Founder and Managing Partner at Lambert Commodities
To answer this question, it’s worth exploring the dynamics of commodity markets. All asset classes should have plummeted following the 2008 financial crisis, the worst global crash since 1929. But commodities bucked the trend after experiencing a short, sharp decline post downturn. It took until 2015 for them to really drop in value. Why? Because of three factors:
1. The perception that no matter what, economies were still feeling the effects of the crisis long after it started
2. A general concern that demand had dropped significantly as China – a major consumer of commodities – experienced a growth slowdown
3. A fundamental increase in oil supply, fuelled by US shale producers.
The economic climate has undeniably improved: the US is strong, Europe and Japan are in much better shape and China’s economy is still growing, albeit at a slower rate than in recent years. Meanwhile, oil is relatively stable, with demand improving this year. These factors should, in theory, lead to a surge in commodity prices, but that hasn’t happened. While prices have bottomed out, confidence in commodities remains low, which suggests we’re unlikely to see another super cycle anytime soon.
Why is that? The super cycle was triggered by a huge boost in emerging markets, driven by Chinese growth and the rise of the middle-class. But China’s momentum has slowed to more reasonable levels. For another super cycle, we need a new superpower to emerge. Will it be India? Maybe, but it will take time for a nation with a GDP equivalent to Italy to reach economic parity with China. As such, demand for commodities outside of China is unlikely to rise significantly for the foreseeable future.
Elsewhere, the commodity supply side is getting increasingly effective. Processes and technology have led to better yields in agri and to cheaper, more efficient ways of extracting shale oil. Supply of gas, metals and mined commodities will remain ample, driven by bullish investment decisions made five to 10 years ago.
A geopolitical shock could derail the relative stability of supply and demand. Prices move for two reasons: when demand increases or supply falls because of some disruptive event. We live in a much more dangerous world than 20 years ago. Tensions in the Middle East, the South China Sea and between Europe and Russia could affect commodities in terms supply and demand. Any conflict would primarily affect precious metals – notably gold, whose price has risen over the summer because of global tensions.
It sounds far-fetched, but the emergence of electric cars and the ban on diesel (cars in the UK from 2040) casts doubt over ongoing demand for this commodity. Many analysts can’t ever see prices exceeding US$100 (£77) again.
Shale oil producers have large operational expenses, with fracking and extracting oil from rocks proving costly. But their rigs are cheaper than ones for conventional production, making shale companies generally more nimble when it comes to activating their rigs. This gives them the flexibility to produce more when prices go up, which increases supply and conversely reduces the value of each barrel.
The situation is different for conventional producers that produce oil to finance huge investments, such as deep sea rigs. A fall in oil price means they have less revenue for reinvestment, making production less viable. This leads to a drop in supply, which then forces oil prices back up. OPEC members have tried to scale back production in order to force prices up. But there remains a healthy supply, thanks to shale oil producers.
The transition towards new energy sources could boost interest in commodities such as cobalt and lithium. But uncertainty around processes and doubts about meeting growing demand for electricity will temper any speculative positions.
Gas is another source that will likely deliver low returns. It’s a perfect alternative to coal and oil because it’s cheap, but the low price means it will take years for investors to see even a modest return when investing in large liquefied natural gas fields in Australia or the US.
As for coal, prices rose significantly in 2016 because the Chinese imported more after cutting production. The country has since started producing again. The paradox is that coal will remain one of the world’s most sought-after fuels. It accounts for 30% of primary energy sources, second only to oil, and will be in greater demand than gas until at least 2030, according to the BP Energy Outlook 2017.
Coal may be in demand, but few investors are tempted to take a bullish long-term view on it, mainly because of concerns about the environment and pollution.
China accounts for 45% of global demand for base metals and more than 60% for iron ore. The US remains at 15%, despite talk of US president Donald Trump’s infrastructure projects (more roads, bridges and railways) driving demand. In any case, a 10% increase in demand from the US would have little impact on the overall market. As one of the world’s biggest economies, China will long remain the biggest consumer of base metal and iron ore.
Prices can be affected by climate change. Yields have been strong and remained stable amid climatic events such as El Niño. Agri commodities are generally quite cheap, which is surprising given the surge in global population and more people moving into the middle classes. Yet this industry is extremely sophisticated, with new techniques emerging for stronger, more reliable harvests. Low prices are good for consumers, but depressing for investors.
Commodities won’t rally unless we experience some geopolitical event. While this is good for developed economies, it’s bad news for emerging markets that rely on commodity production. As for investors, they should look elsewhere at a time when interest rates are still low and stocks remain expensive. For now, commodities aren’t an attractive or compelling alternative to other asset classes.
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