Briefly…on the ‘3 Rs’ Driving Commodity Prices Higher

Goldman Sachs Research’s Jeff Currie and Damien Courvalin

February 7, 2018//-The shift from a lower-for-longer to a higher-for-now commodity price environment is set to continue in 2018 according to Goldman Sachs Research’s Jeff Currie and Damien Courvalin, who last week increased their price forecasts for oil, copper, iron ore, and met coal.

We sat down with the strategists to discuss what’s driving the resurgence and why a $75-$82.5 Brent oil price outlook doesn’t mean the New Oil Order is dead.

Jeff, we’ve already seen significant price appreciation across commodities–what has you convinced this can continue this year?

Jeff Currie: We’re in a self-reinforcing cycle of what I like to call the three ‘R’s–reflation, releveraging, and reconvergence–and we don’t see this cycle breaking near-term. Strong demand surprised everyone last year and, combined with supply restraint, drove commodity prices higher, creating reflation.

That created room for EM currencies to strengthen and for producers to clean up their balance sheets and releverage. The additional leverage is now fueling economic growth in EMs, reconverging with DM growth, and putting upward pressure on prices, which effectively starts the entire cycle over again. We’d need to see a significant supply increase to break this positive feedback loop, so until that happens, prices are likely to trend higher.

Where has low-cost shale been in all of this? Why aren’t we seeing the characteristic rapid supply response that’s helped keep prices anchored?

Damien Courvalin: We have seen rig additions ramp up recently, but there’s a lag before that production comes online as well as a lot of uncertainty surrounding the magnitude of this supply response. Last year was a rough one for oil equities, so we’ve seen a change in US exploration and production behavior to be more focused on deleveraging and increasing shareholder returns than on growing production. There are also logistical bottlenecks to contend with, like the shortage of pressure pumping and frac crews. Ultimately we do expect more new project sanctions in 2018, but we think any supply increases will be gradual and unlikely to draw down prices significantly near-term.

So the New Oil Order lives on?

DC: Yes–this is just a cyclical hiatus. Higher prices and caution today should help strengthen US E&P balance sheets, amplifying the supply response down the road, just when OPEC also ramps up production. We expect Brent prices to fall back to $60 a barrel by 2020.

What about higher-cost producers? Jeff, you’ve said a backwardated market is key to keeping their response to rising prices in check, but the last time reflation, releveraging and reconvergence were in play, spot prices ended up lower than forward prices.

JC: There’s one key difference this time around: emerging markets are more developed. When the three Rs were in full swing in the 2000s, EMs didn’t have their own financial systems and their savings rates were very high.

So the excess savings from higher oil prices created demand for developed market financial assets, namely long-dated oil, rather than physical spot oil, leading forward prices to rise. With much lower savings rates and more developed domestic financial systems today, EM demand for spot oil should be higher this time, reinforcing backwardation.

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