Could a potential recession outweigh tight supplies in commodity sector prices next year? MoneyTalk’s Greg Bonnell discusses the outlook for the energy and mining sectors with Hussein Allidina, Head of Commodities at TD Asset Management.
Greg Bonnell: All year, we’ve been hearing about tight supply for many commodities. But with concerns about a recession on the horizon, will demand be the real concern for 2023? Joining us now to discuss, Hussein Allidina, Head of Commodities at TD Asset Management. Always great to have you on the show. Welcome back.
Hussein Allidina: Thank you for having me.
Greg Bonnell: So we’re going to close the books on 2022 pretty soon. I have had numerous discussions this year about the supply situation, the demand situation. These recession fears, how does that play into the commodities trade next year?
Hussein Allidina: Absolutely. So I think if we look, Greg, over the course of the last couple of weeks, maybe the last couple of months, the market has been very focused on global growth slowing and the impact that that’s going to have on commodity demand. When I look at the oil balance, in particular, for next year, the IEA this morning revised up, actually, their demand forecasts, looking for growth of 1.7ish million barrels a day.
We’ve talked about this before. The supply side, your inventory picture, your spare capacity picture, your incremental supply growth picture is relatively constrained in ’23, ’24, ’25, a symptom of the lack of investment over the course of the last 10 years. So that’s relatively, I would say, well defined.
The question now is, how challenged, if at all, will demand be in ’23? If demand grows by the 1.7 million barrels a day that the IEA is forecasting next year, you still have an inventory picture that will end lower at the end of last year– or end of next year, pardon me– than we are right now.
We’ve talked as well before, if we look at global oil demand, going back to 1970, there’s really only three or four occasions where demand contracted in absolute terms. You need to have a material contraction in economic growth comparable to what we saw at the height of the pandemic in March of 2020 or during the financial crisis. And even in those episodes, we had demand contract, but it was a relatively short-term contraction and a bounce back. We’re looking at demand today reaching 100 million barrels a day, notwithstanding the fact that the weather has been materially warmer than normal, which has tempered demand.
I do think the focus next year is very much on the demand side. My base case right now is that economic growth is probably going to be robust enough to continue to point to tighter balances through the course of ’23.
Greg Bonnell: It sounds like we have some wild cards at play. The weather in the northern hemisphere in the winter always plays into the consumption needs. But even the economic one, you say, we think we’re going to see demand hold up in the face of perhaps some economic softening. What could go in the other direction in terms of demand? If China reopening– there’s a few wild cards out there, aren’t there?
Hussein Allidina: Yeah. So I think one thing we’ve got to remember– and this year has been an incredible year for volatility and for commodity price action, broadly speaking. This is also a year when China has largely been closed. Chinese demand has not been this weak since I think 1994 and 1995 on a growth basis.
Now, there are overtures and signs that China is opening up. I don’t think it’s going to be a straight line higher. But I’m pretty comfortable with the view that Chinese demand in ’23 is going to be higher. Their impact on the oil market, on the commodity market from a consumption point of view should be higher in ’23 relative to ’22. And there are early signs, again, that if we look at flight data or congestion data in China, it’s picking up. And people, like in the rest of the world, when things open up, they want to get out.
Greg Bonnell: Now, one of the concerns, obviously, this year has been inflation. Energy cost has been part of that inflationary story. If you head into a situation next year where we have, obviously, a lot of reasons in the system why supply is pretty tight, and if demand does pick up, at least, or, at least, hold steady, could we be pushing ourselves back into an environment that the central banks won’t like all that much? A higher price for crude, for example.
Hussein Allidina: I think, absolutely. So I think some of the softness that we’ve seen in inflation of late has been commodity prices moving lower. Until you address that supply side, if you have positive economic growth and, by extension, positive commodity demand, I think it’s going to push these prices materially higher again.
One of the reasons why demand maybe is not as weak today as it would have been if prices were at the levels that we saw in the summer is because that price relief has encouraged consumption. When I look at 2023, if my view on demand is correct, if my view on supply is correct, I do think we see oil prices moving back towards the highs that we’ve seen this year, potentially higher, depending on how the supply situation plays out. And I think it will be a focus again.
I think the inflation story is not done. It does appear that inflation is weakening. But the underlying commodity inflation, I think we’re probably in the early innings of it because, again, I’m a broken record, but we haven’t addressed the supply side. The CapEx is simply not taking place, notwithstanding the increase in commodity prices. And for that reason, Greg, I do think that inflation will remain a concern. Maybe not 8%, 9% inflation, but the idea of 2% inflation on a sustained basis I think is a bit of a stretch.
Greg Bonnell: What does it take to start seeing that investment in the oil and gas industry, or even the mining industry? You talk about, OK, we’re going to need– have these needs for several minerals for electrification. But we don’t have the mines. We haven’t been extracting the oil. Is that era behind us, of exploration?
Hussein Allidina: I think we have to break it down almost by commodity or subcommodity category. I think there is not a strong desire on the part of oil and gas– oil, in particular– to invest. And that is because of energy transition. Are we going to be using this stuff 5, 10, 15 years from now? We know that if we go and make an investment today, it’s not going to lead to incremental production for five, seven, eight years. So you’ve got to think longer term when you’re making these investment decisions.
I also think there’s a big ESG focus. And I think many of these oil companies are being challenged by shareholders when they go to make the conventional investments that they’ve made. I think you’ll need to see– I think we need to have a CapEx cycle because we don’t have, frankly, the substitution on the demand side to say, hey, we don’t need these commodities. We still need the commodities. I think you’re going to have to see material increases, frankly, in the return on capital employed to see these companies go and make the investment.
And look, the data this year, notwithstanding the increase in price that you’ve seen, you haven’t seen that commensurate increase in investment. You’ve seen some of it from the private side. So if we look at the US rig count, probably half of the increase in the rig count that we’ve seen this year had come from the private space. That’s becoming challenged now because credit– the cost of money is increasing, a phenomenon that hasn’t been an issue for the longest period of time.
On the metals and mining side, I think you will see more investment to the extent that prices remain elevated and encourage that investment because you have less of that negative ESG story there.
But again, the volatility that we’ve seen in price, Greg, makes these investment decisions all the more challenging. If you were talking to your board about making an investment in oil three months ago, you were using a price deck of $90 a barrel. If you’re doing it today, you’re using a price deck of $70 a barrel. I don’t know where the price is going to be three months from now. But that volatility increases, effectively, the return that I’ve got to make to justify the cost of capital.
Greg Bonnell: It does sound like several years down the road, then, we’re not going to have some of the things that we need. Unless there’s some sort of magical transformation in energy sources or other sources of minerals that provide us with electric vehicles and the electrification of everything else, we’re going to be in a bit of tight space even further down the road.
Hussein Allidina: I believe strongly that if we have economic growth, that commodity balances and commodity prices will act as a tax on that growth because, to your point, we don’t have sufficient supply. We’re not making the investment that we need to make today. To the extent that we’re not able to substitute away from conventional energy fast enough, which I don’t believe the data is showing you we are doing, you’re going to end up in a position where inventories are tight. You have sustained backwardation in the commodity markets. And on any sort of supply disruption or demand surprise to the upside, prices have to move materially higher to find equilibrium. I’m going to have to ration demand in that tight environment. And we saw some of that happening this summer. But I think at $70 a barrel, you see very little of that happening right now.