Understanding the ups and downs of commodities

Understanding the ups and downs of commodities

by Kristina Hooper, Global Market Strategist, Invesco Ltd., Invesco Canada

The past few weeks have seen commodity prices experience some significant swings, with different commodities impacted by different factors. I find that investors have a lot of questions about commodities and what drives them — particularly given all the dramatic weather events over the past few weeks — so this week I’m going to focus on these investments (with a quick note at the end about key events from last week).

First, consider what we’ve been seeing in the commodity markets recently:

  • Last week saw metal prices depressed, with gold getting hit particularly hard, on the increased likelihood of a Federal Reserve (Fed) rate hike in December. However, heightened tensions between the U.S. and North Korea drove gold prices up on Friday
  • Both before and after Hurricane Irma hit Florida, we saw fluctuations in the futures price of one agricultural commodity in particular — orange juice. The price rose in anticipation of the devastating hurricane, only to fall after Irma hit and the damage to orange crops was deemed to be not as bad as expected
  • Before that, the price of crude oil fell after Hurricane Harvey hit Houston, even though gas prices at the pump rose. That’s because a significant portion of the country’s oil refineries were temporarily closed, reducing the demand for crude oil simply because there was not enough refining capacity. Now that most refineries are back on line, production is returning to normal and demand for crude oil, pent up for weeks, has increased, pushing the price of West Texas Intermediate Crude Oil above $50 per barrel

Understanding the factors that drive commodity prices

To understand commodities is to understand the many different factors impacting them. But let’s start by recognizing that there are a wide variety of commodities that can be loosely grouped into the following categories: energy, precious metals, industrial metals, agriculture and livestock. Energy in particular is incredibly diverse, as it includes petroleum, natural gas, coal and renewable energy — which in turn includes solar, hydroelectric, geothermal, wind and biomass energy (biomass is typically produced from waste materials and comes in many varieties including ethanol and vegetable oil).

Weather. The weather and natural disasters have a significant impact on many commodities, as illustrated above. Droughts can affect crops, reducing the production of agricultural commodities, which then drives up prices. However, good conditions can produce an abundance of an agricultural commodity, which can drive down prices. For example, a record harvest in the U.S. last year produced an oversupply of grain that still has not been worked through, keeping prices lower. And recent reports of delays in the planting of soybeans — an important nutritional staple in many regions — in Brazil as a result of dry weather has boosted prices. (As an aside, I am concerned that climate change may result in more natural disasters that create more price disruptions.)

Geopolitics. Geopolitical risk also impacts commodities, as also mentioned above. Gold (and, to a certain extent, platinum and silver) are perceived to be “safe haven” assets; they are considered reliable stores of value. For example, gold prices went up dramatically in the wake of the terrorist attacks on America on 9/11. And geopolitical developments can impact commodities such as oil. For example, usually when there has been political unrest in a major oil-producing nation, fears about a reduction in production have resulted in higher oil prices.

The business cycle. The business cycle also impacts a variety of commodities, especially industrial metals. That’s because when the economy grows, there is typically greater demand for industrial metals, which are an important component of construction and manufacturing. One industrial metal, copper, is used in a variety of applications from electrical wiring to pipes, and its price is closely watched. This metal is often referred to as “Dr. Copper” for its role as a leading indicator of the direction of the economy.

Inflation. Inflation and inflation expectations have historically had an impact on the price of gold. That’s because higher inflation typically reduces the value of cash. As a result, investors are more likely to move cash assets to gold, driving up prices. For example, in the late 1970s in the U.S., inflation rose dramatically — as did the price of gold, which went from $135 in 1977 to $850 in 1980.1

The dollar. Many global commodities are denominated in U.S. dollars, including crude oil, copper and gold. This relationship is an inverse one: when the U.S. dollar is stronger, crude oil prices are typically lower, all else being equal. That’s because when the U.S. dollar is stronger, it takes more money to purchase a barrel of crude oil, driving demand lower and, therefore, pushing the price down. Conversely, when the dollar is weaker, it takes less money to purchase a barrel of crude oil, driving demand higher and, therefore, pushing the price up. An example of this relationship can be seen in the first quarter of 2015, a time when the U.S. Dollar Index rose 4.4% — and the Bloomberg Commodities Index fell about 6%.2

Interestingly, China just announced plans to launch a yuan-denominated oil futures contract — and it would like to do the same for many key commodities. It remains to be seen what impact this will have on the relationship between the U.S. dollar and oil prices, but at this juncture the impact will probably be de minimis — yuan-denominated contracts may become popular with countries subject to U.S. sanctions such as Russia, Iran and Venezuela, but are unlikely to have broad appeal beyond that.

Supply. Of course, supply also plays an important role in the price of commodities. For example, each week the Energy Information Administration releases its petroleum inventory report. Increased inventory has typically pushed down the price of crude oil, all else being equal. Similarly, when OPEC announces a production deal, that also can impact oil prices. Finally, the Baker-Hughes Rig Count, released each Friday, indicates the level of offshore production of oil and gas. The lower the rig count, the lower the production expected and the greater the upward pressure on crude oil prices (and vice versa).

Looking ahead at commodities

I believe the number of substances viewed as commodities will grow in coming years. One key commodity, in my view, will be water. While many wars have been fought over oil, some wars have been fought over water — and many more may be in the future, as water scarcity becomes a growing problem.

One could make the argument that cryptocurrencies such as Bitcoin are also commodities, in the same vein as gold. After all, Bitcoin needs to be mined and there is a finite amount in the world. Like gold, it is invested in, both for speculation and as a store of value.

As for traditional commodities, we could see major disruption in demand in the coming decades. Last week, a Chinese official announced that China plans to phase out fossil fuel (gasoline and diesel) cars by 2050. China joins a growing list of countries planning to phase out fossil fuel cars in the next several decades, including the Netherlands, India, Norway, France and Britain. If these plans come to fruition, this will likely mean a very significant drop in the price of oil over the long run. This decision could be as impactful on the future of oil prices as was Sir Winston Churchill’s decision in 1912 to replace coal with oil as the energy source for British naval ships, which drove up demand for oil, and in turn resulted in greater production of oil.

Key takeaway

As I have been saying, I believe now is an important time for investors to assess their alternatives exposure, given their needs for downside protection and diversification. One key area within the alternatives category is commodities. While commodity prices can fluctuate quite significantly, as we have seen in the past few weeks, they usually don’t move in sync with other portfolio components, such as stocks and bonds, which can make them an important part of a diversified portfolio.

And, because so many different factors affect commodities (agriculture doesn’t necessarily move in sync with energy, for example), I believe that investing in a broad commodity strategy — versus a single commodity such as oil or gold — can add an extra layer of diversification.

A note about the Fed, Germany and more

Last week, investors watched several events unfold around the world — all of which reminded us of the potential for geopolitical and monetary policy risks:

  • The Federal Open Market Committee met last week and announced that balance sheet normalization will begin in October. While the Fed’s plan for unwinding is very slow and careful, it still carries with it the potential to disrupt
  • German elections were held this past weekend, indicating there is “Merkel fatigue” — Chancellor Angela Merkel’s party garnered about 33% of the vote, down from 41.5% in 2013.3 This election indicated there is still a populist/protectionist trend afoot, with the anti-immigration, anti-EU party Alternative for Germany garnering significant support (13% of the vote3). As expected, I believe Merkel will need to form a coalition government, which carries with it the potential for some changes. The euro has fallen on the news of the election results
  • Theresa May gave her critically important Brexit speech in Florence last Friday. She surprised many by offering a two-year delay on the actual Brexit — what she calls a “transition period.” While it’s a positive that she seems to be favoring a softer Brexit, I grow increasingly worried about business confidence in the UK — and of course business spending — given all this uncertainty
  • Japan’s Prime Minister Shinzo Abe called for a snap election, presumably to win support for taking a harder line with North Korea, whose aggressive stance is growing more alarming

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This post was originally published at Invesco Canada Blog

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