July 12, 2023 | 16:45
Higher for Longer Hits Commodities
Quarterly Forecast Update Edition
Commodity Forecast Highlights: [Quarterly Commentary Starting on Page 2]
Quarterly Forecast Update
Energy: Although we never considered ourselves to be (super) bulls on crude oil, we have been surprised by the extent of the pullback in prices. At the beginning of the year, we were forecasting benchmark West Texas Intermediate (WTI) crude to average US$90/bbl in 2023. But it’s clear that we were too optimistic, which led us to make a number of revisions to arrive at our current forecast of $78 for 2023. This implies we expect WTI to average $80 in 2023H2. Our 2024 forecast of $80 remains intact.
If you asked us what we missed or underestimated this year, it has been the impact of the relentless rise in interest rates. This has had a more pronounced effect on crude oil than any other commodity as it is the most speculated on by a wide range of investors who are not involved in the production or final consumption of the physical product. It perhaps goes without saying that higher borrowing rates have raised the cost of speculating (in the futures market) and increased the attractiveness of other financial investments. Meanwhile, central banks’ drive to bring down inflation via higher policy rates has fed fears that the global economy is heading for a major downturn, which would lead to weaker demand for oil. All of this also explains why there has been chatter that typical holders of crude inventories (e.g., refiners, traders, etc.) are carrying less than they normally would.
On the flip side, the fundamentals for higher prices in the coming period are more encouraging, namely: declining supply, rising demand and, as mentioned, relatively low global inventories. Of note, Saudi Arabia has extended its voluntary production cut of 1.0 mb/d in August, while Russia announced it will curtail its exports of crude oil by 500 kb/d in August. Even Algeria chipped in with a small voluntary cut of 20 kb/d in August. However, the fact that the cartel has been forced to scale back production of late cannot necessarily be viewed as a clear-cut positive development. Recall OPEC+ also made big cuts totaling 2.0 mb/d and 1.7 mb/d, respectively, in October and April.
The accumulation of such cuts suggests that the recovery in global oil demand is proving weaker than initially anticipated, likely reflecting the slow return to in-person work, still-sluggish overseas tourism and increasing EV adoption. Interestingly, last month the International Energy Agency (IEA) actually revised up its annual projection for global oil demand by 300 kb/d to an average of 102.3 mb/d for 2023 (vs. 98.8 mb/d in 2022). Although the IEA’s projection may not be met, we’d be surprised if global oil demand experienced an outright contraction this year barring a major global recession.
The relatively tight global oil supply/demand balance is a key factor behind the narrower discount of Western Canada Select (WCS)—a blend of heavy oil produced in Alberta—to WTI. The spread has shrunk to just under US$12/bbl (vs. historical norm of $15) after it blew out to an average of $28 in 2022Q4 following the Biden Administration’s decision to release 1.0 mb/d from the Strategic Petroleum Reserve in the wake of Russia’s invasion of Ukraine. In contrast, it now appears that Canadian heavy oil producers are benefiting from the OPEC+ cuts, as the blends are of a similar quality (medium sour/higher sulfur content).
There is no doubt that the price of natural gas has wrongfooted the forecasting community more than any other commodity so far this year. We were originally projecting Henry Hub, the North American benchmark, to average over US$5.00/mmbtu for the whole of 2023 but have since trimmed it to $2.75. In tandem, we have also lowered our 2024 forecast by 25 cents this month to $3.50 (originally $4.50). The steep cut to 2023’s forecast has had less to do with the outlook for the global economy and the trajectory of interest rates and is more a result of other factors, namely (1) an unexpectedly mild winter across the Northern Hemisphere, (2) Europe’s ability to rapidly reduce its dependence on Russian gas and (3) strong U.S. production. On the latter, the EIA recently estimated that U.S. natural gas production will increase by a hefty 4.8% in 2023 (vs. +4.4% in 2022).
Nonetheless, the outlook for natural gas remains encouraging, which is why we are expecting prices to rise modestly in the second half of this year and gain greater traction in 2024. Although prices will ultimately be determined by the (unpredictability of) weather, conditions are becoming more favourable with the return of El Niño, which is likely to lead to more extreme conditions and higher-than-normal temperatures. However, U.S. production is expected to slow down markedly, rising just 0.4% in 2024, which should result in lower inventories. Meanwhile, global demand for natural gas remains sturdy given Europe is still in the midst of an energy crisis. Although Europe was fortunate to avoid a cold winter in 2022/23, storage levels will need to reach 90% capacity (currently 70%) ahead of the 2023/24 winter. The European price benchmark—Title Transfer Facility (TTF)—remains well above pre-Russian invasion levels, hovering just above US$10.00/mmbtu, compared with a pre-pandemic average of $5.50 between 2015 and 2019.
Across the Pacific, LNG demand from China has rebounded following a sharp 21% decline in 2022 (vs. +17% in 2021), which was primarily driven by COVID-related lockdowns and high spot LNG prices. Indeed, according to data compiled by Refinitiv, China LNG imports climbed 28% y/y in June and are on track to post 10% plus growth for the year. However, Chinese LNG demand would be stronger if not for a pickup in domestic coal production and the rapid installation of renewable energy (solar and wind). According to the EIA, weekly average front-month futures prices for LNG cargoes in East Asia have been averaging just over US$12.00/mmbtu, which makes the region an attractive market for North American producers.
Separately, the price of AECO (Western Canada’s natural gas benchmark)—which typically follows Henry Hub quite closely—has held up fairly well. The Henry Hub-AECO spread averaged just over 25 cents in the first half of the year, which is well below the historical average of $1.00 (the cost of transportation to Henry Hub in Louisiana). However, the razor-thin spread is largely due to a lack of storage in the southern U.S. rather than too little production in the Western Canadian Sedimentary Basin (WCSB), as the latter is still at record levels. Thus, the spread should eventually widen once again with recent contracted prices transacted at wider spreads than current spot prices.
Metals: The near-term outlook for metals prices has modestly weakened since the last quarterly update despite a less-downbeat outlook for the global economy. Expectations of higher-for-longer interest rates and negative sentiment around China’s tepid post-pandemic recovery have driven prices down more sharply than previously anticipated, even as inventories remain broadly tight. Precious metals prices are still firm amid heightened global macro uncertainty (though, gold is off 5% from its recent highs and silver is down a larger 10%), but the major base metals have all seen double-digit declines from early-2023 levels. As a result, some metals (e.g., aluminum, zinc) are no longer trading above their respective cost curves, raising the prospect of supply curtailments by higher-cost producers.
While the advanced economy consumer has withstood aggressive monetary tightening far better than most had imagined, it’s clear that industrial activity is fading. One notable exception is non-residential construction in the U.S., which is being propped up by fiscal spending (i.e., IRA, CHIPS and Science Act). However, the majority of manufacturing PMIs are firmly in contractionary territory and global trade flows are declining. The possibility remains for a firmer demand impulse from China, which has seen very divergent economic trends from the other major metal consuming nations over the last year (e.g., delayed post-pandemic recovery, low inflation). This is because further policy stimulus is likely forthcoming from Beijing to ward off deflationary pressures and restore confidence, especially in the still-struggling property sector.
To what extent Chinese stimulus would have an impact on metals demand—and prices—is uncertain, but indications are that the authorities will continue to follow a restrained and targeted approach as they remain focused on safeguarding financial stability. All told, there isn’t much room for recovery in metals prices until after the low point of the current global economic cycle when rate cuts are closer on the horizon. Still, most metals will continue to hover above historical trends over the near term, supported by a built-in premium from low inventories.
The prospect of higher-for-longer real interest rates and U.S. dollar strength implies headwinds for precious metals. In a scenario where growth temporarily stalls but a serious downturn is avoided and inflation remains sticky, the Fed may opt for additional rate hikes this year or at least a later shift to rate cuts than the market currently expects. In this case, precious metals would likely come under strain but solid central bank and retail demand—a key driver of gold prices in particular—should be sustained, providing some counterbalance. Alternatively, a flight to safety would drive precious metals higher under a ‘hard landing’ scenario where central banks are compelled to cut rates earlier/faster. Ongoing economic resilience points to increased odds of the former scenario and we thus have trimmed our annual average forecast for gold in 2023 to US$1,910/oz (from $1,925, still a nominal record high). We continue to expect prices to drop back to $1,750 in 2024 and have made no changes to our silver forecasts of $22.50/oz in 2023 and $21.50 in 2024.
Though it has dropped back from the US$4/lb mark where it spent most of the first four months of the year, copper continues to outperform the other base metals. Despite the uncertain global growth outlook, further declines in visible inventories and supply disruptions are keeping prices at levels that are still quite profitable for producers. Additional stimulus in China may help to buoy sentiment and prices later in the year, but it’s worth noting that actual copper demand in China has been pretty sturdy so far in 2023, notwithstanding the downbeat news headlines. Still, strong mine supply growth will produce a temporary market surplus by next year, allowing stocks to be replenished and putting downward pressure on prices. After 2024, supply growth will decelerate, leading to a tighter market once again against a backdrop of robust energy transition-related demand. Copper prices are expected to average $3.90/lb in 2023 and $3.65 in 2024 (both unchanged).
The aluminum market is also headed for a surplus next year, albeit a small one. Given the heavy power needs of primary aluminum production and still elevated energy prices, a substantial amount of smelter capacity in Europe and the U.S. has been taken offline. Still, weak demand dynamics have dominated, pushing prices down well into the cost curve, though they have avoided falling further thanks to still low inventories. If a recession does unfold, it bears mentioning that aluminum prices tend to outperform other base metals due to greater producer flexibility. Nevertheless, from a longer-term perspective, the absence of any real raw material constraints and rising scrap availability will help to keep a lid on prices even with demand set to rise from decarbonization and substitution from copper/plastic. We have lowered our average aluminum price forecasts to US$1.00/lb in 2023 (previously $1.05) and $1.05 in 2024 (previously $1.10).
One market where inventory cover is no longer providing much price support is nickel, where prices have fallen over 30% since the start of the year. The demand outlook remains firm, despite a slowdown in Chinese stainless steel production after a decent early part of the year, and Beijing’s new four-year subsidy program for EV sales should provide an additional boost for battery feedstock. But sentiment is weighed by surging supply, which is headed for a second consecutive year of double-digit growth in 2023. In fact, whereas last year’s market for Class I nickel was exceptionally tight, this year is looking like we could see surpluses across all nickel segments. The flood of new supply—primarily from Indonesia—will keep prices trending lower over the next few years until battery-related demand reaches a larger share of total consumption. We continue to expect nickel to average US$10.20/lb in 2023 but we have lowered our 2024 forecast to $8.75 (previously $9.00).
At the back of the pack once again is zinc, which is also down over 30% from its mid-January peak and is currently the only major base metal sitting below its average nominal price of the last decade. With producer margins narrowing and some operations becoming untenable, questions are arising regarding potential mine closures/suspensions, and whether this could ultimately provide a floor for prices. The reality is that prices would have to fall considerably further (likely below US$0.90/lb) for the market to see material supply cuts. There is some modest upside price risk in the coming months from Chinese smelter curtailments, but there could also be downside pressure from restarts at European smelters taken offline during the energy crisis. Whatever happens with supply, longer-term demand prospects remain relatively subdued as zinc is not a clear winner in the energy transition. Factoring in the steep fall in prices to date, we have lowered our 2023 zinc forecast again to US$1.20/lb (previously $1.25), leaving our 2024 projection unchanged at the same level.
Forest Products: Lumber prices are finally showing some signs of life, with benchmark Western spruce-pine-fir (SPF) pushing above the top end of its low and narrow range (US$340-370/mbf) from the past three months. Despite lingering recession concerns, resilient labour markets in North America are bolstering lumber demand, while further production curtailments and wildfire risks are providing additional support, lifting SPF to $430 in early July—its highest level since February.
While this year’s wildfire season has dominated the headlines given its early start and severity, it’s important to note that the direct impact to timber supply, sawmills and shipping has so far been limited. That’s not to say the situation can’t change, so this area is certainly worth keeping a close eye on. Meantime, high-cost producers remain under pressure to continue curbing production at current price levels. Encouragingly, while the impact of prior curtailments had been somewhat undercut by rising imports from Europe, the influence of the latter appears to be waning, putting less of a damper on domestic prices.
The outlook for demand remains mixed. On one hand, the surge in U.S. housing starts in May and continued lean inventories of resale homes are adding momentum to the steady rebound in homebuilder confidence. Still, there remain substantial headwinds in the U.S. housing market, the prime destination for Canadian lumber exports. Interest rates remain elevated, with the U.S. 30-year fixed mortgage rate stuck above 7% since mid-May and the Fed poised to tighten monetary policy somewhat further. High interest rates and sticky home prices that have largely held onto the pandemic surge are contributing to a further deterioration in U.S. housing affordability.
This may explain why the recent uptrend in lumber prices has lost some momentum as higher-for-longer interest rates and generally tighter credit conditions are expected to weigh on housing demand at least through next year. While supply side factors appear to have shifted price risks to the upside, we continue to believe Western SPF prices will average $390/mbf in 2023 (or ~$410 in H2/23), before seeing a modest recovery to $450 in 2024.
Agriculture: Wheat and canola prices have lost considerable ground in volatile trading since the start of the year. The slide has partly reflected concern about prospects for the economy and demand, but supply developments have also played a role. In the wheat space, both Europe and Russia appear primed for solid crops this year and U.S. farmers have increased the amount of acreage devoted to the crop. However, growing conditions have remained challenging across parts of the United States and especially in Kansas, the top wheat-producing state. In early July, more than half of the state’s winter wheat was reported to be in “poor” or “very poor” condition by the U.S. Department of Agriculture (USDA). Conditions have also remained dry across parts of the Canadian prairies, which bodes poorly for both wheat and canola production. Despite ongoing supply challenges in some regions, the near-term outlook for wheat and canola prices has been lowered over the past few months, in part due to the fading market impact of the Russia-Ukraine war, which propelled both crops to record highs last year. Wheat prices are now expected to decline from an average of US$9.00/bushel in 2022 to $6.70 this year (broadly in line with recent levels) before picking up to around $7.00 in 2024 as concerns about the economy begin to diminish. Canola prices are expected to decline from almost US$750/tonne in 2022 to around $550 this year (also in line with recent levels) before edging up to $560 in 2024.
Corn and soybean prices have also come under pressure this year after a solid harvest in Brazil, a top-three global producer of both crops. However, difficult growing conditions in parts of the Midwest are now jeopardizing U.S. production. The U.S. Drought Monitor estimates that around 25% of farmland in the Midwest is now experiencing drought rated “severe” or worse, up from just 2% three months ago. In Illinois, the top soybean-producing state, 46% of land is experiencing such conditions, as is 44% of Iowa, the top corn producer. As a result, prices for both crops remain historically elevated despite moving somewhat lower this year, but will likely continue to ease if growing conditions and crop yields trend back toward to historical norms. Overall, corn prices are expected to decline from around US$6.90/bushel in 2022 to $6.10 this year and $5.70 in 2024. Soybean prices are forecast to ease from US$15.50/bushel last year to $14.00 in 2023 and $12.80 next year. Year-ahead futures contracts for both crops are trading at a discount to spot prices.
Cattle prices have continued to move higher over the past few months, despite demand risks and seasonal headwinds, and recently reached their highest level in eight years. Limited supply remains a major support, reflecting sustained drought in cattle-producing regions. Across North America, the headcount of the cattle herd declined almost 4% between 2018 and 2022 and the USDA expects another large decline this year. Fortunately, the drought in Texas and Oklahoma (the two top cattle-producing states) has eased over the past few months, but it will take time to rebuild the herd in these hard-hit areas. A shift to herd-rebuilding will also involve holding back animals from the market, which will temporarily restrict supply even further. In this environment, cattle prices are expected to increase from an average of US$142/cwt last year to $175 in 2023, and with the segment’s long gestation and development cycle, are likely to remain around $175 next year.
Hog prices have also advanced over the past couple months, albeit following a tough start to the year, which saw prices fall to their lowest level since the onset of the pandemic. The rebound has been driven in part by a seasonal increase in grilling demand, but seasonally adjusted prices have also turned higher. However, hog supplies remain elevated, which will limit further gains. The USDA estimates that the headcount of the North American hog herd will increase by around 1.2% this year to levels exceeded only during pandemic-related processing outages in 2020, which caused a backup of hogs on farms. Overall, hog prices are expected to decline from an average of US$98/cwt in 2022 to $80 this year but should rebound to around $92 in 2024 as farmers temper supply and budget-conscious consumers substitute pork in place of beef.
The BMO Capital Markets Commodity Price Index is a fixed-weight, export-based index that encompasses the price movement of 20 commodities key to Canadian exports. Weights are each commodity’s average share of the total value of exports of the 20 commodities during the period 2012-21. Similarly, weights of sub-index components reflect the relative importance of commodities within their respective product group.
The all-commodities index and sub-indices consist of the following:
Unless otherwise specified, all indices reported in this publication correspond to prices in U.S. dollars.