Commodity weekly: Crude oil risks overshooting the downside

Short-term cyclical weakness versus long-term structural upside

Despite the current price softness, driven by economic growth concerns in China, Europe and potentially also the US, Saxo holds the view that key commodities are at the beginning of a multi-year bull market driven by CapEx drought due to rising funding costs, lower investment appetite and lending restrictions. The green transformation is creating “greenflation” through rising demand for industrial metals towards “new” energy at a time when miners are faced with rising costs, lower ore grades, growing social and environmental scrutiny, and in some cases resource nationalism.

In addition, we are seeing increased fragmentation pushing up demand for, and prices of, key commodities. The agriculture sector will likely face a higher degree of weather volatility and price spikes. Overall, these supply and demand imbalances may take years to correct, ending up supporting structural inflation above 3% which will likely increase investment demand for tangible assets such as commodities.

Tight supply across several key commodities has, since late 2021, delivered a positive year-on-year gross roll yield return on the Bloomberg Commodity index. The gross roll yield shows the difference between the performance of spot and total return, the spot price being the prompt futures contract that strategists and technical analysts tend to follow while the total return index shows the actual realised return which includes funding costs, storage and not least the positive return from rolling futures contracts in a tight market (like now) called backwardation or negative return when rolling contracts in an ample supplied market called contango.

The average gross roll yield return during the past 10 years is -3.25% and highlights a long period of ample supply leading up to the 2020 pandemic-led period of disruptions and surging demand for consumer goods. During this time, roll yields spiked, leading to a 9.25% peak last December before drifting lower to the current 4.5%. We believe positive roll yields caused by this tightness will continue to underpin investment demand for the sector in the months and quarters to come.

Silver, platinum and palladium under pressure

In the short term, we will be watching silver and platinum, both of which have been struggling amid the lower growth outlook raising questions about the near-term outlook from industrial users, not least those in the green transformation industry as the rising cost of financing has been hurting the wind and solar sectors, and increasingly also the hydrogen sector, a future source of expected demand for platinum. Palladium is also worth watching having fallen to a five-year low amid speculative selling forcing producers to hedge at levels that increasingly are through the aggregate cost curve. A 14k lots futures gross short position is close to 4X daily traded volumes, leaving the metal exposed to a major squeeze once the technical and/or fundamental outlook improves.

Crude oil at risk of overshooting to the downside

The energy sector is heading for its worst weekly performance since March with losses being led by the notoriously volatile natural gas contract, down more than 10% on the week, driven by muted demand for heating as November stays warm and production nears an all-time high. Meanwhile, the sell-off in crude oil and fuel products accelerated this past week with Brent briefly falling below $80 for the first time since July while WTI was hurled below $75 before stabilising.

Prices have increasingly come under pressure as the market focus turned from tight supply supported by Saudi production cuts and a brief spike in the war premium following Hamas’ October 7 attack on Israel, and subsequent response from the Israeli Defence Force in Gaza. However, while the death toll in Gaza from Israeli counterattacks continues to rise to unimaginable levels, the prospect of the conflict spreading to the oil-rich part of the Middle East has increasingly been put at near zero.

Instead, the market focus has turned to a weakening demand outlook as the economic outlook weakens in Europe, the US and not least China, the world’s top importer. The turnaround in the outlook and prices has been exacerbated by selling pressures from speculators who bought more than 325 million barrels in the futures market between early July and the end of September on the prospect of Saudi cuts lifting the price. During this time, the gross short slumped to a 12-year low leaving no positions left to absorb a correction like the one we have seen during the past couple of weeks, hence the risk of crude prices falling to low levels that are not justified by current fundamentals.

Brent Crude oil support at around $78.34 with no clear support below until around $72, the May to June lows. Medium-term Brent is in a downtrend that would be further confirmed by a weekly close below $81.94. Likewise a close above may signal a short-term upside to $84.78, the 0.382 retracement of the most recent sell-off from $93.80.