The conflict between Israel and Hamas has led to increased volatility for several commodities, including oil and gold. Jennifer Nowski, Vice President, Director, and Portfolio Manager for TD Asset Management, speaks with Greg Bonnell about the broader implications for commodity-related stocks.
Greg Bonnell: Several key commodities have seen some volatile price action lately amid the conflict in the Middle East. And while markets have been shaken in the near term, what’s the longer-term outlook for oil and gold? Joining us now to discuss, Jennifer Nowski, Vice President Director of Portfolio Management and a portfolio manager– I should say– at TD Asset Management. Great to have you with us.
Jennifer Nowski: It’s good to be here. Thank you.
Greg Bonnell: So, obviously, these are interesting times. We have heightened geopolitical risk. And it has taken its toll on several commodities. Let’s talk about oil and the energy sector. Obviously, these moves short term don’t really tell us about what we might get longer term. How do you see it?
Jennifer Nowski: Yeah, so the oil price did increase as the market started to incorporate a higher geopolitical risk due to the conflict in the Middle East. The key, though, for the oil market balance over the next year really comes down to whether OPEC+ and, in particular, Saudi Arabia maintains its discipline in matching production with what they’re seeing in demand.
Now, starting off on the demand side, this year has actually been a fairly strong year for oil demand growth. And that’s because China’s lockdown ended. And its oil demand rebounded fairly strongly. In 2024, you might see more modest demand growth. And that’s where we’ll probably see a resumption of the oil price being more correlated with global GDP growth.
Now, turning to the supply side, this year’s supply growth in oil was really driven by the US production. But this was offset by OPEC+ restraining its production and, in particular, Saudi Arabia doing a series of voluntary production cuts.
Now, the challenge for the oil market is that there is some spare capacity now at OPEC+, much of it with Saudi Arabia. So to keep the oil market balanced, they’re going to have to continue to be disciplined on how they manage that production capacity.
Now, in terms of geopolitical risk, the concern the oil market has is if the conflict were to impact either key oil infrastructure or transportation routes in the region, the other issue is that Iran has been exporting more oil. In response to the conflict, the market is looking to see if there are any changes in Iranian sanctions or reinforcement of them.
However, I’ll talk briefly, though, on the energy companies. Now, the energy companies are in very strong financial condition. The high oil prices we’ve had for the past couple of years have allowed them to really significantly reduce their leverage. So debt is quite low right now. And free cash flow is still very strong.
Now, there has been some more M&A activity in the sector. But I’d say for the group as a whole, the producers still maintain a disciplined focus on low production growth, keeping that strong balance sheet, and returning cash to shareholders.
Now, the oil stocks will continue to take their cues from the oil price. However, with about, call it, $80 WTI, that would generate a free cash flow yield on some of the larger-cap names in the high single digits to low double digits. So that’s still very healthy. And I would expect much of that would be returned to shareholders in the form of dividends and buybacks.
Greg Bonnell: You briefly mentioned China there. How concerned should we be about the state of their economy? There’s a lot of moving pieces there.
Jennifer Nowski: So China is about 16% of global oil demand and about 50% of demand for some metals. So it’s very important to the commodity markets. Now, broadly in terms of how the Chinese economy has been doing, I’d say at the beginning of the year, there were very high expectations for a big rebound as the COVID lockdowns were ended. However, the recovery has been more tepid than that. And the particular challenge with China is its property sector, which is working through some debt issues.
Now, the Chinese government does want to generate economic growth. However, they don’t want to create overbuilding or excesses. So in the past, where they’ve pursued massive stimulus programs, this time it’s been much more targeted stimulus measures and rate cuts.
And we’re starting to see some stabilization, though, in the Chinese economy. The recent data released in September showed some retail sales growth. Electricity consumption is up. Deflation is less of an issue, just to name a few.
Focusing more on the commodity demand side, I spoke already about how oil demand did rebound. Next year, it might be more tied to economic growth. On the metals side, though, that’s perhaps outperformed expectations. So while property has been a headwind for metals demand, this has been more than offset by China’s investments in renewables and electric vehicles.
Greg Bonnell: All right. So we use the word “metals” there. Let’s talk about the precious metal that everyone I guess is concerned about, gold. Amid this heightened geopolitical risk in the past couple weeks, we have seen a haven play into there. What do we make of gold right now and perhaps where it might be headed?
Jennifer Nowski: Yes, taking a step back, if you look at the gold price over the past couple of years, it’s been rather range-bound between about $1,800 and $2,000 an ounce. And that’s because the main drivers of gold being the real yield US dollar and demand factors, they’ve painted a more mixed picture at time.
Now, there has been a rally in the gold price lately, as you said. And that’s been driven on this flight-to-safety bid. However, if we look underneath the pictures, it’s still a bit more mixed, starting with demand. Demand has been more tepid. If you look at the physical gold ETF, that has been seeing outflows year to date. And I’d say we haven’t seen a clear inflection or definitive stabilization in those flows yet. That’s something we’ll continue to watch.
The other factor is central bank buying. Now, central banks have been net buyers of gold for the past decade-plus. Last year was a particularly strong year for central bank net buying. This year… it’s hard to predict how much they’ll buy in any one year, but it likely might not repeat last year’s highs.
Now, turning to the real yields, there’s been a really big move in real yields. The US 10-year real yield has gone from, call it, 1.5% at the beginning of the year to about 2.5% today. So really big move. And that’s a headwind for gold because gold pays no income. So that’s your opportunity cost.
What the market is watching is rates and what the Fed does. Now, the Fed is very committed to bringing inflation down. And the risk there is that rates remain higher for longer. So this headwind for gold could continue. And the market will be watching closely for any change in tone from the Fed or direction in rates.