Oil prices have remained at higher levels since Russia’s invasion of Ukraine. But with the threat of recession growing, what could that mean for crude? Greg Bonnell speaks with Bart Melek, Head of Commodity Strategy at TD Securities, about the outlook for energy markets.
- Recession risk, something that's increasingly on the minds of some investors. And while a slowdown in growth would hit commodities, our feature guest says a downturn in prices would be short-lived and oil will hold up better than you might think. Joining us now, Bart Melek, Head of Commodity Strategy at TD Securities.
Bart, great to have you on the program. Let's jump right in there. Obviously, there's fears, and we're hearing it from central bankers too, that they need to tame inflation. That could lead to a recession. If we got there, what's the fallout for commodities?
- Well, first of all, wonderful to be here. And commodities, I think, like all other risk assets, will feel a material slowdown in economic activity, mainly because that will impact demand. Let's start off with industrial metals and perhaps oil, because they tend to respond the most to a reduction in economic activity around the world.
So typically, what happens at this part of the cycle is we have lots of inventories and a significant amount of potential investors. We also would have pretty effervescent speculation where speculative traders, money managers, would tend to be quite long. Now, of course, enter the central banks with the most aggressive tightening that we've seen in some 40 years.
And that's, of course, due to inflation none of the major central banks expected. So the central banks are perceived to be behind the curve. And like it or not, they will likely need to slow the economy in order to suppress inflationary pressures, mainly because much of those pressures are supply-driven-- everything from logistics to COVID-based interruptions and, of course, the big war in Europe between Ukraine and Russia.
What does that typically mean? Well, when the economy slows, demand slows, and on the margin, you will have a loosening of conditions. And investors, the ones that were fairly aggressively long, will tend to come off. We're already seeing that.
And we've seen even with oil, prices come off from the highs of over $130 or so now back again to about $113. We've seen copper down some 20% already from the $10,000-plus levels. And that has been the case across the board. Even gold, which tends to be seen as a hedge against inflation and a stabilizing asset-- but even gold tends to move lower when interest rates, particularly on the real side of things, move down.
So all commodities have been down. And if we expect growth to materially deteriorate, we see more downside.
- You brought along some charts for us to really help us illustrate what we're seeing here. I want to focus in on the oil space and show the audience, of course, the supply situation that we have, because we have this interesting crosscurrents, right? You come out of a pandemic, you think you're going to see increased demand. We're worried about a recession. And then the same time, where is the supply that the world is looking for?
BART MELEK: Yes, so this chart is quite telling. What it basically tells us that inventory levels are at a historic low. And they have served as support for prices, not only at this part of the cycle when you're expecting demand to start easing-- we're not saying that demand is going to decline year-over-year, we're saying that the growth rate is going to slow down.
But even so, we would expect speculative traders to start shorting this market and prices fall. Well, we're not really seeing that. In fact, over the next few months, we think that oil might go even higher. For the quarter for WTI-- for the third quarter, that is-- a price of about $116 to $118 on average, that means we could easily see $130, $130-plus, if not higher, just from a trading perspective. Why? Well, two reasons.
It seems that OPEC does not have spare capacity that it can deploy anytime soon. In fact, that was confirmed by Mr. Macron at the G7 meeting where apparently he whispered to one of the other world leaders that OPEC, United Arab Emirates, and others don't really have a lot of capacity.
HOST: A "don't look to us" moment kind of thing. Don't count on us.
- Well, and when we look at data, when we look at spare capacity, that seems to be a fact. Now, OPEC has promised over the next few months to increase production by some 648,000 barrels per day over the next little while. They've been very much a disappointment in that respect. They cannot deliver what they promised.
And it's a case where countries with the quota to produce don't have the capability. Nigeria very much comes to mind where they're underperforming by half a million barrels. They did tell us the other day that, probably in August, they might deploy another 1/2 million barrels.
But August is not necessarily now. So given the fact that we have a loss of refining capacity in the United States of some 1 million barrels a day, demand after COVID hasn't really responded negatively to higher prices. People still have money in their pocket. And I think we all are sick and tired of being at home and people want to get out.
HOST: It hurts me to fill up the car, but I got to go somewhere.
BART MELEK: Yeah. And that is also true for jet fuel. Airline tickets have skyrocketed, but demand is high. So we're not really seeing the sort of price elasticity on demand that we would expect from higher prices. People just want to get out.
And so what does that mean for the next few months? The driving season, and then it's going to get launched during the July 4 weekend in the United States, is going to see a lot more gasoline use than normally, than other times of the year. Refining capacity is not there.
Russian oil and Russian refining capacity can't really reach us because of the sanctions. So we see a recipe for still higher gasoline prices in North America for the next few months, I'm afraid. Crack spreads-- the difference between what the distillates are sold for and what the feed cost is, the oil you put into a refinery to make into a product that you can use-- have skyrocketed.
And that feeds back into the oil price. So the problem is going to be that for the next little while, these markets are going to get tighter, even if, at some point, OPEC and other producers like US shale producers are able to manage more supply.
- How much of a wild card is China in all this? Either they go into more restrictive lockdowns and get us concerned about their hunger for commodities or get past the worst of it and get hungry for commodities again.
- Well, we think, certainly in the short run, the risk is that they, I think somewhat temporarily, lift this market even further. We, of course, spoke about seasonal demand in the United States and North America, and Western Hemisphere generally, as we travel around trying to do something fun for a change outside. And that takes fuel.
And, look, China has been locking down. They have this so-called zero tolerance policy for COVID. And we've seen entire cities of millions of millions, tens of millions of people-- in fact, between Beijing and Shanghai, that's more than the entire population of Canada being locked down.
There is evidence showing that that is opening up. When we track mobility data, it seems that the worst is over. And we're going to probably see more of an opening up. And that means the flows of crude and energy into China are going to be consumed more rapidly than the lockdons. And I think that's a pretty reasonable assumption.
And so just as Western Hemisphere driving season peaks and we're not getting new supply, and we're now thinking of, perhaps, more robust sanctions against Russia, and natural gas is in short supply-- that means whatever substitutes they have, like petroleum products of some sort, if they can use them, they will-- means this market for the next few months can get opened up.
Now, I did say that's temporary, because when we look beyond the third quarter into the last few months of 2022 and into 2023, we expect China to not deliver the growth that it has traditionally. Traditionally, over the last three decades or so, we could always rely on China to make up for our deficiencies. And that helped the commodity market.
We're not expecting that. If we're lucky, China is going to have a 4-handle on its GDP. Many analysts think perhaps 3. That's not conducive to a very robust demand. So we're not going to get a lot of help.
So my thesis that this commodity market corrects will probably be reinforced. But first, it'll get significantly better, potentially even for some base metals, but certainly, we think, for energy, before things go south again.