In June 2017, the price of nearby NYMEX crude oil futures fell to a low at $42.05 per barrel. While technical support for the energy commodity was at the $42.20 level, the break to a lower low by just 15 cents turned out to be a significant bottom for the energy commodity. By early August, the price was back above the $50 level, and at the end of last year, it was flirting with $60 per barrel.
Technical resistance for the price of NYMEX crude oil stood at $62.58, the May 2015 high and it did not take long for the price of crude oil to climb above that price and leave it in the dust in 2018. The price of oil has been moving higher in a slow and steady climb, and by early May it breached the $70 per barrel level for the first time since November 2014.
As the monthly chart highlights, the next technical resistance level in the crude oil futures market stands at $107.73 per barrel, the June 2014 peak.
While the rise in the price of the energy commodity has inflationary ramifications because it increases the cost of powering the lives of all energy consumers, it also is a significant factor when it comes to the production of most other natural resources.
The cost of production is dramatically higher
In many ways, crude oil is the staple commodity for all raw materials. Commodities output requires huge capital investment whether it is extracting ores or energy from the crust of the earth or growing the crops that feed the world. Crude oil and oil products are a major and critical input cost in the production process for commodities price copper to steel, corn to sugar, and lumber to oil itself. Each of these commodities has a total production cost that determines supply levels. If the market price is higher than total output costs, the production tends to rise as producers make money. Conversely, when total production costs rise to a level where they exceed market prices, output declines as there is no economic incentive for producing the raw material. Since commodities production is always an energy-intensive process, the rise in the price of crude oil and petroleum products have increased costs for miners, farmers, and others in the business of producing these commodities. If the price of the raw material they are in business to produce has not moved commensurately higher with the price of oil, it has eaten away at their profit margins over past months.
As the weekly chart shows, the price of crude oil moved from $42.05 per barrel on June 21, 2017, to highs of $71.92 on May 15. In a just over ten months, the price of oil rose by over 71%. Oil is a major energy price component of production for other commodities. Either those prices needed to rise at the same pace or producer margins will decline rapidly and to a point where production could slow until prices rebound.
Base metals production is down
As the weekly chart illustrates, when oil hit its June 2017 low, copper was just under $2.54 per pound. On May 15 the red metal traded to a high of $3.1030, which was 22.2% higher compared to the over 70% increase in the price of oil. Over the same period, aluminum moved from $1873 to highs of $2586, 38% higher, while zinc rallied from $2588 to highs of $3585, an increase of 38.5%.
All base metals and the prices of many other industrial commodities have rallied along with crude oil since June 21, 2017, but oil has outperformed them all. Meanwhile, at the Chinese Party Congress in Beijing late last year, President Xi rolled out many reforms including a plan to cut pollution by limiting refining and smelting of metals and ores near many cities across the Asian nation. China remains the world’s leading consumer of these industrial commodities that are the building blocks of the construction industry. Less domestic production could lead to shortages if China’s appetite for commodities continues to grow with its population, wealth, and economy over coming months and years. The rise in the price of oil combined with less Chinese output of metals and ores could mean prices will play catch up over coming weeks and months in the industrial sector of the commodities market.
Agricultural production is energy intensive
When it comes to the agricultural commodities that feed the world, the weather in critical growing regions around the world is always the primary determinate of the path of least resistance of prices. However, farming equipment runs on petroleum-based fuels, and the cost of crop production is a lot higher during the current planting and upcoming growing and harvest seasons this year than last. Additionally, processing soybeans into soybean meal and oil, corn into ethanol, and wheat into flour to produce bread all requires energy which is another factor that could lead to higher prices for consumers in the coming weeks and months. The demand side of the fundamental equation for agricultural commodities continues to expand with population and wealth increases around the globe. The latest WASDE report issued by the USDA told markets that demand continues to grow at a record pace as more people, with more money are competing for finite food supplies each year. Higher energy prices will only exacerbate price increases if weather conditions do not support the sixth consecutive year of bumper crops in 2018.
Raw materials need to get to from points of production to consumption
Finally, commodities need to travel from areas in the world where they are present in the crust of the earth or where they grow in fertile soil. They also need to move from refineries and smelters to manufacturing facilities to make the products that consumers require. Finally, finished goods for the individual consumer market need to travel to specific and diverse points of consumption. All of the movement by ocean vessels, barges, trains, trucks and other modes of transit are powered by, in many cases, petroleum-based fuels like bunker fuels, diesel, jet, and other energy products. The bottom line is that the energy requirements transcend just the production process, they are present at every step until a product reaches a consumer’s home.
A harbinger of inflationary pressures
The rise in the price of crude oil is a significant event for the global economy and all commodities prices. If oil remains at its current price level or moves higher over coming weeks and months, it is likely that other raw material prices will follow. In what could become a vicious cycle, the prices that consumers pay for all goods that contain commodities are likely to move to the upside sparking what could be dramatic increases in the consumer and producer price indices which are barometers of inflationary pressures.
Additionally, the Federal Reserve told us at their May meeting, that the 2% target rate for inflation is not a line in the sand, the central bank said it is a “symmetric” target meaning the central bank is prepared to allow inflationary pressure to overshoot its target at a time when it could be bubbling up from below the surface like a volcano.
I am keeping a close eye on the action in the gold market as I believe the yellow metal is likely to be one of the first markets to move appreciably higher if crude oil ignites inflationary pressures across a myriad of commodities markets. At the same time, I remain bullish on GSG, the iShares S&P GSCI Commodity-Indexed Trust.
GSG has traded in a range from $12.03 to $76.58 since 2006, and at $17.99 per share on May 16 it is close to the lowest level in a dozen years.
The rise in the price of crude oil is bullish for all commodities prices as the energy commodity is not only a critical cost of goods sold part of the production process, but it also powers bringing products to market for consumers around the globe.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.