Thought of the Week

Damon Walker, AIF | February 22, 2022

A message from Edge Investment Solution's Damon Walker:

Thought of the week

As investors and consumers mull the implications of persistently high inflation, soaring energy prices are a concern. Energy prices are up a striking 27% y/y in the CPI basket and contributed 2.5% points alone to the 7.5% y/y January CPI reading. Strong demand and tight supply have sent prices higher in commodities markets.

Normally, commodity futures markets are in “contango”, meaning current spot prices are lower than futures prices due to the storage and depreciation costs of holding the asset over a period of time. Today, spot prices for the top 8 constituents in the Bloomberg Commodity Index (BCOM) are running an average 6% higher than their 1-year forward price. This condition is known as “backwardation” in futures markets, and commodities backwardation has been hovering around a 15-year high since early 2021. One silver lining, however, is that lower prices for futures contracts imply expectations for a decline in commodity prices by next year, as the pandemic hopefully fades and supply chains catch up.

“An energy price shock would be short-lived and we expect central banks would react appropriately to growth concerns by easing off the tightening path.”

Still, the recent escalation of the Russia/Ukraine conflict threatens to disrupt commodity markets further. If Russia invades Ukraine, the West would likely impose economic sanctions which could trigger a Russian response that cuts natural gas and oil exports. Russia is 2nd largest producer of natural gas globally (17% market share) and one of largest producers of oil (12% market share). Energy prices would spike further and the global economy could weaken as a result of depressed consumer demand. However, if this conflict fizzles out, as most geopolitical events do, we expect markets to come out of this unscathed and energy prices to come down over the next year, as implied by futures markets. Regardless, it’s important to recognize that today’s economy is much less reliant on oil than in the 1970s. An energy price shock would be short-lived and we expect central banks would react appropriately to growth concerns by easing off the tightening path.