As China reopens, what’s ahead for commodities in 2023?

2022 Commodity Performance and Market Context

• Commodities were the best-performing asset class of 2022, finishing the year up 26%, though they experienced significant volatility and recent declines due to recession fears.
• The 2022 rally was primarily a continuation of a trend starting mid-2020, driven by long-term underinvestment, exhausted inventories, and lack of spare production capacity.
• The Russian invasion of Ukraine in early 2022 amplified an existing supply crisis rather than serving as the sole driver of the initial rally.
• Commodity prices peaked in June 2022, at which point the complex had risen 55%.
• Prices corrected in the second half of 2022 due to Chinese lockdowns (reducing oil demand by 1.5 million barrels per day), European energy crises, stronger US dollar, and unexpected Federal Reserve rate hikes.
• Goldman Sachs explicitly notes that the current market setup resembles 2007, a historically bullish environment for commodities.

2023 Demand Drivers and Forecasts

• China Rebound: The reversal of China's "zero-COVID" policy and the repeal of "three red lines" on property development are expected to drive a surge in demand.
  • Gold Sachs economists forecast a rebound in Chinese oil demand between 1.5 and 1.82 million barrels per day.
  • This increase represents a potential 2% rise in global oil demand (based on ~100 million barrels per day baseline) and would push demand above 2021 pre-lockdown levels.
  • The property market recovery is specifically linked to stronger future copper demand.
• Europe Energy Dynamics:
  • Early 2023 saw lower energy prices due to an unusually warm winter and energy conservation measures (efficiency gains reduced heating demand by 16-20%).
  • While warm weather provided short-term relief, the 2023-24 winter is forecast to present a problem, with prices expected to escalate as the need for investment in production capacity becomes urgent.
  • A stronger China is expected to boost European exports of capital goods and luxury items, creating a synergistic positive effect.
• US and Global Macro:
  • The combination of a US Fed "taking the foot off the brake" (slowing rate hikes) and China stimulating its economy creates a distinct bullish backdrop.
  • Goldman Sachs economists place the probability of a global recession at approximately 30%, with a base case of no recession.
  • This environment is expected to weaken the US dollar, acting as a tailwind for commodity prices.

Supply Side Constraints and Investment Trends

• Russian Supply:
  • Russia successfully redirected crude oil to China and India by the December 5th ban deadline, but product redirection will be difficult by the February 5th deadline due to the need for specialized ships.
  • Base case forecast predicts Russian supply will drop by another 600,000 barrels per day by February.
  • The International Energy Agency (IEA) forecasts a potentially larger drop of 1.5 million barrels per day.
• OPEC+ Market Power:
  • OPEC's pricing power is at a historical high due to underinvestment in non-core OPEC countries (e.g., Angola, Nigeria, Venezuela) and limited US supply growth.
  • Unlike previous cycles, core OPEC (Gulf countries) faces little competition and can maintain market share if they choose not to bring spare capacity online immediately.
  • Goldman Sachs expects OPEC to begin bringing capacity back online in the second half of 2023 to accommodate rising demand.
• Underinvestment Drivers:
  • Real Capital Expenditure (CapEx) in the sector declined sharply in 2022 due to inflationary pressures offsetting nominal spending.
  • Depressed share prices relative to free cash flow make share buybacks more profitable for companies than drilling new wells or mining new ore.
  • Corporate hesitation is compounded by CEO beliefs regarding recession (90% of US CEOs believe a recession is occurring) and ESG/decarbonization concerns.
  • This underinvestment applies across the entire commodity complex, including metals and agriculture, not just oil and gas.

Decarbonization and the "Old Economy" Trade

• Investment Shift: Higher interest rates have favored "short duration" old economy assets (mining, oil) over "long duration" new economy assets (green tech, clean hydrogen).
• Policy Impact:
  • The US Inflation Reduction Act (IRA) is viewed as a game-changer, providing $400 billion in incentives and forcing Europe to match competitive investment strategies.
  • The EU's Repower EU plan allocated roughly €2 trillion toward renewables and grids, though it faces criticism for picking specific technologies rather than remaining technologically agnostic.
• Green Metals Demand:
  • The primary beneficiaries of decarbonization legislation are "green metals": copper, aluminum, nickel, silver, lithium, and cobalt.
  • Copper and aluminum are identified as the most critical; global copper deficit could reach 15% of the market.
  • The amount of copper required for global decarbonization exceeds the total copper already produced in history, necessitating massive upstream investment.

Asset Class Outlook and Strategy

• 2023 Price Forecasts:
  • Goldman Sachs forecasts commodities could be up 43% in 2023, making them the best-performing asset class if realized.
  • Oil is expected to deliver higher returns than copper but will involve significantly higher volatility ("painful ride").
  • Copper is expected to offer a better Sharpe ratio with a smoother, longer-term trajectory.
• Inflation Hedge:
  • Commodities remain the best hedge against headline inflation and hostile market environments (e.g., geopolitical conflict).
  • Core inflation is less correlated with commodities, driven more by wages, shelter, and housing.
• Portfolio Allocation:
  • Investors are advised to view commodities as a primary hedge against inflation and equity market volatility.
  • The "Revenge of the Old Economy" thesis suggests the underinvestment narrative has only just begun, with further upside potential as investment returns to normal levels.