Jun 11, 2021

Oils well that ends well

As our economy sees commodities reach new heights, one question looms—how long will these increases last? Given that conditions driving commodity prices are likely temporary, it’s logical to conclude that we aren’t in another commodity super cycle that will last years. But that doesn’t mean the current boom doesn’t matter.

• Are we in the next commodity super cycle?

• Implications for the Canadian economy, dollar, and stock market

• Alberta to lead the way for growth

 

Just over a year ago, we wrote an article entitled “Oil Dressed Up with No Where to Go” that highlighted the dire situation of the global oil market. To recap, demand for petroleum products collapsed once COVID-19 lockdowns went into effect globally, causing a glut for these products. The situation was so severe that market participants worried about storage capacity becoming completely overwhelmed, which caused the price of oil to enter negative territory in the futures market. This was the first time in history that this happened.

 

Although the move downward in oil prices was extreme, it was not unique. Most commodities fell as we stared into a major economic slowdown. Fast forward to today and the situation has completely switched, with most major commodities moving dramatically higher. The prices of oil, copper and corn are close to double what they were a year ago (as of May 31st). As dramatic as this is, nothing beats lumber, which recently moved above $1,400 US/thousand board feet. That’s 250% above its price one year ago. In fact, prior to the recent surge in prices, the record for lumber was $600 US/thousand board feet! A truly stunning move.

 

Such massive increases in raw material costs will undoubtedly be passed on to consumers: first, through purchasing the products themselves (such as wood products from your hardware store) and later, through those items that are created from these raw materials. The question is, how severe will the commodity boom be? To answer this question, let’s first put the move in context.

 

The Bank of Canada Commodity Price Index below starts on Jan 1, 2001. Oil, metals and minerals, agricultural products and forestry are the main drivers of this index. Early in the century, we saw a commodity super cycle where prices consistently rose from 2001 to 2008 before crashing down during the Global Financial Crisis (GFC). Back then, demand was driven by China which was growing at a very rapid pace and requiring evermore materials. After the GFC, commodity prices stabilized at a lower level for several years before adjusting further downward in 2016.

 

Figure 1: Commodity prices consistently rose from 2001 to 2008 before crashing down during the Global Financial Crisis.

Commodity prices consistently rose from 2001 to 2008 before crashing down during the Global Financial Crisis
Source: Bank of Canada

 

Commodity prices today are being driven by economic re-openings, a very flush consumer and low interest rates. All three are somewhat temporary. The re-opening is a one-time event that will largely be behind us sometime in 2022. Consumer balance sheets are in fantastic shape, due in part to government programs through COVID-19. These programs are ending and pent-up demand is real. Balance sheets will normalize. Lastly, we don’t think rates will rise dramatically anytime soon, but it’s also hard to imagine them staying this low.

 

Given that conditions driving commodity prices are likely temporary, it’s logical to conclude that we aren’t in another commodity super cycle that will last years. But that doesn’t mean the current boom doesn’t matter. In fact, it has strong implications for the Canadian economy, our dollar and the stock market.

 

First, consider our economy. Canada has a dynamic modern economy, but there is no doubt that natural resources are more essential for our country than they are for most economies. Commodities are a big reason why our GDP is forecasted to rise by 6.2% in 2021 and 4.1% in 2022. Given its energy exposure, it’s no surprise that Alberta will lead the way in growth, with 7.2% expected this year. It’s also positive for our dollar, which has often been linked to the price of oil. We can see the two have moved together historically and are doing so again (Figure 2).

 

Figure 2: Price of Oil (WTI) vs Canadian Dollar (CAD)

 

Price of Oil (WTI) vs Canadian Dollar (CAD)

Source: Bloomberg

 

Next, consider our stock market. It also benefits from commodity exposure. Energy and Materials make up over one quarter of our primary benchmark (S&P/TSX), versus around 5% for the U.S. benchmark (S&P 500). When you combine the commodity weight in Canada with a strong dollar, it becomes easy to see why Canadian equities have led the way this year (especially in Canadian dollar terms).

 

We think there is a good chance Canadian equities will continue to perform well over the near term. Sometimes Canadian investors get frustrated by our market, as it tends to underperform when technology stocks are rising; our currency is often weaker during these times as well. Today’s market environment is a good reminder to stay diversified across equity markets and of the important position Canadian equities have in Canadian investor portfolios. After all, no market or currency outperforms forever.

 

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