U.S./China trade truce and looming Fed cuts providing some traction

The BMO Capital Markets Commodity Price Index decreased 3.0% in June, largely reflecting early weakness in crude oil, which offset solid gains in precious metals, lumber and grains. This marked the second straight decline, though a rebound is expected in July, as oil has bounced off its June lows and gold has soared amid lower U.S. yields and expectations of easier monetary policy.

The Oil & Gas Index sank 10.1% in June, with crude oil and natural gas recording sizable average monthly declines. The drop in oil (see the Commodity Focus on page 2) largely reflected a steep slide in May, due to global slowdown concerns, that was only partially reversed in June. Natural gas edged down through much of June and early July on strong U.S. production gains and below-average demand for air conditioning, though there was a moderate firming during the second week of July.

The Metals & Minerals Index rose 2.7% in June as the gold rally took centre stage. Falling U.S. yields and a weaker greenback, sparked by Fed easing bets, drove the yellow metal to a six-year high by late-June and prices have remained near those levels through mid-July. Base metals were weaker in June, but found some stability in July amid a U.S./China tariff truce.

The Forest Products Index snapped its slump in June, with prices rallying 13.6% on news of production curtailments. SPF prices soared 15.3% as cuts amounting to over 800mbf of B.C. supply were announced, representing 3% of Canadian production. Prices have since moderated in July, though they remain well above their May lows. Similar announcements at two OSB mills lifted prices toward the end of June, though a poor May hand-off saw the monthly average decline 2.5%.

The Agriculture Index ended its four-month losing streak with an 8.1% rebound in June, driven by a 14.7% jump in wheat prices amid a sluggish U.S. winter wheat harvest—especially in all-important Kansas, where wet weather delayed last year’s planting and this year’s harvest. Crop prices also received support from soggy conditions in the U.S. Midwest. In the livestock space, hog prices dropped 9.4% as rising U.S. supply more than offset fears about the continued spread of African Swine Fever in Asia.

Commodity Focus: Oil

Tough Balancing Act

Over the past nine months, oil prices have been jolted by multiple crosscurrents, including shifting expectations about trade and monetary policies, recession risks, and OPEC+ strategy. West Texas Intermediate (WTI) plunged from US$76/barrel in early October 2018 to a Christmas-eve low of $43, before surging to $66 in late April, skidding to $51 by mid-June and, most recently, rallying to $60, before slipping again on renewed trade tweets/concerns. Where to next in terms of volatility and pricing? We’ll probably see less volatility—note that the recent highs have been getting lower and the lows higher—as the U.S. and China attempt to de-escalate trade tensions, the Fed almost certainly lowers its policy rate as insurance against growth-inhibiting uncertainties about trade and fiscal policy, and OPEC+ shows resolve in managing potential excess supply. The latter is crucial, given the underlying downside risks to oil prices of rapidly rising U.S. production—not to mention expected gains in Canada, Brazil, and Norway—and weakening growth in the global economy and demand for oil products.

On the demand side, we expect the pace of global economic expansion to slow materially this year and next—to an average of 3.1% from 3.7% during 2017-2018—reflecting notable cooling in the United States, Euro Area, and China. We anticipate that this will reduce the increase in the global demand for oil from an average of 1.4 million barrels per day (mmb/d) during the past two years to 1.1mmb/d during 2019-2020. On the supply side, U.S. crude oil production surged by 1.6mmb/d in 2018 and is on pace to climb a further 1.7mmb/d this year, reaching an estimated 12.7mmb/d—almost 2.5 times higher than a decade earlier thanks to the shale boom. That would account for more than 90% of the total increase in non-OPEC+ supply. Thus, on its own, the rise in U.S. production will outpace global demand growth this year by a wide margin, potentially leading to a substantially over-supplied market and very weak prices. Facing this daunting prospect, OPEC+, led by Saudi Arabia, began to reduce its oil output during the second quarter and, on July 1^st, Saudi Arabia, Russia and other members of OPEC+ extended their production curtailment agreement through the first quarter of next year. Compliance will have to be high to avoid a further build in global inventories. So far it is, with Saudi Arabia cutting more than the agreed amount and output in Venezuela, Libya, and Mexico falling due to political stresses and/or industry mismanagement. If OPEC+ output were to be held steady at its current rate through 2020:Q1, then the oil market may be able to avoid a destabilizing inventory build. However, as non-OPEC+ oil production is expected to continue to outpace global demand growth next year, OPEC+ will likely have to give consideration to extending its restraint through the rest of 2020 and possibly be faced with a decision to cut output even further to avoid a downturn in pricing.

Overall, we project WTI to average US$57/barrel in both 2019 and 2020—which would be very close to its average real value during the past 45 years ($56 in 2018 dollars)—though with important downside and upside risks. The primary downside risk would be materially slower-than-projected global economic growth or an outright recession due to an intensification of trade protectionism. A likely rise in the U.S. dollar stemming from such an outcome would exacerbate the downward pressure on oil demand and prices. Failure of OPEC+ nations to meet restraint commitments and/or to extend the agreement throughout 2020 would present another important downside risk for prices. Upside risks include the potential for stronger-than-expected global economic growth due to an easing in trade tensions and the recent trend toward more accommodative monetary policies in the United States and other jurisdictions. There is also the risk of a spike in oil prices if socio/political/economic stresses in Venezuela and Libya intensify even more than currently, interrupting oil production, or if relations between Iran and the West deteriorate to the point where production and transportation of oil in the Middle East are impacted.

In Canada, the discount from WTI of Western Canada Select (WCS)—a blend of heavy oil produced in Alberta—is currently running a bit below its long-term average of 24% after having blown out to as high as 65% during October and November of last year when rising production was stranded by inadequate pipeline capacity. The improvement in pricing reflects mandated production cuts by the Alberta government—initially about 325,000 barrels per day (b/d) but now being eased—rising rail transport of oil, and steps taken by pipeline companies to increase throughput on existing lines. According to the National Energy Board, rail transport of crude oil during January-April of this year rose 34% to an average of 215,000 barrels/day (b/d) despite weakening in February and March when the discount narrowed to the point where heavy oil became less competitive at U.S. refineries. With the likelihood of increasing rail transport and increased flow through existing pipelines even before major capacity is added (potentially, Enbridge Line 3, TransMountain, Keystone XL), the WCS discount will likely be less volatile than during the past year, ranging from 15%-35% and averaging 25%, which would generate an average price for WCS of US$43/barrel in 2019/20.

Technical Note

The BMO Capital Markets Commodity Price Index is a fixed-weight, export-based index that encompasses the price movement of 16 commodities key to Canadian exports. Weights are each commodity’s average share of the total value of exports of the 16 commodities during the period 2012-16. 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:

Source: BMO Economics

Unless otherwise specified, all indices reported in this publication correspond to prices in U.S. dollars.