Market Synopsis – May 2024

Market Synopsis – May 2024

May 3, 2024 | 0 comments

What the conflict between Iran and Israel means for oil

On the 13th of April, Iran attacked Israel with a barrage of drones and missiles. Israel and its allies intercepted 99% of the projectiles. Less than one-week later Israel responded, firing several air-launched ballistic missiles towards an air base near the Natanz nuclear complex. Despite the expanding conflict in the Middle East and the very real risk of it breaking out into full-scale war, oil markets have not responded, instead Brent crude oil fell 2.9% in the days that followed. Which prompts the question, are investors too complacent in their response to the very real risk of an oil shock?

While oil markets did not react to these attacks, Brent crude oil is up 14.0% year-to-date driven higher by a robust US economy, the bottoming of the global manufacturing cycle, and production discipline from the OPEC 2.0 cartel – see Figure 1. Looking forward, the macro context is ripe for further geopolitical disruptions, which could push the price of oil up beyond fundamentals in the short term.

Figure 1 – 2024 has witnessed a rising oil price

Due to the political instability within their borders, both the government of Israel and the regime in Iran are motivated to escalate the conflict to improve support for their governments and ensure their continuity. Meanwhile, the Biden administration is actively discouraging escalation by Israel in the hopes of avoiding an oil shock during an election year. The administration has gone as far as turning a blind eye to illicit Iranian oil exports (Figure 2), and admonishing Ukraine for launching drone strikes against Russian refining facilities.

Figure 2 – Iran’s oil production is proceeding unrestrained

As a result, we believe it is probable that Israel will limit their escalations and rather contest the buffer zone in the north of Israel with Hezbollah. This base case scenario would likely only lead to minor oil shocks. Of course, the situation remains volatile, and the persistent risk of full-scale war remains. If a full-blown conflict in the Middle East were to break out, it could remove as much as 33% of global oil production. This would lead to a major oil shock as global oil reserves, which make up just 4.5% of global oil consumption, would do little to dampen the shortfall. Investors should not be too complacent.

Beyond the near-term risks presented by the conflict in the Middle East, we still expect the slowing global economy to drag down oil prices. Our view is reaffirmed by the International Energy Agency (“IEA”), which just last week cut its 2024 forecast for global oil demand growth by 130,000 barrels per day, citing “exceptionally weak” deliveries in developed economies in the first quarter. The IEA also cut its forecast for 2025. If our expectation of a global economic downturn does come to fruition, the IEA’s muted oil demand forecast may end up not being sombre enough.

Copper demand driven by China

Another commodity that has risen strongly in 2024 is copper, now up 17.3% year-to-date to USD 4.54/lb. However, unlike oil, China is the dominant source of copper demand. In 2023, China accounted for more than 60% of demand for the metal. The picture is much the same for aluminium, zinc, and nickel – see Figure 3.

Figure 3 – China is the largest consumer of base metals

Despite the strong start to the year for copper, the BCA’s emerging market strategists expect overall Chinese copper consumption to increase by only 4% in 2024, compared to 13% in 2023. Demand growth is expected to be driven lower by a depressed construction sector amid the country’s ongoing real estate bust. Housing starts are down 63% from their peak, while completions are only down 6%, as the government supports developers to finish their existing projects. As copper is mostly used towards the end of construction projects, the reduction in demand is likely only just beginning.

An even bigger detractor of copper demand will come from the green energy sector, where copper consumption growth is set to fall from 88% in 2023 to just 14% in 2024. Growth in copper demand has fallen as the Chinese power grid has struggled to keep up with the large increase in energy produced by the myriad of new green projects. As a result, several provinces have decided to limit the number of new green projects approved.

The Chinese electric vehicle (“EV”) sector, which has become the world’s top automotive exporter, has also been a strong source of demand for copper. However, Chinese manufacturers appear to have gotten a bit ahead of themselves, producing so many EVs that European port operators are now demanding proof of onward journey before accepting any more shipments. With Chinese-made EVs piling up at European docks, and an ongoing EV price war in China, we expect production and thus copper demand to slow down in the near term – see Figure 4.

Figure 4 – China’s EV export growth is slowing

What is driving the supply of copper?

As has been the case in much of the commodity complex, lacklustre investment has constrained the supply of copper coming to market. Despite the limited investment in production capacity, output has continued to steadily grow. Driven higher by Chile, Peru, and the Democratic Republic of Congo, all of which have benefited from new projects coming online – see Figure 5, Panel 1.

Figure 5 – Copper supply continues its steady expansion

The Democratic Republic of Congo has now surpassed Peru to become the world’s second-largest copper producer, accounting for nearly 80% of the increase in global copper ore production last year. This growth has been made possible through increased foreign direct investment from Chinese companies in recent years.

Figure 5, Panel 2 also depicts how the supply of scrap copper swelled in 2023 and has now moderated in recent months on lower copper prices. Scrap copper producers can quickly adjust their output depending on the copper price. Thus, any major upwards shift in price will be met with additional supply. In effect creating an upper limit on copper prices.

Investment takeaways

Both oil and copper have rallied this year, 14.0% and 17.3% higher year-to-date respectively. While differing factors have driven each commodity, we believe both are likely approaching a near term peak. Oil has risen on a resilient US economy and disciplined OPEC producers with the potential for increased volatility in the near term due to ongoing skirmishes in the Middle East. Having said that, we believe that the expected recession towards the end of 2024 will weigh on medium-term oil prices. On the other hand, copper prices are typically a function of Chinese demand, which is already showing signs of slowing due to fewer property starts and falling EV production. Coupled with the increase in copper supply coming online and we expect that copper prices could be poised to finish the year lower than where they are trading at presently.

If you interested in finding out more about how cognisance of the macroeconomic backdrop helps our clients invest, connect with Integrity Asset Management and let us help you navigate your investing journey.

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Source: Bloomberg, 30 April 2024