Our recent report on The Tale of Two Economies concluded with the need to watch for clues from oil and copper markets as early harbingers of economic change. Capital expenditures for structures and equipment have contracted for 3 straight quarters for the first time since the Great recession of 2007-2009. Exports have not grown in 2 years. Without this normal material support, the US economy’s condign punishment has been increasing reliance upon the consumer to provide “all” the fuel for our modest economic growth lately. Without the negative private capital investment component of the last 3 quarters, we would have seen US GDP average 2% growth each quarter instead of the less than 1% rate we actually witnessed.
As long as oil and copper prices remain weak, the industrial sector will curtail exports and commercial investment, keeping our GDP below healthy growth rates of over 3%. A sideways to higher commodities sector led by oil and copper allow for GDP growth rates back above 2%. Our forecast for oil and copper will provide clues for the direction of our economy.
Where Is Oil Going?
On May 27th, with oil closing above $50 for the first time in 2016, we stated: “we advise investors to take profits reducing their exposure to oil in the $50s and $60s and expect corrective price action”. As seen here, oil prices were reaching a top at $50 to $51/barrel in June as forecast and have now fallen 20% to test $39. With global GDP slower than consensus and the Energy Administration recently cutting US consumption forecasts by a whopping 27%, it’s understandable that our expected seasonal declines this summer have brought summer driving gasoline prices down from $2.39 to just $2.12/gallon ($1.83 in St Louis).
Seasonally, we expected springtime record oil surplus inventory levels to decline into late summer 2016. Thus far, the inventory reduction is right on our projection given months ago.
Looking ahead we expect seasonal influences along with new Gulf of Mexico production coming online to send US production higher in the 4th quarter 2016 and early 2017. Russia and OPEC countries will continue pumping oil near record levels because dictators care more about revenues than profitability. When prices do attempt a move to in a year or two we can expect US frackers to quickly bring production online at a faster pace cementing a longer term ceiling on energy prices.
We would not expect oil prices back over its /barrel 2016 top until 2017 when steady demand growth and further supply reductions by the US, Mexico, and China could support higher prices. Global supply and demand consensus predicts that the inventory glut will “start” to decline on a protracted basis in the 2nd half of 2017. That forecast will depend upon actual prices averaging less than and stable to faster global GDP growth rates.
Sentiment, as represented by historical oil contracts held by institutional traders, imply that prices were relatively overbought in May/June, just as they were in the same period of 2015. Assuming oil speculators adjust their positions close to oversold levels, we would expect the correlation to pressure prices lower into late 2016 – early 2017 with support in the s. Any recession, of course, would send oil prices even lower and delay the hoped-for inventory constriction. While not in our forecast, any time oil moves under it’s a major yellow flag for the economy and stock prices in general, while prices above would be an economic green light.
Where Is Copper Going?
Like oil and most commodities, the world has too much copper with growing surpluses likely through 2017. The largest copper producers in Canada and Chile had break-even costs of just .34 & .53 per pound respectively. Chilean production and Chinese demand are the most important parts of the copper equation. Huge Chilean investments over a decade ago have allowed Chile to usurp market share and become the key global copper supplier. With cheap production costs and dependence upon copper exports, Chile has maintained high levels of supply despite a 50% loss in selling price. Export volumes are no longer growing and export values have fallen sharply the past 3 years commensurate with the price.
Weather prevented normal short-term exports to China in late June which may have supported the recent leg higher to .27. Record long positions by commercial hedgers in June also supported the recent rally in prices. However, commercial and large speculative traders have quickly, if not alarmingly, liquidated their holdings and increased the odds for sideways to lower copper prices. Anytime copper moves below /pound it’s a yellow flag for the economy and a move above .50 would be a green light.
If China follows through on its intentions of managing commodity surpluses lower, we should expect gradual Chinese production declines over the next couple of years. At the same time, they will strive to allow higher stockpiles of copper to ease the pain of domestic supply chain disruptions.
It will be difficult for copper and oil to recover much above their 2015-2016 highs over the next year, which implies US GDP will also likely remain subdued near 2% annual rates. With short-term economic pressures post-Brexit and pre-US election uncertainty suppressing capital investments, we suspect rate hikes will remain off the table and both fiscal and monetary stimulus will increase here and abroad into 2017.
