What the Economic Environment Means for Commodities

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Daniel Greenspan

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Daniel Greenspan, CIBC Asset Management, senior analyst and resource team director.

Thinking about the outlook for oil this year, in the near term, we think the outlook is going to be volatile. The daily push and pull from the risk-on/risk-off sentiment in the market is certainly dragging oil around with it. Generally speaking, oil prices have been dragged lower through March. We’ve seen bank failures in the U.S., and clearly that’s had a negative impact on pro cyclical assets like oil. That said, we do think a good portion of the move lower in oil prices is being driven by financial unwinding of long positions in energy rather than by market fundamentals.

If we focus on the supply and demand fundamentals, we think the oil price outlook remains okay through 2023. On the demand side, we see upside potential from China reopening and targeting plus 5% GDP growth this year. And we’re seeing signs of demand growth with industrial production numbers and with flight activity picking up in China in recent weeks. And we view that as a positive for energy demand. We also see potential for the U.S. Strategic Petroleum Reserve to look to refill at current prices, which would be another source of potential incremental demand for oil in 2023.

The risk to oil on the demand side comes from the U.S. and Western Europe. If central banks get monetary policy wrong and can’t engineer a soft landing and do actually push economies into a recession, then demand for oil could moderate in these key end markets.

But there are two sides to the supply and demand picture, and while there is some uncertainty around demand, the supply side has actually been more clear in recent years. So, we continue to see discipline from energy producers. The balance sheets are strengthened, and the capital is being returned to shareholders via dividends and buybacks. Investment in growth from producers is modest at best. We’ve seen OPEC willing to take barrels out of the market to try to support the price, and we’ve not seen North American producers rushing to pump more oil at elevated prices. So in our view, the supply side remains supportive for oil this year.

Thinking about geopolitics, which have a big impact on oil as well, the Middle East has actually been relatively stable for the past couple of years. We have seen OPEC compliance with production quotas at high levels, and to be fair, some of that compliance is related to production capacity being constrained. But we’ve also seen tensions between rivals in the region ratchet down in recent weeks. And so we think the Middle East has been fairly stable. We’ll be watching the next OPEC meetings closely to get a sense for how the group is thinking about the outlook for demand and its plans for supply for the remainder of 2023.

The real geopolitical event that has impacted the energy market over the past year and a bit has been the war in Ukraine and the resulting sanctions on Russia. The initial view was that the market expected a significant decline in Russian energy supply and that the world would be in an oil deficit as a result of the sanctions. We thought that both the technical and financial sanctions would negatively impact Russia’s ability to export energy to the rest of the world. What we’ve actually seen is a redirection of trade flows with more Russian barrels going to Asia and the rest of the world supplying Western Europe. We’re continuing to watch Russian output data for any signals that supply is being impacted. But for now, more Russian barrels than we expected are being brought to the market.

Looking past the immediate geopolitical events and looking out over the medium term, we’re constructive still on the outlook for oil. We do see headwinds for demand with electrification, but we also see constraints on the ability of the world to deliver lower carbon energy and expect that demand for oil will remain robust through our forecast period. Really, the key to the longer-term outlook is on the supply side. We’re not seeing companies invest in the next generation of multi-billion-dollar long-life assets. With an uncertain demand outlook and with political pressure to decarbonize economies, companies are focused on running existing assets more efficiently and returning cash to shareholders rather than on growth. The result is a lack of new supply that’s set to come to the market in the medium to longer term. What we do expect is to see further M&A and consolidation in the sector as a means for growth from the producers rather than investing in the next generation of long-life assets.

In terms of companies we prefer in the energy sector, we’ll start from a sector allocation perspective, and we do prefer the upstream producers to the midstream and infrastructure companies. We see better beta to oil in the producers and view the valuations at current levels as attractive. The producers’ balance sheets have largely been repaired, dividends are up and growing, and buybacks across the group are active. The midstream and pipeline companies have attractive qualities as well. They have high dividend yields and good valuations at current levels, but we’re more focused on upstream producers given the beta to oil.

So in the producer space, our top picks are Cenovus and Canadian Natural Resources. For Cenovus, we see an intersection of quality and value. The company’s delivering on the asset base, on the integration of the Husky assets, and on the capital allocation strategy. We see potential for further optimization of operations, we see ongoing balance sheet strength, and further capital returns that can continue to drive the stock to outperform. We think the stocks undervalued at current levels and we see upside potential as the company delivers on key milestones. Specifically for Cenovus, we see significant dividend growth potential from the company compared to its peers.

For CNQ, we view this as a very high-quality business. They have a solid asset base, a good balance sheet, a very strong management team with a track record of operational performance, M&A, and capital allocation. We see potential for CNQ to outperform as it delivers on expectations driven by its industry-leading production base and its low breakeven, which is expected to generate strong free cash flow in the coming years. The company is a little bit catalyst light, but we do think it remains a go-to name for global investors looking for exposure to energy companies in Canada.

Turning to the mine commodities and specifically copper, this is a commodity that’s been closely tied to China for the past 15 years. Despite the recent chaos in the market and the risk-off sentiment, the copper price is actually hanging in quite well and continues to trade around $4 a pound, which is a very solid price that most miners will do quite well at. The price hanging in like that likely reflects expectations for China’s reopening this year post the zero-COVID policy being offset somewhat by recession fears in the U.S. and Europe.

In the near term, copper will most likely continue to trade around with sentiments on the global macro outlook with a close focus on China. Copper is often used by financial players as a proxy for Chinese industrial production and housing, and with China reopening and targeting 5% GDP growth this year, we think the outlook for copper is likely supported by the China reopening.

Where copper is really interesting to us is looking out over the medium to longer term. The transition to a lower-carbon economy will be hugely copper-intensive. Whether it’s the manufacturer of wind turbines, solar cells, electric vehicles, or in the distribution networks to deliver the low-carbon electricity to end users, the demand for copper is set to accelerate meaningfully due to the energy transition. In fact, it’s our view that one of the big limiting factors to the lower-carbon economy will be the ability to mine commodities necessary to generate and transmit green energy to end users.

So with that in mind, it’s our expectation that copper prices will have to move higher to incentivize the next generation of copper projects into the market to supply the metal needed for the energy transition. So we like the medium to long-term outlook for copper as a necessary commodity in the green economy.

And then finally, turning to gold, the price has been really strong of late with a move lower in rate expectations and the impact on the U.S. dollar. The gold price is closely tied to the inverse of the U.S. dollar, and that trend has continued with the DXY rolling over a bit in recent weeks. The weaker U.S. dollar has been a function of changing interest rate expectations as we’ve seen some bank instability in the U.S. in March, and that has shifted expectations on the outlook for rate hikes in the near to medium term. Again, through this part of the cycle, gold has shown its worth as a portfolio hedge in uncertain macroeconomic times.

Our view is that the Federal Reserve is likely close to done on rate hikes, and we’ll watch inflation data closely in the coming months to see if the recent banking concerns that we’ve seen in the U.S. are in fact meaningful deflationary event.

We think gold can outperform an environment where the Fed is on pause and the market is on alert for recession risks.