Crude correlations

With Brent crude oil prices down 75% since the start of 2020 its worth looking at what commodities are likely to be most affected by the slump and whats happened so far.

Given that energy accounts for a significant proportion of the production cost of many commodities, a drop in the oil price reduces the output cost. This typically increases the downside risks for other commodity prices.

However, the covid-19 outbreak may mean that relationships between commodity prices and the price of oil during ‘normal’ times starts to break down. Production shutdowns due to health concerns, fears over food shortages and logistical challenges in accessing end markets are likely to be more important in guiding decisions than the cost of energy.

In terms of agricultural commodities, corn is most directly affected by lower oil prices as lower energy costs reduce the cost of production, increase margins and encouraging more planting. In normal circumstances lower corn prices could result in higher demand for bio-ethanol. For now at least that demand side mechanism is broken under lock-down conditions.

You may think that all that home baking and snacking would have propelled sugar prices higher. It’s worth noting that demand for sugar also comes from the Brazilian ethanol industry (vehicles can run either gasoline or ethanol). The fall in vehicle traffic in Brazil due to the covid-19 lockdown has decimated demand for ethanol, in turn negatively affecting sugar demand.

Cotton has the largest per-acre energy costs of all agricultural commodities so it is likely to see the steepest falls. According to a 2015 report from Societe Generale the historical correlation between cotton and crude is the highest across all commodities at 0.45:1.

The impact on metals is more complex. Aluminum production has the highest energy-related costs at around 40%, copper the lowest at 18% with gold coming in second last with 22% of production costs related to energy prices. While electricity accounts for 40% of the production costs of aluminum, the most energy intensive of the base metals, thermal coal is the predominant power-source rather than crude.

Gold also has a complex relationship with crude. Lower oil prices, if reflected in a decline in fuel prices could increase consumer spending on gold jewelry, particularly in countries like India who normally benefit from lower crude prices. However investment demand for gold could decline if lower oil prices lead to lower inflation.

Macquarie note that in in recent years platinum, silver and aluminum have had the highest correlation with oil prices but over the longer term platinum, copper and tin had the highest correlation with oil prices with palladium the weakest correlation.

Finally, the effect on natural gas prices is more nuanced, at least in the short term. With gas contracts linked to oil (particularly in Europe and Asia), a decline in the oil price will feed directly into gas prices. In the U.S. the decline in oil prices has led to a decline in gas production from associated fracking wells.

Of these commodities here’s what happened since the start of 2020:

The losers: Corn (down 20% ), cotton (down 22%), sugar (down 26%), aluminium (down 16.5%), copper (down 20%) and US natural gas (down 18%).

The gainers: Platinum (up 15%), palladium (up 14%), silver (up 14%) and gold (up 13%).

Correlations only last for so long, until they break down. With so many other factors affecting individual commodity markets, the price of oil is likely to be less important in driving other commodity markets than in the past.

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