The article below is an excerpt from our Q2 2023 commentary.
Commodities and related natural resource markets were broadly weak in the second quarter. Investors remained concerned about a global recession driven by rising interest rates and persistent central bank hawkishness. Adding to the overall gloom was a perceived disappointment in Chinese economic activity. Caused by problems in the real estate sector, disappointing exports, and weaker-than-expected aggregate economic data, investors were decidedly “risk-off” when it came to China, and commodity markets were not spared.
With its heavy energy focus, the Goldman Sachs Commodity Index fell almost 6%, while the Rogers International Commodity Index, emphasizing metals and agricultural commodities, fell by 2.5%.
Natural resource-related equities were weak as well. The S&P North American Natural Resource Stock Index (heavily energy weighted) fell 1% during the quarter, while the S&P Global Natural Resources Index (more metal and agricultural exposure) fell almost 6%. By comparison, global equity markets were strong during the second quarter: the S&P 500 rose 8% while the MSCI All Country World index advanced almost 6%.
Metals were among the weakest performers in the second quarter, reflecting concerns about China. Copper prices pulled back 9%, despite easily mobilized copper inventories approaching all-time lows during the quarter. Nickel fared even worse, falling by 14%. Aluminum, meanwhile, fell by 11%, while zinc plummeted by 21%. Cold-rolled steel fell almost 25% in the ferrous metal sector, while iron ore fell 10%. Mining equities were also weak. The COPX ETF (which tracks copper equities) fell by almost 3%, while the S&P Global Base Metals Index fell by 4%.
Weak LNG and Chinese worries drove coal prices lower. Australian and South African thermal coal pulled back 30% and 22%, respectively. In the US, coal with access to seaborne markets (notably Central Appalachian and Illinois Basin) fell 28% and 32%, respectively, after surging last year.
The oil market was also weak during the second quarter. West Texas Intermediate (WTI) fell almost 7% during the quarter, while Brent fell 5%. Energy-related equities were mixed. The XLE ETF (mega-cap international energy weighted) fell 2%. However, the S&P Oil & Gas E&P index and the OIH oil service stock ETF were strong, rising by 1% and 4%, respectively.
Global energy demand continues to surprise to the upside, and even the IEA has raised its estimates. For example, at the end of 2022, the IEA estimated global oil demand would average 101.6 mm barrels per day -- a significant 1.7 mm increase over 2022. In their June “Oil Market Report,” the IEA raised their 2023 demand estimate by an additional 700,000 b/d, with the bulk of their underestimation again coming from China. Since the end of 2022, the IEA has raised its Chinese oil demand estimates by 400,000 b/d.
Responding to global recession worries, the IEA reduced global oil demand by 200,000 b/d in its July 2023 OMR. However, we believe the IEA is still radically underestimating global oil demand and that further upward revisions must be made. For example, the IEA has 1.3 mm b/d of missing barrels in its first quarter 2023 balances. Our readers know that missing barrels represent the excess of supply less demand that are missing—literally-- they can’t be found in global inventories. Historically the IEA has made missing barrels disappear by revising global demand upwards, and we believe this time will be no different. We believe the weakness in oil prices in the second quarter can’t be explained by faltering demand.
We believe the primary weakness in global oil prices in the second quarter is unexpected supply issues.
In the final week of March, the US government began selling an additional 26 mm barrels of Strategic Petroleum Reserve oil under previously legislated Congressional mandates. All 26 mm barrels had been sold by the last week of June. Over the next four years, the DOE, under Congressional mandate, was scheduled to sell an additional 155 mm barrels of oil out of the SPR—42.5 mm barrels in 2024 and 2025 and 35 mm barrels in 2026 and 2027, and these sales would represent almost 50% of the remaining SPR reserve.
In July, however, the DOE announced the cancellation of these sales as part of the attempt to begin “refilling” the SPR. Over the last 18 months, 330 mm barrels have been released by US, European, and Japanese SPR and have been 100% responsible for the slight build we’ve seen in commercial inventories. Given July’s DOE announcement, SPR sales will be zero over the next four years, which we believe has already begun impacting oil prices. We think it’s no coincidence that oil prices rebounded almost 18% since the last week in June—just as US SPR releases wound down.
SPR sale cancellations, combined with rapidly slowing production growth from the Permian basin and unexpected production cuts from Saudi Arabia, mean that commercial inventories will experience rapid drawdowns in the second half of 2023.
Natural gas staged a massive rebound in the second quarter, advancing 26%. European gas, still influenced by swollen inventories related to last winter’s record warmth, fell by 26%. Asian gas also continued its retreat—falling 5%.
With the restart of the Freeport LNG export facility, US inventories have begun to decline versus historical averages, even in the face of highly cool weather at the beginning of the 2023 air conditioning season. Adjusted for population, cooling degree days were 33% below average for May and June. US natural gas inventories peaked relative to ten-year averages in mid-March, just before the Freeport facility returned to service, and now sit only 6% above ten-year averages. We remain incredibly bullish on natural gas prices. The Natural Gas section of the letter discusses the rollover in Marcellus natural gas production and how the 40% plunge in the Haynesville rig count over the last six months will severely impact its output in the next six months. In the next eighteen months, we will add close to 6 bcf per day in LNG export capacity, and our modeling continues to suggest that US natural gas supply will begin a prolonged contraction starting now. Convergence of US natural gas prices-presently at $2.50 per MMBtu with international prices—presently at $12mmbtu—is practically unavoidable given our modeling of both US natural gas demand and supply. Much of the turmoil in global gas markets, weather-related over the last twelve months, has given investors another extremely opportunistic chance to invest in North American natural gas markets.
Uranium rose 10% from $50 to $55 per pound in the second quarter. In the Uranium section of the letter, we discuss our updated supply and demand models for uranium and their implications. Since 2011—post-Fukushima—the global uranium market has been in massive surplus as Japan’s 50 reactors came offline and global uranium supply surged—primarily from Kazakhstan. Between 2011 and 2018, we calculate global uranium inventories built by over 265 m lbs, resulting in substantial downward price pressure—uranium prices bottomed in the fourth quarter of 2018 at $18 per lb. However, as our models suggest, the uranium market has now slipped firmly back into deficit. Also, the Yellow Cake and Sprott Uranium Trust closed-end physical uranium investment vehicles have removed over 80 mm lbs of uranium over the last five years. Since 2020 we calculate that uranium has shifted back to deficit and that commercial inventories have been drawn down by 180 mm tonnes. We calculate excess commercial uranium inventories related to the Fukushima-related shut-downs have now been 50% worked downand stand at approximately 250 mm lbs, covering reactor demand by less than 18 months. Depending on how much physical uranium the two closed-end vehicle buyin 2023 and 2024, we calculate that 100% of the excess Fukushima-related inventory will have been consumed by the end of 2024. Given the deficit between power generation demand and mine supply, and given that almost all easily mobilized Fukishima- related inventory has been removed from the market, we believe uranium prices could move chaotically to the upside.
Global agricultural markets fell in the second quarter. Corn fell 16%, wheat fell 8%, and soybeans rose 3.5%.
Fertilizers also sold off. Urea (the solid form of nitrogen) fell 10%, phosphate fell 27%, and potash fell 3%. We believe the correction has run its course, and markets have now set up for another crisis. Dry weather continues to plague the corn belt. In their latest World Agricultural Supply and Demand Estimate report (WASDE), the United States Department of Agriculture (USDA) significantly reduced their US corn yield estimate from 181.5 to 177.5 bushels per acre.
Food nationalism has also reemerged. Once again, India banned rice exports as adverse growing conditions lowered the expected harvest. India is the largest rice exporter, representing almost 50% of the seaborne trade. Finally, Russia suspended its agreement allowing Ukrainian grain shipments via the Black Sea. Also, the Russian military has now started to systematically target Ukrainian grain infrastructure over the last month, including Ukraine’s grain export facilities on the Danube River.
Ukrainian wheat and corn exports were already halved compared with their peak two years ago. After the recent destruction, a further reduction in export volumes is a distinct possibility. In 2021, we predicted a coming agricultural crisis. Our same models now call for a new crisis to develop as we progress through the rest of the year and into 2024. The recent pullback presents an attractive entry point for long-term investors.
Precious metals were weak in the second quarter. Gold fell 2.5%, while silver fell 5%. Platinum and palladium fell 10% and 17%, respectively.
Gold and silver equities were also weak. The GDX and SIL ETFs (which track gold and silver equities) fell by 7% and 15%, respectively.
Earlier in this letter, we outlined the fundamental underpinnings of the upcoming gold bull market and provided a framework for how high gold prices might go.
Since the summer of 2020, precious metals have been in a corrective phase. We believe things are about to turn much more bullish.
On a short-term basis, one headwind remains. Western investors have again started to liquidate their precious metals holdings.
We track the behavior of 18 gold ETFs. For the twelve months ending March 2023, the ETFs liquidated 450 tonnes of gold. Beginning in April, the ETFs stopped shedding. For a moment, it appeared they were starting a period of accumulation. The same ETFs added 60 tonnes of gold holdings from March to May. Unfortunately, western investors returned to shedding over the last two months, this time by 100 tonnes.
The ETFs indicate Western interest in gold remains bearish. Western investors, we believe, will drive the upcoming bull market. Thus far, they remain uninterested.
On a more positive note, central banks continue to buy gold.
In the first six months of 2023, central banks purchased 387 tonnes of gold – a record first-half result, according to the World Gold Council. China accumulated 103 tonnes in the first six months of 2023 and has continuously purchased gold over the last nine months.
Since the start of the corrective phase in mid-2020, the ETFs have shed over 600 tonnes of gold.
Over the same period, open interest in the COMEX gold futures contract contracted by over 300,000 contracts – or 900 tonnes of “paper gold,” the majority of which were likely matched with physical gold. In total, we estimated western speculators have shed 1,500 tonnes. Central banks, meanwhile, have more than offset this liquidation. Between 2020 and mid-2023, central banks accumulated 2,200 tonnes of physical gold. It stands to reason that prices are now re-testing the mid-2020 highs. Even though Western investors have been gold sellers, all selling has been met with central bank buying. We believe Western investors will turn into aggressive buyers once central banks turn dovish. When that happens, western demand will collide with central bank buying and gold prices will move dramatically higher.
As outlined in our introductory essay, we believe gold prices are heading much higher than many envision today. Given our projected increase in gold prices, we believe significant exposure to physical precious metals and related equities should be considered.
Intrigued? We invite you to download or revisit our entire Q2 2023 research letter, available below.
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