We’ve written before about why we think commodities are a critical component of a genuinely diversified strategic asset allocation. They have tended to perform well during inflationary booms, when bonds have struggled, and they have often performed outstandingly well during inflationary busts, which tend to punish both bonds and equities.
But have investors missed the opportunity to build those strategic allocations?
They say that the best cure for high prices is high prices. With bigger profits on offer, more providers enter the market, bringing supply and demand back into equilibrium. Oil prices have risen to over $120/bbl this year. The Bloomberg Commodity Index is up around 30%. Raw materials are back on the covers of investing magazines—often a sign of a top in the market. If you invest now, do you risk creating an exposure at unsustainable prices?
We don’t think so. And the reason is that we believe the supply and demand issues besetting many commodity sectors are structural and not easily resolved.
On the supply side, while some logistical and geopolitical blockages could conceivably be loosened, the deeper issue is that, despite higher prices this year, underinvestment remains the prevailing regime.
Figure 1. Capex Capitulation
Capital expenditure in the energy and metals sectors ($bn)
Source: WorldScope, MSCI, GMO. Data as of March 31, 2022. Energy/metals capex represents the aggregate capex of 30 of the largest publicly traded fossil fuel and mining companies globally.
Returns have been so poor over the past decade that it is taking a lot to persuade investors to come back in off the sidelines. Looking forward, uncertainty around environmental regulation, such as cap-and-trade systems, makes it increasingly difficult to come up with a valid discount rate for valuing the commodities sector. The resulting increased weight now given to environmental and social risks in sector and security analysis has raised a tall hurdle against investing in raw materials production—even when an investor is still willing or able to allocate to these sectors at all. Those that are invested now tend to prioritize cash flow and dividend safety rather than growth-oriented capital expenditure.
But it’s not only investors’ changing attitudes holding back capital allocation. It’s also the tighter risk constraints that banks have faced since the Great Financial Crisis (GFC). In this respect, high prices are not necessarily the cure that economic theory suggests. Higher commodity prices tend to mean more volatile commodity prices, and more volatility means higher Value-at-Risk (VaR) metrics. Higher VaR makes it more difficult to extend capital, and less capital from banks means less funding for productive capacity, which, all other things being equal, means higher commodity prices.
If there’s no relief from supply on the horizon, demand will need to adjust. But we see structural dynamics here, too, which we summarize in the three themes of Redistribution, Decarbonization and Deglobalization.
While the direct cash payments associated with the COVID-19 crisis are over, a broader set of policies aimed at redistributing wealth and reducing inequality are likely to continue to stimulate demand from those on lower incomes. Gasoline tax subsidies and caps on energy bills will help to keep millions out of hardship—but they will also sustain demand above capacity. Higher wages and redistributive fiscal policies put more money into the pockets of a larger group of people who spend a greater share of their income on food, energy and other raw materials.
Decarbonization is also a redistributive policy, inasmuch as it stimulates the creation of new “green” industries and jobs, including heavy industrial jobs in manufacturing and infrastructure that are not easy to offshore. Moreover, while decarbonization implies less demand for fossil-fuel commodities, the resulting electrification of the global economy will be very metals-intensive (figure 2).
The International Copper Association says that a typical internal combustion engine vehicle contains around 23kg of copper, whereas an electric car uses 83kg and an electric bus might use up to 370kg—16 times as much. Facing this rising demand are just five major copper mines, worldwide. Copper prices are still not high enough to incentivize investors to capitalize new mines, and even if they were, it takes an average of seven years to bring a copper mine to production.
Figure 2. Going to the Wire
Projected global copper supply versus five demand scenarios
Source: Wood Mackenzie. Data as of March 31, 2022.
Decarbonization is, in turn, part of a broader deglobalization trend. Renewable energy is generated more locally than fossil-fuel energy; oil, gas and coal trading is likely to decline. That decline in trade will feed a decline in petrodollars, and therefore a decline in the recycling of petrodollars—whereby fossil-fuel exporters invest their dollar revenues in the economies that are buying their oil and gas. That flow of capital is already being depressed as sovereigns see Russia’s foreign assets being frozen and otherwise sanctioned following its invasion of Ukraine.
Furthermore, an era of energy scarcity is likely to be characterized by more energy hoarding. Countries are also likely to hoard the newly critical and strategic metals that are required for renewable infrastructure. As an era of energy scarcity is likely also to be an era of food scarcity, grain hoarding may be a feature of deglobalization, too. All of this comes on top of other incentives to shorten and localize supply chains, from rising geopolitical risk to our new appreciation for the disruptive potential of pandemics.
Echoes of the 1970s
Many commentators hear echoes of the 1970s in all of this, and we would agree to some extent.
Today, governments in the developed world appear to be moving toward stimulative policies aimed at reducing inequality, after 40 mostly market-friendly years. In the U.S., the late 1960s and 70s were similarly characterized by the “Great Society” and “War on Poverty” policy mix established by Lyndon Johnson’s administrations, and its associated fiscal expansion.
The supply-side story of the 1970s looks familiar, too. Renewable energy, internet, social media and cloud computing stocks have led the equity market recovery from the GFC, leaving old-economy and long-cycle sectors in the dust. In the 1970s, the “Nifty Fifty” bull market was also led by the high-tech companies of the time—names like IBM, Eastman Kodak, Xerox, IT&T, Digital Equipment Corporation, Texas Instruments and Polaroid. This lack of old-economy investment was then compounded by an exogenous geopolitical shock: the 1973 Arab-Israeli War and subsequent oil embargo. Today, we have the crisis in Ukraine disrupting two of the biggest exporters of food and energy commodities.
Back then, substantial government subsidies eventually opened up huge new oil and gas fields in North America and the North Sea. Government was the only social entity big enough to offset the risks associated with these projects. That remains the case today, but, unlike 50 years ago, the decarbonization agenda precludes the incentivization of oil exploration and mining on anything like the scale required to bring prices down.
This time around, it is difficult to see any clear prospect of new supply.
Too much demand and too little supply is often a spur to higher prices. But in commodities—unlike in bonds and equities—it is often also associated with higher yields.
When we talk about yield in commodity markets, we mean the “roll yield” that comes from selling a near-dated futures contract and buying a later-dated one, which an investor must do to avoid taking delivery of the commodity itself. That yield is positive when the near-dated contract is more expensive than the later-dated one—“backwardation”—and that tends to be the case during times of scarcity, when the right to take delivery today is more valuable than taking delivery in six or 12 months.
Figure 3. Backwardation and Yield
One-year roll yield
One-year roll yield of the Bloomberg Commodity Index versus other market yields
Source: Bloomberg, FactSet. Data as of May 31, 2022. Commodity futures and Commodity Index roll yields are based on contracts one year apart with nearby being the most active contract. Nothing herein constitutes a prediction or projection of future events or future market or economic behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Past performance is not necessarily indicative of future results.
To summarize, a severe supply-and-demand imbalance has raised commodity prices over recent months. There appears to be very little prospect of meaningful additional supply, as neither investors nor governments are incentivized to capitalize it. Tightening financial conditions and a slowing economy could trim some demand, but in our view that is unlikely to have a big effect relative to the structural trends of redistribution, decarbonization and deglobalization that command today’s global economy.
For those investors who can bear the volatility, we therefore believe that commodities will continue to provide a number of benefits. First, there is the potential for further rising prices as markets try to restore equilibrium. Second, investors are currently receiving high roll yields as steep backwardation in futures markets continues to reflect scarcity and efforts to incentivize production. And third, they can provide much-needed negative correlation with equities and bonds, and positive correlation with inflation expectations and inflation surprises.
Far from missing the opportunity to build strategic allocations to the asset class, we believe we are still in the early innings of this cycle.