Commodity prices painting a mixed picture

One of the big surprises so far this year has been the weaker than expected oil price. It wasn’t that long ago that many forecasters were calling for $150 per barrel oil and the looming European winter freeze. But like all too often, the market forecasters were wrong.

Then there were expectations that oil prices would trade higher as better than expected data come through the US and China started to open. But again, it hasn’t yet eventuated into higher prices.

Most of the time when our underlying narrative doesn’t eventuate we are tempted to explain the reasoning. We try to reverse engineer. We can easily point to several factors to justify the weaker than expected oil price. But at the end of the day, the reasons don’t really matter. It’s like looking at a melted ice cube and trying to explain what it looked like in solid frozen form.

What matters to us more is why the price of oil is still stuck within its current band in the US$75-85 per barrel price range.

According to BP in their most recent research “The single biggest factor driving the decline in oil consumption is the falling use of oil within road transport.

Rising prosperity and living standards in emerging economies support an increase in both the size of the global vehicle parc and in distances driven, boosting the demand for oil.

But this is increasingly offset by a combination of the road vehicle fleet becoming more efficient and the growing switch away from oil to alternative energy sources…”

There is a case growing that perhaps the transition to cleaner fuels are impacting oil consumption. However, we don’t think this necessarily tells the whole story with where the oil market is today.

Sure efficiency gains and a switch to alternative sources will impact future oil demand, but for the time being, oil consumption is still very high. We want to know why oil prices today aren’t moving in line with prior expectations.

According to our own research, China consumes around 15.4m barrels of oil per day. The United States and entire European Union in comparison consume 18.6m and 10.4m respectively.

There’s an argument in markets that oil prices are soft in anticipation of a recession in the US, but we don’t buy that argument for the time being, because China’s re-opening would be a large enough offsetting factor.

We also don’t buy the argument because US and European economic indicators have held up relatively well so far this year, beating expectations and dampening forecasts of a hard landing recession. We wrote about corporate earnings last week.

China opening slower than expected

What oil markets are indicating is that perhaps China’s re-opening is occurring slower than expected. This is becoming our central case, as reflected in the oil markets. There could be some other supply factors at play, particularly regarding Russia.

But in a market which is already tight and somewhat opaque, China’s role cannot be understated.

Copper prices provide another clue. They have bounced off their 2022 lows quite nicely, but this could be more of an anticipation of increased Chinese activity rather than actual activity. Copper stockpiles are at 5 year lows, yet the copper price is still below its late 2021 peak. This further supports our anticipation vs reality assumption.

Our key thesis this week is not that China is in some sort of trouble, but the opening is perhaps taking longer than expected and will not have a meaningful impact until later this year. Oil will guide us in the coming months as to the timing.

China’s slower than expected opening isn’t necessarily a problem, particularly for the US Fed or European Central Bank as they look to tame inflation. One of the biggest casualties of the slower China opening is the Australian dollar which is seen as a commodity currency and play on China.

The Aussie dollar is looking a little weaker in recent weeks after a nice recovery to start off the year. This week’s lower than expected wage growth would have eased some concerns for the Reserve Bank of Australia (RBA). We wrote two weeks ago about the wage price spiral that the RBA is most worried about and how that is now the main priority in setting interest rates.

Canada is also in a similar boat to Australia, with regard to its exposure to China and balancing inflation with interest rates. Data out of Canada this week shows that inflation is cooling and that the Bank of Canada’s watch and wait stance is probably a sensible one for the time being.

In summary, we continue to watch the Chinese recovery with interest and will look for clues as to the extent, timing and impact on markets. So far things are slower than expected, but that could change rather quickly and flow through into other markets.

Each week we use classical artwork in our thumbnail links as a source of inspiration. See this week’s artwork here.