Implications when oil and other commodities are in recession

From its peak of 120 dollars per barrel in June, oil has decreased by roughly 30%. Some publications claim that copper, a metal that fluctuates with the health of the overall economy, even signals an impending worldwide recession. 

According to the Minutes of the Federal Reserve, interest rates are expected to be raised unless inflation declines considerably. Commodity prices, which had been beginning to appreciate against the dollar, ended the week down. 

Following the most recent macroeconomic data, the likelihood of a US recession has now increased even more significantly. With concerns being expressed that the housing market would fall even more in the third quarter of the year – due to the substantial decrease in home development – high mortgage rates and material price increases are likely to be a bearish sign for commodities worldwide.

Prices of commodities are very highly correlated. Direct economic connections are one factor for this reason. As diesel-powered harvesting equipment and natural gas-produced fertiliser raise the expenses for wheat farmers when oil prices rise, grain prices are pushed upward. There are now two reasons to believe that commodity prices will continue to decline. 

The degree of economic activity which plays a significant role in determining both the pricing of commodities as well as the demand for goods being in decline. A less visible important component is the real interest rate – the rate that has been adjusted for inflation. Moreover, an increase in interest rates encourage extraction today, increasing the supply of an exhaustible resource. Second, an increase in interest rates encourages institutional investors to switch from commodities to Treasury bills in the case of “financialised” commodities. Lastly, for a commodity that is traded internationally, a rise in the domestic real interest rate results in a real appreciation of the local currency, which lowers the price of the commodity in domestic currency. 

These elements may indicate that the current decrease in real prices of oil, minerals, and agricultural items will continue, along with the slowing of global growth. The prospect for global growth and real interest rates at this time point to a decline in commodities prices. Currently, global growth is sluggish. The Chinese economy has seen severe decline, due to lockdowns imposed by the zero-COVID policy, which affected Shanghai and several other major cities. Growth went negative in the second quarter here and globally, with Russia’s invasion of Ukraine, negative implications on the economy of Europe is expected.

Most investors were unprepared for the reversal in both bonds and equities, especially after 40 years of declining interest rates and growing stock prices. Investors started to price in a period of both slow growth and rising inflation, which led to a simultaneous sell-off in both stocks and fixed income. Natural resource stocks, which are particularly economically sensitive, have been identified by analysts, as the pick that would not follow the trend. 

With the exception of the global financial crisis of the late 2000s, history too demonstrates that the larger business cycle frequently doesn’t match with commodities bull and bear runs. After years of underinvestment, commodities like lithium, coal, and oil and gas are now testament to these unexpected profits.

This is a hallmark of the capital cycle for natural resources. First, the sector experiences a time when the price of energy or metals is extremely high, leading to a time when earnings are above average. The industry starts a new cycle of exploration, research, and development as a result of these substantial returns on investment. This increasing investment eventually results in additional supply that finally outpaces the rise in demand. As a result, there is a time of commodities surplus. Projects that were financed at higher prices are now becoming unattractive and end up being written off as commodities prices decline. 

Usually around this time, a different sector of the economy or investment strategy gains popularity, prompting investors to reallocate funds to lucrative new speculative ventures, leaving the resource sector even more cash-strapped. Supply then falls, demand grows, and with time the inventory gluts get worked off and the cycle starts all over again.