Oil-Fueled Commodities Rally Has Room to Run After US Iran Decision
Published May 11, 2018
While markets had largely priced in the US decision to withdraw from the Iran nuclear deal and re-impose sanctions, we believe the balance of supply and demand dynamics will keep oil prices elevated in the near term, driving commodities higher. After years of lagging equities and bonds, commodities have outperformed traditional asset classes through the first four months of 2018, primarily fueled by the surge in oil prices (see Figure 1). Brent and US WTI Crude have soared to three-year highs on improved fundamentals and elevated geopolitical risks, with Brent breaching the USD 75 per barrel mark, while WTI has risen above USD 70 per barrel.
Geopolitical risks to supply could drive prices higher as fundamentals show the OPEC-led production restraints have effectively eliminated the global supply surplus. Further tailwinds should come from the ways in which commodity futures contracts are priced and rolled over. As a result, we started building a tactical overweight to commodities as a diversifier and inflation hedge earlier in the year and have since added to it as overall global growth returns to trend.
The US president pledged to institute “the highest level of economic sanctions” on Iran, effective immediately. But businesses will be allowed to unwind financial deals over the next 180 days. The secondary sanctions on Iranian crude exports are expected to reduce global oil supplies by between 300,000-500,000 barrels per day over the next six months to a year. Any escalation of military conflict in the region could disrupt supplies further.
Other major oil suppliers like Saudi Arabia and Venezuela also face risks to their oil production. Saudi Arabia has experienced an uptick in attacks on Aramco storage and distribution facilities by Yemen- backed Houthi rebels, raising fears of supply disruptions. Venezuela’s production has reached lows not seen since 1998, and further US sanctions are likely. In November 2016, Venezuela was producing over 2.1 million barrels per day, but agreed to a production quota of 1.97 million barrels per day as part of OPEC requirements to support prices. Since then, output has steadily declined to 1.49 million barrels per day at the end of March 2018, due to poor conditions for oil workers, hyperinflation and economic collapse, according to the latest International Energy Agency (IEA) report.
These supply disruptions together with greater production discipline among oil exporters have dramatically reduced the global supply overhang from 300 million barrels (over the five-year historical production average) in 2016 to just 30 million barrels today. As Iranian barrels go offline, the market may now move to a supply deficit over the five-year historical average. Saudi Arabia has produced less than their 10 million barrel per day quota in an effort to keep prices well bid ahead of the Aramco IPO, and have publicly expressed a desire to see oil prices rise to above USD 80 per barrel. The IMF recently estimated that Saudi Arabia needs Brent to reach USD 88 per barrel in order to balance their budget as they execute Vision 2030 reforms to diversify their economy. According to Rapidan Energy Group, Saudi Arabia gains approximately USD 3.1 billion a year in revenue for every dollar increase in oil prices.
Strong global demand growth, particularly from India and China, has helped to offset rising US shale production (Figure 3). In April, China’s oil imports jumped 9% month-over-month to an all-time high, and demand is set to rise in the US as the heavy summer driving season approaches. Global demand has been so robust that, even as US production has reached new records of 10.6 million barrels per day, exports have also notched new highs of 2.3 million barrels per day, spurring the WTI price higher and leaving US stockpiles below their five-year averages for the first time since 2014. Longer term, US shale production has the potential to undermine OPEC’s efforts, but as long as OPEC is willing to undershoot their quotas, they should be able to absorb the increased US supply.
Investors seeking to leverage the rally in oil and commodities can gain broad exposure to an equal weighting of energy, metals and agriculture commodities through the Bloomberg Commodities Index. For a more concentrated bet on oil-related commodities, the energy-heavy S&P GSCI Index offers more than double the exposure to energy than the Bloomberg Commodities Index. Another opportunity would be to invest in an energy sector ETF, as energy equities have trailed the price of oil, and appear poised to follow oil commodities higher.
 This is known as backwardation in the commodities futures market, when the forward price of a contract is lower than the current (spot) price and the forward pricing curve slopes downwards. It reflects the market’s willingness to pay a convenience premium for prompt delivery of the physical commodity when inventories are tight. It can provide index investors with a tailwind of positive roll yield, as they are selling high and rolling to a lower-priced distant contract.
 Source: S&P Global, Platts: https://www.platts.com/news-feature/2018/oil/us-iran-sanctions/index
Bloomberg Commodities Index: A broadly diversified commodities price index that tracks prices of futures contracts on physical commodities on the commodity markets.
S&P GSCI Index: A broad-based that is production weighted to represent the global commodity market beta.
S&P 500 Index: A market value weighted index of 500 stocks that reflects the performance of a large cap universe made up of companies selected by economists.
The views expressed in this material are the views of Michael Narkiewicz through the period ended May 9, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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