Commodities at the crossroads
Commodity prices fell to earth last year, and even gold has started to lose its lustre. But before deserting the sector, investors should consider the part that a resilient China could play in its recovery.
Commodities markets lived a boom in the mid-2000s, creating fortunes for investors in staples as varied as oil, copper and soya. Even after the start of the current crisis, many commodities continued to perform strongly thanks to unfettered demand from the Chinese economic machine. Even the struggles of the rich world have created opportunities by providing enough liquidity to boost the price of gold and other precious metals seen as attractive options in times of low returns.
In 2012, however, commodities disappointed investors almost across the board, and even bullion has lost some of its glitter. As a result, investors have been asking themselves whether the time has come to move away from this highly volatile, politically sensitive asset class.
It might be the case, however, that the recent lacklustre performance has created the conditions for investors who had previously been priced out of commodities to enter the sector as the global economy increasingly shows signs of recovery. In fact, some of the factors required for the asset class to perform in 2013 are coming into place.
“The year of 2012 was a real sea change for the commodities industry,” says Carmignac Gestion investment board member Sandra Crawl. “We have seen the stabilisation of emerging economies’ growth and the fading out of the global slowdown, which of course will bring more demand for energy and metals in general.”
She adds: “The third wave of quantitative easing by the US, and the announcement by Japan that it is going to increase its asset purchase programme, will bring extra liquidity into the commodities industry. This is something that underpinned the gold market in 2012 and should continue to do so this year.”
The outlook for commodities is varied. Some analysts, like Crawl, predict better performance this year than in 2012, when prices fell in the first half and recovered only a tad by the end of the year. Others, such as the World Bank, expect the sector to carry on slugging around. The bank has forecast falling prices for most commodity products in 2013, even though it expects the European debt crisis to ease during the course of the year.
The determining factor is likely to be China. Which is good news for commodities bulls as the country appears to have avoided a hard landing and is surprising many analysts with its economic resilience. A buoyant China could help boost the prices of several commodities owing to its sheer weight in the market, although it can also give Chinese buyers a dominant position in their deals with providers, as potash producers have found out recently.
For example, China gobbles up 45 per cent of all metals produced in the world, according to the World Bank. This is the kind of statistic that explains why commodities investors have been looking closely at the political changes taking place in the country.
“Chinese commodity demand will be a very important factor, which means that it will be essential to monitor how the change in Chinese leadership influences that dynamic,” says Bradley George, head of Investec Asset Management’s commodities and resources Team.
Crawl adds: “The change of government in China should bring renewed investments in infrastructure, and still more social housing construction.”
Anyone feeling optimistic about China should take a close look at commodities such as copper, nickel and aluminium, which are much in demand by the Chinese housing and construction sectors. These metals benefited hugely from the infrastructure and housing boom that the country went through in the 2000s. For instance, the price of copper shot up from less than $2,000 (£1,265) a tonne in 2000 to more than $8,500 in 2009. It took a dive after the collapse of Lehman Brothers, but the expansionist policies adopted by China to cushion the impact of the crisis in the following months took the price back to almost $10,000 in 2011. Lately, copper prices have hovered at about $8,000 a tonne, but there is optimism that they will pick up again in the near future.
“Demand for copper in China will not be as fast as it has been, but it will continue to be strong,” says David Donora, head of commodities at Threadneedle. A brake on rising prices could come, however, from the supply side.
Walter de Wet, head of commodities at Standard Bank, says there will be a surplus of copper in the market during the year, while China itself has more than one million tonnes of it stocked above ground. “We need to see the construction sector in China pick up steam for real in order to sustain a copper rally,” he says.
He suggests that investors with copper holdings in their hands might take advantage of any rallies that materialise during the year.
Crawl says that copper producers face challenges that could affect supply of the metal to the market if demand picks up. “Producers have faced higher costs and have reduced production,” she says.
Other metals are placed more comfortably in terms of supply. Aluminium, for example, is set to come into huge demand if China shifts up a gear, but the Chinese themselves are the biggest aluminium producers in the world and have much spare capacity, according to Donora.
The World Bank forecasts that metal prices should increase only marginally in 2013, with aluminium and nickel seeing some improvement but copper prices going down. Donora foresees better prospects for higher prices in metals markets in three-five years’ time.
More upbeat forecasts tend to be associated with precious metals, which have been much helped by the woes of industrialised economies. As investors tried to escape from record low-interest rates and QE policies implemented by central banks in Europe and the US, they turned to gold, silver, platinum and other precious metals to achieve results. The strategy worked a treat in 2010, when gold delivered returns of a whopping 29.2 per cent. The performance was not bad in 2011 either, with an 8.9 per cent increase, or in 2012, with 8.2 per cent. But gold has been slipping in recent months, as have other precious metals.
Curiously enough, they could be a victim of the perception that the rich world’s economic problems are inching towards a close. “Precious metals like silver and gold have struggled to deliver performance of late, and the main reason is that there have been concerns about how long the [US Federal Reserve] will maintain their unconventional stimulation policies,” De Wet says.
The positive data that has been emerging sporadically about the US and European economies could make one think that the time to be into gold is gone, as asset purchases by the Federal Reserve and the European Central Bank should come to an end and interest rates could rise once the economies heat up a bit. But experts suggest that the case for gold is far from over.
Their main reason is that, even if the US and European economies are recovering, the debt situation in both regions is likely remain on the dire side for a long time yet. And that usually means that investors will carry on pursuing safety by piling up gold.
“The keys for gold are the American interest rates and any significant reductions to the US budget deficit,” Donora says. “But the US are adding more than $1trn a year to their national debt. In order for gold to have a bear market, we would need to see that number decline rapidly.”
Other factors are weighing in too, according to Crawl. “Over the recent few years, central banks have become net buyers of gold, which has not been seen since the 70s,” she says.
According to Singapore-based bank OCBC, countries such as South Korea, Brazil, Kazakhstan and Russia have been active buyers of gold. And there is much potential for emerging markets to stay on the lookout for bullion to shore up their accounts, as gold represents a mere 5.9 per cent of the total reserves kept by Asian banks, compared with 76 per cent in the US and 64 per cent in the eurozone, OCBC notes in a report. The bank also says that gold investments by exchange traded funds have reached record levels.
Several fund managers have, therefore, been bullish on gold, with Donora forecasting that prices should increase by 5-10 per cent in 2013. De Wet says that an ounce of gold could approach $1,750 during the year, from the current $1,690, though more sanguine players such as OCBC are going as high as $1,950 with their forecasts.
Other precious metals, such as platinum and palladium, also look good, analysts say, especially as a result of production problems faced in major exporter South Africa. “Gold, platinum and palladium prices are likely to be supported in the near term by the fact that South Africa’s operations remain plagued by rising costs, infrastructure bottlenecks and policy concerns,” Investec’s George says.
Oil is often called “the black gold”, but the outlook for this particular commodity looks more nuanced than the prospects for its yellowish peer. If China continues to improve, the logic would point to a hotter demand for oil, which should move prices upwards.
“Chinese growth has been more driven by consumption this time around, and as a result it will boost demand for those commodities used to produce things that consumers buy,” Donora says. “Oil [that is] used to make gasoline and diesel sits at the top of the list.”
Demand-side pressures come from China and also from an eventual economic recovery in the industrialised world. The turn taken by Japan away from nuclear power after the Tukushima incident has also helped to fuel demand for oil, indicating how unexpected events can affect markets. In fact, Japan was the only OECD country to increase its consumption of oil in 2012, according to the World Bank.
But the picture becomes much more complicated when supply factors are brought to the fore. On the one hand, disruptions to the production of hydrocarbons occur all the time, especially in areas such as the Middle East or, more recently, North Africa. Prices are influenced hugely by Opec, the cartel of oil producing nations, and particularly by its most powerful member Saudi Arabia, which is capable of moving the market on its own. The Saudis have strived to prevent prices from spiralling up in times of political uncertainty, but have also been careful not to let them fall below levels acceptable to producers.
The market-setting power of Opec and Saudi Arabia could be affected somewhat by the emergence of new producers in South America, Africa and other parts of the world, and especially by the exploitation of new sources of oil in the US. The black stuff being extracted from tar sands by the Americans, for instance, has the potential to reduce the import needs of the country that remains by far the world’s largest oil consumer. “Oil markets are subject to supply shocks, but if they are taken out of the picture, fundamentals look fairly weak,” De Wet says.
He adds that the most likely scenario is that prices will fall below current levels. The World Bank believes oil prices will drop 3 per cent in 2013, which would be good news for economies but probably not very enticing for investors. Credit Suisse, however, says prices could rise in 2013, albeit not dramatically.
However, the story could be different with natural gas. Credit Suisse has noted that demand for gas has gained a boost from Japan, which in recent months has adopted it along with oil as a replacement for nuclear power. At the same time, US companies are still not able to export the gas from their plentiful shale reserves. Allied to a lower than expected increase of production in some export countries, such factors helped prices to a late rally last year and could put upward pressure on them this year as well.
Agricultural commodities, with their constant exposure to the whims of the weather, have a reputation for volatility - a reputation that was confirmed again last year when a spate of floods and droughts in different parts of the world disrupted production of food staplesand grain prices rose sharply in the second half of 2012. At the same time, the World Bank notes, edible oils went in the opposite direction, posting a dramatic increase in the first eight months of 2012, though falling 12 per in the final third of the year.
The World Bank forecasts that agricultural commodity prices will fall by an average of 3 per cent in 2013, barring a major climatic event during the year - an important caveat. The Chinese factor could affect the prices of commodities such as soya, used as cattle feed, which the country has consumed in ever bigger quantities. “China will be buying a huge amount of soy beans from Latin America, and from the US as well,” Donora points out.
The oil market can have an important infuence on the performance of agricultural commodities, too - the World Bank has noticed that crude oil prices answered for two-thirds of the increase in food costs observed since 2004 - and so can recoveries in particular sectors of the largest economies.
Patricia Mohr, a vice-president and commodity specialist at Scotiabank, pinpoints forest products used in buildings, such as timber, as top picks for investors in 2013, owing mostly to the recovery of the housing sector in the US.
In general, the outlook for commodities markets does not suggest it is where investors will make a killing in a weak market. But that does not mean that the asset class should be discarded altogether by those hoping to pump up the performance of their portfolios. The inclusion of a commodity element into a portfolio could prove valuable in terms of diversification and the spreading of risk, for example.
“Numerous long-term studies support the case for commodities in an investor’s portfolio, driven by the attractive properties of equity-like returns combined with low correlations to traditional asset classes,” George says.
He notes that commodities often have a positive correlation to inflation, contrary to equities and bonds. “Furthermore, this correlation remains robust both against volatile inflation levels and monetary policy changes, due to the fact that, compared with equities, commodities perform well at different stages of the business cycle,” he says. “An allocation to the asset class could also act as an alternative to inflation-linked bonds, which, although they protect income from inflation, do not protect growth portfolios.”
Many investors may feel more comfortable, however, making a commodity play by means of an investment in equities linked to the sector. That option has probably looked less appealing with the problems that some of the largest mining companies in the world have reported of late.
In mid-January Rio Tinto chief executive Tom Albanese resigned after announcing that the company was writing down $14bn worth of investments related to its aluminium and coal-mining activities. Anglo American also lost its CEO Cynthia Carroll after investments in Brazil and other countries performed poorly.
Like other miners, its South African operations have suffered from unrest among workers. George says that he was able to make a profit by shorting Lonmin, an embattled South African miner.
But miners’ woes can hardly be taken as a sign that the sector does not offer good investment opportunities, Donora says. He adds: “Some of the troubles that have plagued the mining companies have had to do with decisions they have taken, and those decisions were taken on expectation of prices and the production that those projects would be able to deliver. There is a long list of decisions that weighed against the CEOs who took those decisions.
“What their struggles can tell us is that there has been a pretty tough time for mining companies for the past few years. It has not been easy, with prices going up and down dramatically, a lot of political instability, and cost inflation that has tremendously affected their margins. But in our view these are the symptoms of a very long cycle, and we may be seeing the end of this cycle for mining companies.”
Another sector not for faint-hearted CEOs is oil and gas production. There, companies can see their investments threatened by factors such as the nationalisation of assets - as Spain’s Repsol found to its profound dismay last year in Argentina - and armed conflicts. The recent attacks against gas plants and pipelines in Algeria have served as a stark reminder of the risks those firms need to take.
“Companies operating in the production of oil and gas in Algeria are major oil companies and they do not fly away from a little bit of conflict,” Donora says. “On the other hand, they will invest in boosting their security, and that will cause their costs to go up in the country. And it may give them pause when it comes to planning new investments in that area.”
Crawl says that companies that are big oil producers have disappointed investors lately, but that there is value to be found in the industry anyway. Carmignac has a fund that invests in equities linked to the commodities sector, and energy firms represent about 45 per cent of its portfolio. They are more often than not outfits that do not appear in newspaper headlines but nonetheless provide significant niche opportunities.
“In the US oil and gas sector, we like companies that have specific skills in deep-sea drilling,” says Crawl, giving an example. “And also companies that are directly involved in the technologically advanced non-conventional gas and oil exploration. In addition, we have invested in companies like chemical and ethanol producers that are benefiting indirectly by their massively cheaper energy sources, such as gas, giving them an enormous cost advantage over their non-American peers.”
Even in the sub-sector of gold, she adds, investors need to be careful to identify the right opportunities. “You need to be a good stockpicker to find the companies that have been able to dig gold ore of good quality. Lower-quality ore means that their cost per ounce is higher.
“We have added gold royalties firms rather than producers today, as they benefit from high prices without the burden of higher exploration costs.”