against Russia.
There are three ways that global supply could be curtailed by the current war: Russia has trouble bringing oil to market as a result of limited buyers and export routes, Western leaders sanction Russia’s oil exports, or Russia voluntarily cuts off supply in response to Western sanctions.
Even without any supply troubles from Russia, the supply/demand balance had tightened, as high frequency data suggested global crude oil stockpiles were drawn down counter-seasonally in January and February. Among the key factors was OPEC+ (Organization of Petroleum Exporting Countries and select allies), which has so far struggled to meet its commitments to ramp up output. Diminishing Omicron variant fears and pent-up demand for travel staved off the typical winter seasonal drop in demand. Looking ahead, the International Energy Agency estimates oil consumption will rise from its present level of about 97 mb/d to 100 mb/d—a return to pre-COVID-19 levels by the end of the year, even before global aviation fully recovers.
US producers are also beginning to feel the effects of the inflationary environment via higher input costs. Typically, publicly traded oil companies would be ramping up output as rapidly as possible at the current price point. However, climate and shareholder activists have succeeded in forcing US and European fossil fuel producers to restrain their capital spending. US shale producers have yet to meaningfully boost their production in response to surging oil prices, signalling continued discipline with respect to capital spending and returns to shareholders, though in early March some indications surfaced to suggest management teams were beginning to consider reinvigorating their drilling activity and production growth.
Russia is a key supplier of natural gas to Europe, and Ukraine is an established transit route for Russia’s gas shipments. The advent of war has sparked concerns that supply curtailments will get worse on the continent. Germany’s cancellation of the Nord Stream 2 pipeline’s certification has already put the Russian energy industry on notice, though Russia also just signed a 30-year contract to supply China via a new pipeline, boosting its energy alliance with Beijing. Nord Stream 2 was completed last year but had not received final certification, which appears unlikely now. The cancellation does not immediately affect gas supplies to Europe, since it would not have begun shipping until the second half of the year, but it does indicate that Russia’s biggest customer is willing to risk supply disruptions to punish Russia’s energy industry. Pipelines from Russia through Ukraine account for about 10% of all gas supply to the EU, and that supply is now at risk. LNG exports from both the United States and Qatar have helped narrow the supply deficit in Europe in recent months as the continent’s LNG imports moved to record highs, yet Europe-wide storage remained at a five-year low. US natural gas exports have reached a limit until new capacity comes online, and a fully integrated global market is still a long way off.
The situation is dynamic, and as of this writing, Russian troops continue to lay siege to several Ukrainian cities. Sanctions have begun to impact the Russian economy and currency, the latter of which has lost significant value, as traders struggle to insure cargoes and shipping companies refuse to transport the country’s raw materials. Commodity prices have begun to reflect risk of disruption, which was strongly apparent in crude oil markets, where Brent prices have risen by more than US$20 per barrel (or 34%) since the invasion began, bringing the year-to-date increase to about 70% (through March 8).
Metals prices and palladium, in particular, have also experienced significant increases due to both supply disruptions and rising production costs, which in turn elevate marginal costs. These types of price spikes raise obvious questions about the durability of economic growth, a factor that we believe must be considered in the current environment.
Accurately predicting potential outcomes, applying market probabilities, and estimating the impact on commodity prices and related equities amid such a high level of uncertainty is a nearly impossible task. We therefore focus on what we know. Most commodities are trading above the marginal cost of supply and in some cases far above that baseline. In our estimation, natural resources equity valuations are not reflecting currently high spot commodity prices, but appear to be imputing prices that are also above marginal cost. While this situation in and of itself does not mean the stocks are overvalued, it does elevate the importance of cycle duration. Commodity prices typically revert to marginal cost—or lower—over time, and equity valuations should reflect excess profits generated during periods of high prices in addition to the discounted value of long-term normalised profits and terminal values (i.e., the value of an asset, business, or project beyond the forecasted period when future cash flows can be estimated).
Cycle duration in the current environment is obviously difficult to estimate, but we have written repeatedly about the lack of investment in new and existing resources and continue to believe this backdrop will result in a prolonged cycle of elevated prices. This is not to say that current prices will not retreat, which we believe is likely over the intermediate term, and natural resources equities may decline as a result. However, barring significant economic damage from the current Russia-Ukraine conflict and inflationary pressures, we think supply and demand balances should remain healthy for the next several years.
Given this outlook, we are seeking to reduce holdings in securities that have appreciated significantly and appear fair to fully valued. Uncertainty and volatility often lead to the mispricing of securities, both higher and lower than their intrinsic value, and so we are also focused on identifying attractive buying opportunities for our shareholders.
Performance across the energy sector’s seven industries has not been uniform lately, and we continue to find opportunities in the various sub-groups such as oilfield services and energy transportation infrastructure (e.g., pipeline operators).
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