Morgan Stanley
  • Thoughts on the Market Podcast
  • Jun 3, 2021

Mid-Year Commodities Outlook: Risks Ahead?

With Martijn Rats and Andrew Sheets


Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley.

Martijn Rats: And I'm Martijn Rats, Morgan Stanley's Global Oil Strategist and Head of the European Energy Team.

Andrew Sheets: And today on the podcast, we'll be talking about the outlook for oil and energy as the world continues to reopen. It's Thursday, June 3rd, at 3:00 p.m. in London.

Andrew Sheets: So Martijn, commodity prices have seen big moves over the last several months. I think a great place to start is just putting some context around the price changes in commodities we've seen and how these compare versus history. What's been happening?

Martijn Rats: Over the last year or so we've seen price changes that we've really only seen back in the 1970s when commodities were also very much in vogue. So we've seen historically very strong rallying commodity prices.

Martijn Rats: I would say a few things have come together to really drive that rally. First of all, it's simply the reopening trade - economies are opening up, the world is getting back to business, and that is stimulating demand more than supply, and a lot of commodity markets have naturally tightened as a result of that. The second factor that has played a role is this inflationary backdrop. And in many ways, this goes a bit two ways: on the one hand, rising commodity prices are a source of inflation, but all financial investors also use commodity futures to hedge themselves against future inflation. And with inflation expectations rising, we've seen a lot of macro investors buy baskets of commodities as a result of that, and that also reinforced to move higher.

Martijn Rats: And then finally, there are elements around sort of ESG and the energy transition that in many areas also through various different mechanisms, have driven upward prices to commodities. For example, if the world is to electrify, we're going to need a lot of copper. But also, if you look at, for example, at the oil markets, the pressures of climate change are rising in such a manner that actually in the immediate future, it looks like those concerns have much more impact on the supply of oil than, for example, the demand of oil. So the broad ESG and climate sort of theme actually has an upward pressure on prices. And if you put these three things together. Yeah, that has produced this extraordinarily strong rally.

Andrew Sheets: So Martijn, I think you've highlighted well, you know, these factors that have been strong tailwinds to commodity prices: And yet, you know, if I look at our forecasts at Morgan Stanley, we're not really forecasting commodity price gains to continue. So why don't you think this trend continues as a base case? And why are you more skeptical that these kind of extraordinary returns would continue from here?

Martijn Rats: Look, most of us that cover commodities at Morgan Stanley, we approach the market from a fundamental perspective - supply, demand, inventories, marginal cost. These are our starting points for forecasting prices.

Martijn Rats: Fundamentally, those price levels should elicit a supply response. If you then combine this with some of the beliefs of other colleagues in various macro teams here at Morgan Stanley, that the dollar is likely to strengthen a bit, that perhaps current inflation expectations have run ahead of themselves a bit. Yeah, then our call is that this extraordinary rally in commodity prices should take a bit of a breather, if not sort of normalize somewhat at slightly lower levels. So that is the basis for our call. But fundamentally, we would see prices sustained at levels that are a little closer to where the factors of supply, demand, inventories, would suggest they should be.

Andrew Sheets: So Martijn I actually wanted to focus next on the commodity market that you spend most of your time on, which is the oil market. You know, you have a market that's caught between these two pretty interesting dynamics. One is, as you just mentioned, is that there does seem to be the ability of the market to supply more oil, especially at current prices. And yet you also have a really strong economic recovery that's being forecasted by our economists here at Morgan Stanley, and that should mean more demand for oil and oil related products. So, when you think of those dynamics kind of pushing and pulling against each other, where do you think oil prices shake out from all that?

Martijn Rats: Our forecast is that oil stays in the high 60s, up to $70 a barrel for the balance of the year. Our belief is that $70 will turn out to be a level that will be difficult to break sustainably over long periods of time. For short periods of time oil prices, can move, very dramatically. And we saw the flipside of that broadly this time last year. But nevertheless, above $70, the price starts to give a very strong signal to suppliers to produce more. And that can come from two areas. First of all, OPEC itself still sits on a very large amount of spare capacity. OPEC has done a very admirable job over the last year, year and a half, balancing the oil market. But to do so, they had to withhold large quantities of oil. So, when prices go higher from here, it seems likely to us that there'll be more countries releasing more of their spare capacity and that should cool the market down somewhat.

Martijn Rats: Then on top of that, if you think about prices substantially above $70 already, you know, in the next couple of months, that will probably lead to the resumption of more drilling activity, more fracking activity in the United States. There are some time lags that mean that U.S. production will probably grow very modestly under almost any condition this year. But it would then set up the oil markets for much stronger growth from U.S. suppliers in 2022. You could reasonably expect, if that were to happen, that the back end of the forward curve would come under some pressure. When that happens, it has a habit of dragging down the front of the forward curve also with it to an extent. Above $70 both OPEC's spare capacity and U.S. shale growth could likely start to limit some of these price gains. And that's why we're calling for high 60s, up to $70, but not an awful lot more than that.

Andrew Sheets: Now looking a little bit farther out. Obviously, this question of environmental impact is enormously important to oil prices and the oil sector. So, you know, you and your colleagues have recently done a pretty deep dive into how you think the impact of environmental, social and governance concerns could impact the longer run oil prices. I was hoping you could just give a few thoughts on that and how that's thinking about the long-term trajectory for oil prices, in your view?

Martijn Rats: Basically since 2015, I would say there's been a real active discussion on peak oil demand and what it means. So, oil companies have been seeing this coming, and they're moderating their levels of investment already well in advance.

Martijn Rats: So what is increasingly unclear is whether demand will actually peak before supply or supply might even peak before demand. Now, given the factors that you just highlighted, the shareholder activism, there's been a landmark court ruling in the Netherlands, there have been further studies by the International Energy Agency, which have had some pretty clear language of what oil companies should do with their investment levels if they want to meet the Paris climate accord. All of these things make the scenario in which actually for a sustained period of, you know, several years, much of the rest of this decade, actually supply comes under pressure before demand.

Martijn Rats: Of course, it's relatively straightforward to say that demand should moderate to prevent excessive climate change. But for now, the next billion people in terms of global population growth is projected by the UN to happen in the next 40 years. Over the same 40-year period, the OECD is estimating that world GDP per capita in real terms will grow by 50%. So, a billion extra people, 50% more GDP per capita, that's an awful lot of people and an awful lot of GDP. Now, historically, across countries, across time, this is correlated with more demand for energy, including oil. And if you think that demand is going to grow for, say, another 10, maybe 15 years, and at the same time publicly listed oil companies, which produce about half of the world's oil, are increasingly under pressure from their shareholders to start limiting investment at the same time, then their production will likely roll over by 2023/2024.

Martijn Rats: And that opens up a large gap to be filled, which then presumably needs to come from national oil companies owned by governments and other privately owned oil companies. So, in a note that we published earlier this week, we talked about $80 oil as potentially required for those non-public companies to fill up that gap. And, yeah, it’s too early to make that the base case. We're not moving our oil price forecast to $80 between now and 2030 straight away. But it does highlight the extent to which once we get out of this reopening trade and some of the shorter-term transitory factors, there could be substantial, sustained upward pressure on oil prices because of the friction that transitioning to a decarbonized energy system that lies ahead ultimately will create for the balance of this decade. And that's where that stronger oil price forecast eventually comes from.

Andrew Sheets: Interesting. An important dynamic to watch. Martijn, thanks for taking the time to talk.

Martijn Rats: Great speaking with you.

Andrew Sheets:And thanks for listening. If you enjoy Thoughts of the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today. 

Commodities prices have seen big moves over the last several months, but could a potentially stronger dollar and the mechanics of supply and demand cool the rally?

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