Commodities have enjoyed an extraordinary start to the year with prices for oil and gold reaching record levels. Will $100 a barrel prove a ceiling for oil, or will it be a platform for further gains? Or indeed, could oil fall sharply should global growth slows? Will commodities continue to outperform global equities and bonds?
Francisco Blanch, Merrill Lynch’s head of global commodities research, answers your questions on oil as well as the outlook for metals, agriculturals, soft commodities and commodity index strategies
How sustainable is the current price of oil per barrel and is there a possibility of a vicious trend reversal in the coming months/years?
Francisco Blanch: In my view, the recent oil price increases will be rather sticky due to a combination of factors. First, the expansion of emerging markets into consumer economies will likely continue to support energy demand growth for years.
Second, Opec compliance/cohesion has increased in the last decade, and many member countries will likely need high oil prices going forward to support expanding fiscal policies. Third, cost inflation, particularly at the margin, has increased tremendously in recent years with the movement towards non-conventional crude oil production.
Fourth, resource nationalism is on the rise, and with it the increasingly limited access to low cost supplies. Fifth, the apparent lack of consumer price elasticity is a function of the limited opportunities for substitution in transportation.
Are there factors that could create a sharp reversal in the recent trends? I will list three. First, a technological change that allows us to move away from oil in the transportation sector. Second, an unexpected doubling or trebling of Iraqi oil production capacity over a short window of time. Third, a global recession that curbs demand for energy around the world, particularly if the recession is linked to protectionist and/or anti-free trade policies.
Gold has had a great year in 2007. Do you expect precious metals like gold, platinum and silver to continue to be investors’ safe havens amid the uncertainties surrounding the equity market in the 1st half of 2008 at least?
Francisco Blanch: Gold has experienced a phenomenal rally in recent months, and we remain bullish on the precious metal. However, gold is a sentiment, not a fundamentally-driven market. Thus, our bullish stance on gold is based on our bearish views on the dollar, our view that central banks in emerging markets will continue to diversify into gold, and our view that investors perceive gold to be an inflationary hedge. So worries on inflation and the dollar, as well as EM central bank buying, will all provide support to the precious metal this year, in our view.
How seriously do you take theories on peak oil and peak gold?
Ian Selkirk, UK
Francisco Blanch: I am not a huge fan of peak oil theory simply because we have only burnt about 1,000bn barrels of oil, and we have about 4,500bn barrels to go before we run out of oil, according to the most recent estimates.
However, it is important to make a distinction between two types of oil: conventional and non-conventional crude oil. The remaining conventional crude oil is mostly out of bounds for ”profit maximizing” oil companies, as it sits for the most part within Opec. Non-conventional crude oil, on the other hand, is very expensive (possibly we are looking a $70+ a barrel in many instances) and hard to extract. Thus, the world economy is primarily facing political and technological constraints, not resource constraints, and that is why I am not a big fan of peak oil theory.
Now, could conventional oil production ”dip” until we find solutions to the technological and political challenges that we face today? Possibly, and this is why peak oil theory will always find supporters.
Do you think the worst of the problems in the US refining industry have been resolved, or should we be concerned about a repeat of last summer’s downstream-led price rise in summer 2008?
Hugo Ruiz-Kuss, HM Treasury
Francisco Blanch: While more Opec and non-Opec crude is coming on line, refining capacity will likely remain constrained for a good part of 2008 due to limited expansions in distillation and upgrading capacity. Specifically, we do not see a large increase in coking and cracking capacity-the equipment used to convert heavier residual oils into light fuels for transportation-over the next six months.
Moreover, the refinery turnaround season in the US starts in January, further limiting the market’s ability to cope with incremental amounts of crude in the short-run. Nonetheless, the return of a number of large US refineries by the start of 2Q08, including Whiting, Pascagoula and Texas City, should add almost 500 thousand b/d of capacity. In addition, the expansion of Jamnagar, a 580 thousand b/d refinery expansion project in India, is likely to be on-stream by June next year, suggesting that some of these bottlenecks will start to ease towards 2H2008.
The IEA has forecast robust oil demand growth for 2008 at 2.5 per cent (over double what was observed in 2006 or 2007), based on assumptions of a return of normal weather, Asian and European de-coupling from the US (and its slowdown), and subsidised demand in the Middle East and Asia. If this projection turns out to be excessively bullish and oil demand growth is, say, closer to the previous two years at 1 per cent, what prices do you think we would see?
Francisco Blanch: Our own projection is that demand will grow at 1.6 per cent year on year in 2008, well below the current IEA’s projection, partly because we expect some reversal in energy subsidies this year. However, you also have to factor in that we have had warm winters in recent years, limiting oil demand growth, and we expect a reversal to normal weather in 2008. Thus, under our demand assumptions, we expect WTI and Brent crude oil prices to average $82/bbl in 2008.
This is already a 12 per cent increase on last year’s average levels. Should global oil demand increase by just 1 per cent, I would expect prices to average slightly below our forecasts, always under the same supply growth assumptions.
Many countries are still enjoying subsidised energy and food prices, and some are more capable of funding these subsidies than others. How would the prolonged rising commodity prices affect the economic outlook of these countries ranging from Indonesia to India and China?
Michael Sim, Singapore
Francisco Blanch: As commodity prices increased rapidly in recent years, China, India, Brazil, Argentina, Russia, Iran, and many other countries rushed to cap retail energy and food prices in order to protect their economies. These subsidies have continued to grow, posing questions on the sustainability of the current economic expansion.
In my view, the basic problem is that there are simply not enough raw materials to fuel 12 per cent yearly economic growth in China or other EMs on a continued basis. A soft-landing of oil and the world economy in 2008 is still feasible, but emerging markets may have to react soon in order to achieve it.
Should emerging markets act swiftly to revalue their currencies and hike domestic fuel prices, world commodity demand growth would slow and some of the current problems could be reversed. This adjustment has already started. Despite their recent vow to freeze government regulated prices in an effort to fend off rising inflation, China lifted domestic petroleum product prices by 10 per cent in November. However, domestic fuel prices are still well below global fuel prices, suggesting that there is significant pent-up inflation in the system in China and elsewhere.
In my view, the current trends will ultimately be most painful for resource poor developing countries and for countries where inflation is already out of hand. Thus, the big losers will be those developing countries that either have no resources or no good macro policies to control inflation.
How likely do you think it is that Opec production will increase this year?
Tim Thorne, Panama
Francisco Blanch: Opec publicly decided against an oil production increase in early December. Yet the message coming out of the cartel is rather unclear. Judging by the significant increase in routes from the Arab Gulf to Singapore and Japan, the outlook for global oil supply is positive near-term.
However, judging by Opec’s unwillingness to advocate an increase in output after crude oil traded at $99/bbl, it looks like the high oil prices are here to stay.
Of course, part of the increase in Opec’s shipments has to do with the return of the 280 thousand b/d Lower Zakum West field in the United Arab Emirates, but Saudi production also appears to be on the rise. In addition, Iraqi production has recently increased to 2.4m b/d, the highest since September 2006, partly reflecting improved security in the country.
My view is that Opec crude production will increase significantly in 1H2008. Because crude inventories globally have fallen to very low levels, it is in Opec’s interest to increase crude oil production to replenish them. After all, crude oil price spikes are not in the interest of Opec or the consumer nations.
What will be the main factors that drive the price of oil in 2008 on the supply and the demand side?
Marcel Kling, Germany
Francisco Blanch: The demand backdrop for oil prices is positive for now on the back of healthy emerging market demand, and the fact that global crude and product supply remains constrained.
What are the key potential surprises on the supply side? First, non-Opec output could surprise to the downside. Currently we expect healthy non-Opec supply growth of 925 thousand b/d in 2008, but non-Opec production has a tendency to disappoint.
Second, Opec recently showed that $100 per barrel oil does not necessarily warrant a supply increase, which is a rather bullish signal. However, Opec’s stance could change due to political pressures, and increase production again.
Third, Iraqi oil output could increase above and beyond the markets’ expectations, although this factor may not play out until 2009/10.
On the demand side, emerging market oil consumption could surprise to the upside, if subsidies on domestic fuel prices continue, or to the downside, if subsidies are removed and consumers have to face substantially higher gasoline and diesel prices.
Finally, a potential contagion from a rapidly decelerating US economy into emerging markets poses significant downside risks to oil prices in 2H2008.
As Bernanke lowers the interest rates to stimulate the US economy will that tend to push both oil and commodity prices significantly upward?
L Fleske, Kansas, US
Francisco Blanch: The energy sector is currently stuck between a rock and a hard place. Concerns about an economic slowdown are driving down interest rates in the developed world, a movement that has created a flurry of liquidity in emerging markets, supporting energy demand. In contrast, faced with robust growth and growing imbalances due to their skewed FX and domestic economic policies, many EM countries are hiking interest rates to contain inflation (and to slow down energy demand growth).
Thus, the prospects for global energy and commodity demand in 2008, and ultimately commodity energy prices, will very much depend on the outcome of the ongoing battle between EM inflation and developed market growth. As you suggest, lower interest rates in the US initially supported rallies in world commodity prices in 4Q07, and will likely continue to do so in the next few months.
Will we see a continuation of high prices in commodities in 2008, given the fact that the US economy is entering into what many economists are calling a ”mild recession’’?
Francisco Blanch: Running at about 5 per cent between 2003 and 2007, the world economy has experienced the fastest and most prolonged period of growth since the 1960s, primarily driven by the strength of emerging markets. In turn, this robust above-trend global growth has lent phenomenal support to energy demand, also mainly on the back of emerging markets. Yet, oil supply expanded at 6 to 8 per cent per annum back in the 1960s, as energy was cheap and abundant.
Now, the world economy is trying to grow at the same rate with yearly oil supply growth of 1 to 2 per cent. Thus, even if the US economy slows down, oil and commodity prices will likely hold firm in the first half of the year. Supply growth is constraining demand growth at the moment, and of course the growth momentum in emerging economies is very strong. Still, the macro-environment is possibly the most uncertain since 2001, and I am more cautious about the second half of 2008, particularly if slower US growth starts to damage economic activity in the emerging markets.