PODCAST: twin threats for global commodities markets

“The economic impact is going to be quite significant. For countries like the US, where the central bank has been quite aggressive in taming inflation, there's going to be complications,” Hynes says.

“We've seen a lot of futures markets start to price in a fairly aggressive rate hike cycle which has led to lower estimates of economic growth. Clearly commodity markets which are driven by that global activity are now expected to weaken.”

However, demand has held up relatively well in previous rising rate cycles because high inflation means the economy is performing strongly - too strongly in some cases which causes other problems, Hynes says.

Conflict has caused another problem in Europe as countries try to wean themselves off Russian gas. The war in Ukraine and sanctions against Russia have led big energy consumers like Germany to search for alternatives. Many sectors will be affected and not just in Europe.

“The sheer scale of cuts to Russian gas to Europe is so significant because they just can't replace it with anything in the short term. That's going to force them to make some hard decisions like restricting gas consumption to certain sectors, particularly big industrial users,” Hynes says.

“Cutting gas to industrial users will ultimately lead to weaker industrial output and that does not bode well for countries like Germany. Unfortunately for the rest of the continent and the globe it will also likely lead to an increase in emissions in the short term as they push back towards fossil fuels to meet that gap.”

Silver lining

Hynes adds: “Coal in particular will be leant on a lot more with Germany already looking to restart old coal-fired power plants. And they're also look to delay the phase out of their nuclear power industry.”

The silver lining to the conflict in the medium to longer term is it will likely accelerate investment in renewable energy. In the meantime, energy users must work out how to plug the gap.

Liquefied natural gas may play a bigger part as the transition evolves because it produces fewer emissions than coal or oil and it can be brought on relatively quickly compared with other energy sources. It may also allow Europe to more quickly phase out Russian oil and gas.

The feat would be significant as Russia produces about 12 per cent of global oil supply. A hit of that magnitude will create big waves across the industry and the full implementation of sanctions don't take effect until year end, Hynes says.

“We haven't yet seen the full force of those sanctions apply to the oil market and ultimately it will be extremely difficult to replace,” he says. “Especially due to the lack of investment in new capacity, in part because we've had prices falling as demand weakened just prior to the pandemic.”

“OPEC has boosted output and the US shale producers have become more financially prudent. Still the lack of investment in new capacity has come home to roost because producers have limited ability to react quickly to the supply disruptions emerging from Russia.”

In becoming more prudent, energy and minerals producers have put more capital into projects that will improve returns for their shareholders. This has resulted in less capacity hitting the market.

A good example is key critical minerals crucial to the renewable energy transition, many of which are located in difficult regions. Take lithium: much of the world's resources are held in brine deposits in South America which require lots water to process.

And much of the world’s cobalt is mined in the Democratic Republic of Congo which has experienced conflict and security of supply issues. This raises environmental and sustainability problems, Hynes says.

“Mining companies now take time to work through those issues and improve the approach to ESG, which means more time and cost is involved to bring new supply in. Until we see a catch up in that investment cycle a lot of commodity markets will struggle to meet demand which will be relatively positive for prices.”

Demand for critical minerals is soaring due to the electrification of transport networks and the proliferation of electric vehicles which require huge amounts metals including copper, nickel, cobalt and nickel.

“The estimates of demand for these metals are going to be underestimated if we continue to see this energy transition accelerate at the levels we are now seeing in regions like Europe. There is a real lack of quality assets. The ability to find a large-scale, high-quality copper mine is becoming increasingly difficult. The cost rises when you have to look deeper underground in more difficult environments. It also adds time.”

Another geopolitical issue is the deteriorating relationship between the US and China, the world’s two largest economies. China has dominated not only production of materials like rare earths but also their smelting and refining. It also consumes more than half of all global supply of some commodities.

In addition to the geopolitical tension, supply chains in and out of China have been impacted by the country’s zero-COVID policy which has curtailed the movement of goods and people.

“As the relationship becomes more fractious, we’ve started to see the US look to support those industries in other parts of the world. They want to ensure they have security of supply to develop their markets without being beholden to the political ramifications in China,” Hynes says.

“At a recent meeting, the (Chinese Communist) party highlighted they would place increasing importance on their zero-COVID strategy over economic growth. So that raised warning bells for markets because that means demand for commodities could continue to be impacted by ongoing restrictions and lockdowns.”