Assessing Inflation Through Five Commodity Price Themes

#1: The Sound of (A)Synchronicity

Starting with the pandemic slump in early 2020, the movement in commodity prices was generally synchronous in the four years that followed. For example, they initially firmed during the post-pandemic correction and Russia's invasion of Ukraine in early 2022 before moderating as global supply-chains normalized (Figure 1).

However, that synchronicity began dissipating through the first half of this year. While energy prices settled into a range before weakening from late July, metals moved considerably higher, and agricultural commodity prices eased.

Figure 1

The asynchronicity of commodity prices in 2024

^{Source: Bloomberg and PGIM Fixed Income as of September 2024.}

Although each market has its own story, we believe this divergence signals a shift toward an environment in which prices are influenced more by their respective market dynamics instead of uniformly reacting to global events. For example, while the geopolitical environment has impacted all commodities this year, its effect has been varied across the complex. While regional tensions are a factor driving energy's current range—a point we discuss further below—they are also a prevailing influence pushing metals' prices higher due to their impact on trade relationships and flows (also discussed below). Overall, the shift in price synchronicity could act as a headwind to inflation volatility over the short term, as price movements within the complex offset each other, at least to some degree.

#2: Dispersion of Price Factors

Taking the asynchronous movement in prices a step further, we've found that the factors contributing to price movements have also become more disperse. For example, Figure 2 shows that the weight of a single component behind commodity price movement has continued to decline, following the trend that surfaced after the Global Financial Crisis and became more pronounced since Russia's invasion of Ukraine.

Figure 2

The influence of a single factor on commodity prices continues to fall

^{Source: Macrobond as of September 18, 2024.} 

^{Note: First principal component of daily price changes over the last month of the following commodities: oil, natural gas, gasoline, aluminum, copper, nickel, zinc, gold, silver, platinum, corn, wheat, soybeans, and coffee.}

Here again, instead of being driven by a dominant global disruption, commodity prices are more reflective of their respective market fundamentals. Indeed, the sharp push higher in base and precious metals is largely driven by shifting demand patterns, while the tighter range in energy prices reflects sufficient capacity relative to demand. The improved balance across a larger set of factors should be another aspect that mitigates the possibility of a sudden and potentially prolonged increase in commodity prices that ultimately feeds into inflation volatility.

#3: The Price Floor for Metals is Rising

Although metals prices are no stranger to dramatic swings commensurate with shifting supply and demand dynamics, we believe that structural changes currently underway will raise their floor and ceiling for future cycles. We've identified three main factors that impact metals markets broadly. First, elevated geopolitical tensions are causing significant changes in trading partners and the directionality of flows. Price shocks aside, we've noted an uptick in friendshoring and nearshoring, as metals consumers focus less on lowest price and more on supply source diversification and stability. Second, domestic and regional political dynamics have become more extreme, with political parties on the far left and the far right exerting more influence. This has led to greater difficulties for mine approvals, tighter regulations, and more tariffs, putting upward pressure on production costs and, ultimately, prices.

Setting political uncertainty aside, the third factor is rooted in ESG-related variables, which can drive prices higher from a supply and demand perspective. In supply terms, environmental and social influences are applying upward pressure on prices via longer permitting processes and greater oversight of procedures, adding to extraction and production costs. However, on the demand side, certain metals are poised for robust growth as part of decarbonization efforts. For example, copper prices are set to continue their gains as the metal is a key component in electric cars, among various other technologies. Inversely, palladium is one of the main losers in the race to increased electric vehicle creations as its use in internal combustion engines is expected to fall sharply over the coming years.

Figure 3

ESG can drive price growth via upward supply and demand pressure

^{Source: PGIM Fixed Income. For illustrative purposes only.}

Taken together, we believe that the incentive price to produce most metals has increased, and that increase will be passed on to buyers going forward. In future cycles, we also believe that the ceiling prices of metals may reach new heights.

#4: The Range for Retail Fuel Prices

After a tumultuous four years, gasoline prices appear to have settled into an elevated range that is nonetheless below the historical highs reached in 2022. At 3.5% of the consumer price index (CPI), gasoline's influence on inflation might not seem overly significant. Yet, beyond comprising half of energy's 7% CPI component, it also plays a key role in consumer sentiment. While other core components of CPI are less volatile on a short-term basis—such as housing and food costs—even small moves in gas prices can be "felt" daily. When gas spiked in 2022, consumer sentiment plunged as prices paid at the pump seemingly reinforced the full magnitude of consumer inflation.

Figure 4

Following the decades-high peak in 2022 retail fuel costs have settled into an elevated range

^{Source: U.S. Energy Information Administration, as of July 8, 2024.}

Although we're highlighting a well-known inflation indicator, the background of how retail fuel arrived at its current range provides key context going forward. With the cost of crude oil accounting for about half of the price of retail gasoline, the disruptions from the Russian-Ukraine conflict were obvious drivers of the price rally. But an equally prevalent, yet lesser-known, factor was the plunge in U.S. refining capacity by more than a million barrels-per-day due to the idling of several U.S. refineries during the height of COVID in 2020. While refining capacity has recently increased with the addition of a massive new refinery in Nigeria, it has not fully recovered to its pre-COVID levels.

While improved refining capacity is a key component to gasoline's current price range, two other influential variables remain at play. First, with more than four million barrels-per-day in spare oil production capacity at OPEC+ and increasing production from the U.S., Guyana, Brazil, & Canada, oil markets are very well supplied. However, the second variable is that potential geopolitical risks, including the current conflict in the Middle East escalating into strikes on oil infrastructure or further crackdowns on oil sales from the region, nonetheless provide upward pressure on crude oil prices.

Meanwhile, as U.S. crude oil demand has been steady and solid, Chinese demand growth appears to have decelerated considerably. Furthermore, we view OPEC+'s decision to delay scheduled production increases as an acknowledgment of tepid global demand. Indeed, we believe the near-term outlook for crude oil prices, and therefore gasoline, is lower.

#5: AI-driven Electricity Demand

After years of stagnation, demand for electricity in the U.S. is poised for a sustained and meaningful increase as the world adjusts to the artificial intelligence "revolution." Although the demand increase is expected to occur gradually at about 2% to 3% each year for the foreseeable future, this change in electricity demand patterns carries direct implications for inflation (Figure 4).

Figure 5

The AI revolution is expected to reignite electricity demand

^{Source: U.S. Energy Information Administration annual energy outlook 2023, as of April 2023.}

After retail fuel's 3.5% of CPI, consumer utilities—i.e. electricity and natural gas expenditures—account for another 3%. Although some of that electricity demand could be satisfied by renewable sources, natural gas will likely remain the primary source. Current demand levels for natural gas are around five billion cubic feet (BCF) per day, but by some estimates demand could reach 20 BCF per day to satisfy AI needs. In addition to the direct demand pull on the natural gas commodity itself, infrastructure—e.g. generation capacity, pipelines, and transmission lines—will also have to be constructed at an accelerated rate, a cost for which a significant portion is likely to make its way into utility rate bases and paid for by consumers. While gasoline is the inflation of today, your utility bill—depending on where you live—is going to be the inflation of the future.

Looking Ahead

With commodity market fundamentals back in the driver's seat and the reduced dominance of a single factor driving prices, we do not believe commodities are signaling an imminent uptick in inflation volatility. Further, with correlations among commodity prices now low, understanding the dynamics of each respective market will be crucial as we seek to assess alpha opportunities in the corporate credit sectors tied directly to each commodity. That said, with ongoing, elevated geopolitical uncertainty, increasing ESG-related risks and opportunities, and structural changes to utilities demand underway, the above themes offer a balanced and real-time perspective on the directionality of inflation over the short and long terms. In doing so, they enable us to draw an updated relationship between changes in commodity prices and inflation—indeed, a relationship that extends beyond the common perception of a positive correlation—which we'll explore in a follow up post.