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Why hedge your commodity risk?

Many commodities have reached new all time highs in nominal price terms. If we however adjust for inflation we see that Bloomberg’s Energy, Metals, Agri and Precious metals indices are currently still 40%, 8%, 16% and 25% below their historical highs in real terms.

The price rally has been underpinned by a significant drop in commodity capex spending throughout the last decade where years of limited investments have resulted in a significant deficit or tightness in many key commodities today.

Spending anomaly is now on track to be normalized

This deficit didn’t really become evident before the global economy moved from a balanced spending and consumption of services and goods to instead a solid overweight of spending on physical goods during the pandemic. Fiscal and monetary stimulus flooded into the global economy. An unusual large share was spent on consumer goods and the “physical” part of the economy (requires commodities) since the services part of the economy was largely locked down. This spending anomaly is now on track to be normalized as the global economy increasingly opens up again while stimulus dissipates. But markets have become painfully aware that there has been a significant underinvestment in many commodities over the past decade resulting in a constrained commodity supply situation even when demand anomalies from the pandemic normalizes again.

But the pandemic also created serious damage to supply as panic, fear and low commodity prices in 2020 led to sharp reductions in commodity capex spending which led to lower commodity production capacity.

Russia’s invasion of Ukraine has created a huge, additional damage to the supply side of the many commodities which Russia exports. Russia is the world’s biggest exporter of energy as well as grains (agri) but it also exports large amounts of steel, aluminum, nickel, palladium, fertilizer and more. The large scale sanctions towards Russia from most of the OECD countries is going to damage Russian commodity production capacity as well as its ability to export these commodities for several years to come.

Elevated commodity prices are to be expected

The result of all this is that most commodities have been pushed into the exponential part of their supply curves. This is where commodity prices either explodes or falls sharply along with expanding or contracting demand. We are likely stay in this part of the supply curve until new and sufficient supply has been brought online and that usually takes several years or even up to a decade or more depending on the type of commodity.

Needless to say it will require a lot of additional capital to create the additional needed supply. Many of these commodities and their normal extraction methods are however close to black-listed by the new ESG standards. High commodity prices has historically lead to a flood of capex spending into new supply. Now, however, it will be much more muted due to the new ESG standards even if prices move to very high levels. New supply is thus likely going to take longer than normal to arrive. Until that happens we are likely going to have both elevated and very volatile commodity prices as fluctuations in the global economy pushes prices up and down the exponential part of their supply curves.

Producers and consumers of commodities who haven’t hedged before will likely find that it will be imperative to do so in the coming years.

Contact us

For more information, please contact us through this e-mail adress:

commodities@seb.se