Picking the winners in a diverse commodities sector

Commodities are a heterogenous group of assets whose price movements bear surprisingly little correlation to each other, and this divergence is growing as a characteristic of the sector.

Research by Investec highlighting the diverse performances of commodities reveals, for example, that there has been no discernible pattern regarding each year’s best and worst performing commodity types since 1999. The winners and laggards are drawn randomly from different commodity groups, with only Brent Crude topping the performance tables in more than two years, while only natural gas, wheat and zinc fare the worst in more than one year.

Fund managers therefore believe that it pays to take overweight positions in the commodities they anticipate will outperform and most remain relatively bullish.

“We expect divergent performance among commodities to continue, and are therefore tilting portfolios towards areas with positive demand developments and supply issues, particularly integrated oil and gas companies, gold and gold equities, palladium, iron ore equities and potash fertilisers,” says Bradley George, head of commodities and resources at Investec Asset Management.

“After a strong start to the year, from March onwards commodity markets have been turbulent and resources equities have been under significant pressure due to uncertainty in the eurozone, but beyond this uncertainty, looking forward over the next six months, we believe there are some positive signs,” he explains. “Although Chinese demand has been soft we believe it should strengthen again in the second half, supported by monetary loosening. Also, at current valuations many resource equities appear to offer attractive entry points.”

Investec analysts are forecasting Brent at $110/bl (€87/bl) in 2012 and $105/bl in 2013, natural gas at $2.50/mcf in 2012 and $3.50/mcf in 2013, rising in subsequent years, gold at $1,730/oz during 2012 and $1,800 in 2013, and Platinum and Palladium at $1,550/oz and $750/oz respectively.

The biggest single factor for many commodity prices is the strength of China’s growth.

“Although there are signs that investor confidence in the global economy is improving, geopolitical concerns in the Middle East and the on-going debate about China’s economic growth are likely to continue to cause volatility in mining and energy company shares and the underlying commodities,” says Joanne Warner, manager of the First State Global Resources fund which focuses on resources companies, many of which are improving efficiency in their production.

“Overall, resource company business strategies stress the decline of the importance of the Western economies and the continued growth of emerging markets, led by China, even if a temporary slowdown materialises.”

For example, undisciplined drilling of shale in new areas and warm weather has led to an oversupply of natural gas to the US market and ramped up production has weighed on gas prices and related stocks over the past year. Critically, although US gas drilling activity has now fallen with the rigs deployed instead for oil drilling, US gas in storage remains above five-year levels.

The longer-term story however is that worldwide demand for the fossil fuel is forecast to increase by 17 per cent over the next five years, largely owing to demand from China. Despite concern that its economy may be slowing, Chinese consumption of gas is expected to double during the period, according to The International Energy Agency (IEA), and is forecast to grow by 13 per cent a year through to 2017.

“Asia will by far be the fastest-growing region, driven primarily by China, which will emerge as the third largest gas user by 2013,” the IEA wrote in a recent paper. “There are no doubts that China will become a major importer of gas. The question for external suppliers is how much pipeline gas and liquefied natural gas China will need in five or 10 years.”

Chinese demand also has huge bearing on soybean, which has recently been the commodity sector’s biggest success story, rising 17.1 per cent in the year to May. While the drought in Argentina and Brazil damaged soybean yields, the prime focus is on China’s demand which has grown from 2011 levels.

Robert Baker, fund manager of the active Oppenheimer Commodities Strategic Total Return fund, says he was overweight soybean and corn in the spring because the stocks-to-use ratio was running at a 30-40 year low.

“The planting season in the US is already wrapped up for this year,” he says, “so poor weather conditions for pollination could see prices go much higher.” In addition, the US Prospective Plantings report provides further colour that soybean plantings came in below expectations.

Baker is less enthusiastic about wheat because although Kansas, Ukraine and South Russia have all experienced a lack of rainfall, wheat production is geographically diverse.

Many managers are also underweight coffee, sugar and cotton primarily because prices shot up to levels that prompted a rationing in demand and a strong production response. Conversely, there is a general bullishness on potash fertilisers, owing to short-term capacity restraints and record US corn plantings. Another widely favoured commodity is palladium where managers expect firm industrial demand particularly from the auto industry and reduced supplies to tighten the market.

Chinese construction is also central to demand growth for base metals, but here confidence appears to have faltered. “For base metals, sentiment has soured, and we expect metals prices to continue to face headwinds and remain under pressure until the market becomes more comfortable with the macro outlook,” says Oliver Gregson, head of UK Investment Advisory at Barclays Wealth.

Spot iron prices are falling back but from high levels and supply is recovering from Australia and Brazil, although supply from India is still weak and the monsoon season has now begun.

Gold, of course, is the odd man out. It is not controlled politically and investor appetite is largely driven by concern about inflation, which is hard to predict. Gold-bugs highlight the metal’s desirability as a diversifier in inflationary times, particularly as historically inflation has been bad for both bonds and equities. Prices have been driven higher by negative real rates and dollar weakness, and the Fed has promised to keep rates low until 2013 or until the US economy has started to stabilise.

Paula Bujia, manager of Schroder’s gold fund which invests in a mix of physically backed ETFs (exchange traded funds), gold mining companies and cash, says she is adding to her equity position as she “really believes that the bull market in gold prices is still intact and we have not yet seen the price peak. Gold is a fantastic position for hedging regardless of what happens.”

In particular gold miners, beset with operational issues such as labour, taxes and currencies, are cheap, with a high upside in the price. Many now trade at 1x NAV (net asset value) – a significant de-rating, as historically they have traded as high as 1.5-2 x NAV. Similarly, they are trade on 10-15 x next year’s earnings.

Oil remains a tight market and prices have been resilient with Brent around the $100/bl mark despite mounting macroeconomic concerns surrounding Greece and the peripheral economies. Data showing that China's oil imports touched a record high in May also produced a rally while US demand has also made significant improvements, supported further by OECD Pacific demand. Western trade sanctions against Iran are expected to continue to support oil prices in the coming months, despite assurances from Saudi Arabia, the world’s top exporter, that it will make up for any shortfall.

“We continue to like oil-based energy on a fundamental basis,” says David Donora, Threadneedle's head of commodities. “There are short-term headwinds with Europe but we feel fundamentals across the spectrum are strong such as growth in demand from emerging markets and the demographics driving that demand and the limited scope for material increases in production.

“The economy has been buffeted by the macro situation in Europe and relentless headlines,” he adds. “A number of investors recognise this as a tempting pull back and that when economic growth does improve, prices will move higher because demand will pick up quickly.”

Barclays Wealth recently suggested an idea for clients to gain exposure to long-dated Brent crude futures. “Geopolitical risks and the inability for supply growth to match demand growth will keep global spare capacity and inventory buffers at low levels,” says Mr Gregson.

“This long-term tightness in fundamentals, coupled with a steep backwardation in the futures curve, makes long-term prices attractive. Our longer-term average annual forecast is 135.”

Gold continues to glitter

The rationale for investing in commodities is the effect they have when added to a portfolio of cash, bonds and equities, says Oliver Gregson, head of UK Investment Advisory at Barclays Wealth. “They offer the degree of protection versus inflation and a low incidence of instances of large negative returns – lower left tail risk (ie they help protect the portfolio from the most extreme downside performance periods).”

Barclays Wealth uses a combination of exchange traded commodites (ETCs), such as ETF Securities, and ETFs such as iShares, as well as various structured products. In the long only space, they use the massive Schroder AS Commodity Fund and alternative trading strategies through specialist firm Armajaro.

As well as selecting managers for consistent and repeatable investment processes, and for niche investment styles where research can provide an edge, Barclays Wealth also focuses on emerging strategies because historical return data suggests that managers often achieve their best returns during the early lifecycle of their strategies.

Mr Gregson warns that commodity-linked equities are contaminated by equity volatility, while commodity-linked currencies are currencies whose GDP contains a large component of production but are swamped in the short-term by relative growth rates and interest rates.

Coutts Wealth Management is broadly cautious on the commodities sector. “We keep coming back to gold as a commodity we want to hold at this stage of the cycle,” says CIO Henry Lancaster.

“Gold is easier to hold than most other commodities; there are fewer unforeseen costs and it protects against the risk of inflation that we are primarily looking for from commodities. Most other commodities have some element of being subject to economic cycle and we see too many headwinds, especially in industrial metals, as China is slowing down, although it is more bullish than other nations. There is also more to come in deceleration and monetary policy easing,” he explains.

“The headline spot prices in some commodities have not translated into investor returns. Gold is much more predictable,” says Mr Lancaster. Gold can be accessed via an ETF which holds physical gold which is verifiable and not too different from buying physical gold bullion, he explains.

“One of the difficulties of investing in commodities has always been roll yield, which is such a feature of holding oil and depresses returns. We believe the recession in Europe and the slowdown in Asian growth is a classic mid-cycle slowdown and stocks are starting to build. Saudi oil managers have said $100 is a reasonable target for oil and when investors should look again, maybe in later part of the year.”

VIEW FROM MORNINGSTAR

Faltering growth hits returns

Most commodities funds have delivered negative returns over the past year (May 2011 to May 2012), with the “Morningstar Commodities – Broad-Basket” category average down by 9.5 per cent. Global equity markets were still in good shape until the summer of 2011, thanks to improving US economic data and Europe not yet experiencing the full extent of the debt crisis. In this context, commodities initially remained flat but the macroeconomic environment then deteriorated in the last quarters of 2011.

Commodities were hurt across the board, with the sharpest fall registered in the most GDP growth-sensitive subsectors such as industrial metals and energy. Overall, only precious metals sheltered investors over the last 12 months period, with gold leading the way.

Many funds in the commodities broad-basket category invest in derivatives to replicate a diversified commodity index. Pimco GIS Commodities Plus Strat managed by Samil Parikh follows such a strategy and has performed relatively well over the past year, outpacing the category average by 1.8 per cent.

On the other hand, DB Platinum Commodity Euro has gone through a difficult time, shedding 31 per cent of its NAV from May 2011 to end of May 2012. This fund aims at offering exposure to four sectors (energy, industrial metals, precious metals and agriculture) with energy the most important. Continued strong production growth and new fields being discovered have forced natural gas prices down by almost 50 per cent over the past 12 months. With almost one third of its assets exposed to natural gas, this particular fund has suffered.

Mathieu Caquineau, Senior Funds Analyst, Morningstar France