From April 2020 to June 2022, the energy transition and the war in Ukraine combined to generate a significant surge in commodity prices. Since then, commodities have struggled, weighed down by the weakness of China’s economic recovery and mixed economic data across the globe. More recently, however, they have started to tick higher once again. Should investors be taking note?
The S&P Goldman Sachs Commodity index is up around 14% since June. This is small fry in the context of its 230% rise between 2020 and 2022, but it has started to reverse the decline of the previous 12 months. The immediate catalyst for the recovery in commodity prices appears to have been a shift in Chinese monetary policy, with the central bank cutting policy rates in August.[1] China remains the marginal buyer for a range of commodities and any stimulus to revive the ailing economy is considered likely to raise commodity demand.
However, the aggregate picture masks a lot going on beneath the surface. In reality, the past three years have been characterised by a flip-flop between energy transition commodities, and traditional fossil fuels. Areas such as precious metals have been mixed. Natural gas has surged, only to slump and then revive, coal has shown a similar trajectory. Agricultural commodities such as corn, wheat and coffee have been persistently weak over the past 12 months.
The trusts that have done best in this environment have tended to be those that have significant flexibility, looking across the market for specific opportunities. This has helped them trade both sides of the market – the boom in energy transition commodities, but also the surge in traditional fossil fuels in the wake of the Ukraine crisis – and pick up specific opportunities within individual commodities.
The CQS Natural Resources Growth & Income and BlackRock Energy & Resources Income trusts have delivered annualised returns of 15.7% and 14.9% respectively over the past five years. While Geiger Counter has delivered a higher return (24.9% annualised), its focus on uranium assets makes it a unique option. Riverstone Energy, which focuses exclusively on low carbon energy, has stronger recent performance, but fell over 80% from 2018 to 2020. The Global Prospect Precious Metals fund has been weak, down 22.8%.
Opportunities are increasingly idiosyncratic
The outlook for commodities from here is not clear-cut. Previously, an approximate line could be drawn between commodity performance and global growth. Today, it is more complex, investors need to consider not just the economic cycle, but also the situation in China, the progress of the energy transition, geopolitics, alongside local supply and demand dynamics. Opportunities within commodities are likely to be idiosyncratic.
On balance, global growth will be a tailwind for the commodities sector as a whole. The hoped-for bounce in China’s economy in the wake of its reopening has not materialised. Policymakers continue to struggle with weaker credit growth, rising deflation risks and a reluctant consumer. While monetary policy easing should stimulate the economy, it may be limited by the falling Yuan. US economic strength is, to some extent, acting as a counterbalance in the short-term. In particular, the Inflation Reduction Act is creating demand for specific materials: manufacturers’ spending on construction rose 76.3% in May from a year earlier[2].
Energy transition isn’t straightforward
The energy transition is creating structural demand for specific commodities, but this is not as simple as suggesting that, for example, lithium is good and oil is bad. Rob Crayfourd, manager on the CQS Natural Resources Growth and Income trust, says the trust’s 33% weighting in oil and gas is a reflection that the energy transition isn’t straightforward and there will need to be transition fuels: “Gas is a clear requirement to balance the grid in the short-term. As a result, we have a meaningful gas weighting in the portfolio. Gas has a far lower carbon output than coal and will be required for the grid until they create batteries of sufficient scale.”
The team at BlackRock take a similarly pragmatic view, seeing fossil fuels as essential for a smooth transition to net-zero goals. They also believe that these areas, on the whole, remain undervalued compared to the wider market. These companies have high free cash, attractive dividends and there has been underinvestment in new supply.
Crayfourd points out that supply and demand dynamics can be complex. For example, the demand trajectory for key energy transition commodities should be clear. Offshore wind power generation requires six times the amount of mineral commodities – copper, zinc, nickel, chromium and rare earths[3]. However, prices for zinc and nickel have been weak, alongside lithium, a key component in electric vehicle manufacturing. They have been pushed lower by, among other factors, sliding demand for EV batteries in China colliding with some exuberance in pricing.
A mix of top-down and bottom-up considerations
For Crayfourd, all decisions need to be a mix of top-down and bottom-up considerations. He is cautious on copper, for example, in spite of its key role in electrification. Valuations for the copper producers are high and there has been supply disruptions and protests in the Peruvian Bambas region. In Chile, a new constitution is being prepared that is likely to increase the role of the state in the development of natural resources. As the world’s largest producer of copper, it is not yet clear the impact this might have on the market. These domestic factors disrupt an otherwise benign demand picture.
He says that each commodity needs to be considered in context. Some are priced globally, while others are not transportable and are therefore more influenced by local supply and demand dynamics. Commodities are often located in difficult countries, and may be those countries’ key source of economic growth. This can make them a target for government interference and taxation.
None of this makes it any easier to determine whether now is a good time to invest in commodities. It is perhaps safest to say that there are long-term structural forces that are creating demand for specific commodities, from construction commodities to build new infrastructure, to the specific commodities required for batteries, solar panels or wind farms. Global growth is rising after a period of weakness, but China’s slow growth remains a problem. At the same time, underinvestment in new supply is a challenge across the commodities complex and is altering the supply/demand dynamic.
Commodities is a capricious sector, subject to a range of competing forces. A good manager with flexibility is required to uncover opportunities as they arise.
[1] https://www.reuters.com/world/china/china-central-bank-cuts-rates-second-time-three-months-support-economy-2023-08-15/#:~:text=SHANGHAI%2FSINGAPORE%2C%20Aug%2015%20(,boost%20a%20sputtering%20economic%20recovery.
[2] https://edition.cnn.com/2023/07/27/economy/second-quarter-gdp/index.html
[3] https://am.jpmorgan.com/be/en/asset-management/institutional/insights/market-insights/market-updates/on-the-minds-of-investors/clean-energy-investment/