WHY IT´S TIME TO INVEST IN COMMODITIES, AND HOW TO DO IT / BARRON´S MAGAZINE

Why It’s Time to Invest in Commodities, and How to Do It

By Reshma Kapadia 

Illustration by Doug Chayka

Commodities are rarely exciting—and the price of copper, corn, or even oil doesn’t stir investors the way a tweet from Elon Musk does. 

Yet commodities sit at the crossroads of three of today’s biggest investment themes—rising inflation, a changing China, and the transition away from fossil fuels amid increased attention to climate change.

Barron’s highlighted this opportunity a year ago as commodities emerged from a decadelong bear market. 

It was a good call: The Bloomberg Commodity Index rose 27% in 2021, its best year in decades. 

Those three big trends are still going strong, so more gains could be ahead for some commodities, like oil, and agricultural commodities such as corn. 

But the price run-ups mean that investors need to pick their spots carefully. 

The factors affecting commodity prices—and determining which ones investors should focus on—often overlap and have different short- and long-term implications. 

Actively managed funds are better able to spot and take advantage of changing trends; for three good fund options, see the article on page L7.

Inflation

Inflation has been one of the biggest drivers of many recent economic and market trends. 

The most recent consumer price index, or CPI, inflation report showed that prices rose across the board in November—by quite a lot, 6.8%. 

And in December, the Federal Reserve acknowledged that inflation was indeed a sustainable trend—not transitory—and that it’s moving ahead with plans to raise interest rates to battle inflationary pressures. 

Even as the Omicron variant spreads, the world is snapping back from pandemic lockdowns. 

There is pent-up demand for household items, corporate endeavors, municipal projects, and, of course, for the commodities that are needed in all kinds of production. 

Meanwhile, many of those commodities are in short supply. 

Add in supply-chain problems in getting those commodities into production and the produced goods to the end user, and it’s no wonder that prices are rising.

Investors wanting to hedge against inflation, which makes stocks more volatile, have long turned to commodities. 

It’s a broad “if- you-can’t-beat-’em, join-’em” strategy: If inflation is rising, the prices of commodities are typically rising, as well, so part of your portfolio will benefit even as some investment returns are muted. 

Energy futures have the best correlation with U.S. inflation, but over the long term, agriculture, livestock, and industrial metals are all positively correlated. 

Since 2000, the Bloomberg Commodity Index’s monthly year-over-year returns have had a 76% correlation with U.S. consumer-price-index data, according to J.P. Morgan. 

And today’s inflation is driven by structural factors that are changing the economy, business, and how we all live.

“Greenflation” is an additional factor driving inflation, and will benefit commodities needed for the green energy transition—especially copper, which is used in all things digital; lithium, used for batteries; aluminum, used to build solar panels and wind turbines; and cobalt, a catalyst for producing clean fuels. 

More companies and governments are setting goals to reduce or eliminate the use of fossil fuels such as coal, oil, and natural gas.

These efforts are the basis for plans to become carbon neutral or “net zero” that many companies and nations have made. 

These institutions are setting dates by which their operations won’t add to the release of carbon dioxide into the atmosphere, and any emissions they do produce will be offset by green projects that reduce carbon. 

These are costly, decadeslong plans that will change the supply-and-demand profile of many commodities.

While inflation is a broad argument for investing in commodities, the influence of China—the biggest consumer of commodities—the dynamics around specific trends, and the already big run-up in the prices of some commodities mean that investors would benefit from a more targeted approach.

China

The health of the Chinese economy is one of the biggest determinants of commodity pricing—and the near-term outlook isn’t great. 

The world’s second-largest economy was the primary driver for the last commodities supercycle, as the country’s swift urbanization, aggressive stimulus after the financial crisis, and rapid economic growth created voracious demand. 

The backdrop is very different today: China’s economic growth has slowed to 5%, and its policy makers are focused more on creating a balanced, resilient economy than unbridled growth. 

One example of this shift in priorities is Beijing’s crackdown on China’s debt-laden property sector, by implementing fiscal regulations that pushed large property developers like China Evergrande Group (ticker: 3333.Hong Kong) to the brink of bankruptcy, and left investors concerned that property problems would drag the economy down even further.

“Instead of a country industrializing, we have a country that accounts for 55% of metals demand slowing down,” says Natasha Kaneva, J.P. Morgan’s head of global commodities research.

Yet over the long term, China will remain a big driver of demand. 

Its property market accounts for 30% of the global demand for copper, which means further gains in copper prices aren’t likely in the near future.

But metals, and especially copper, have a bright future as China embraces green technology. 

Beijing has announced plans to be carbon neutral by 2060, a transition that will be years in the making and bodes well for industrial metals used in electric vehicles. 

Just a fifth of the cars sold in China today are some type of electric—think battery, plug-in, or hybrid—compared with 40% in Europe. 

Demand for EVs probably won’t rival demand for traditional cars until after 2026, says Kaneva. 

Until China’s energy transition gets further along and its property sector stabilizes, industrial metals are not the best near-term option for combating inflation or boosting returns.

Energy, Green and Black

The energy transition is another big factor in commodity prices, and one that’s creating lots of opportunity. 

As anyone who has raised a teenager knows, transitions can be difficult and full of conflict.

There are three big forces at work in energy prices: fuel shortages in the short term, the inexorable march toward renewable energy in the longer term, and the increasing emphasis from U.S. companies and their investors on environmental, social, and governance issues, known as ESG.

The three forces are interrelated. To achieve its goal of carbon neutral by 2060, Chinese policy makers put restrictions on factories last fall—which resulted in a power shortage that disrupted already tight supply chains and spurred inflation. 

Europe, meanwhile, is facing fuel shortages that could cause blackouts this winter, in part because of its increasing reliance on wind energy and too few windy days in the past year.

In the U.S., alternative energy is in short supply, creating a backdrop for higher prices, thanks to two forces: Demand for alternative energy has increased while big commodity companies have underinvested in their businesses for years. 

That has created a shortage of old-school commodities like oil and copper. 

Expect these shortages to continue as companies and countries around the world invest heavily in renewable energy, decarbonization, and efforts to make buildings more energy efficient.

Investors have also increased their scrutiny of business practices, making it harder to mine for commodities that are already in short supply. 

Rio Tinto CEO Jean-Sébastien Jacques and other senior executives resigned after the company blew up a 46,000-year-old sacred Aboriginal site in Australia to mine iron ore. 

Likewise, the best copper deposits have already been discovered, with remaining areas in locations rife with ESG constraints, says Calvert ESG Senior Research Analyst Suleyman Saleem.

Such challenges have dissuaded energy and mining companies from funding big projects or ramping up production as demand increased. 

Instead, companies have use their extra cash for share buybacks or higher dividends, adding to the supply shortages—all of which point to higher commodities prices over the long term. 

“The energy transition helps reinforce the commodities story,” says Nicholas Johnson, who oversees $19 billion in commodity and multi-asset strategies at Pimco and is a manager of the Pimco CommodityRealReturn Strategy fund (PCRAX).

Agriculture

Higher energy prices cause some agricultural commodities to rise in price, as well. 

Farmers use petroleum to power their tractors and other farm equipment, and fossil fuels are used to make fertilizer. 

The more expensive these energy inputs are, the more likely it is that farmers will plant less or raise prices on their yield, which leads to higher prices for commodities like corn, soybeans, and wheat.

Bigger trends are also at work, creating a backdrop for strong gains in agriculture commodities. 

From 2014 to 2021, the number of vegetarians in the U.S. rose 500%, increasing demand for pulses, soybeans, and alternative protein sources like nuts and avocados, says Martin Davies, president and CEO of Westchester, a Nuveen affiliate that invests directly in farmland. 

Low-carbon fuel standards in states like California, Oregon, and Washington will cause greater demand for soybeans and sugar cane, which are used in biofuels, he adds.

Climate change has made extreme weather situations—a major source of volatility—more frequent, forcing investors to rebuild their models using 10-year rather than 30-year averages. 

This underlines the need to own a broad array of agricultural commodities, Davies says; diversification will ensure that your investment isn’t dramatically affected by a single earthquake, tornado, or regulatory change.

The Technical Case

One of the factors that most excites investors is a technical feature that’s a byproduct of the broader industry backdrop: Most commodities are in “backwardation,” which means prices for a commodity tomorrow are lower than what it costs today. 

Backwardation is typically short-lived, but some investors expect it to persist, particularly in the energy market, where it is a manifestation of the energy transition, shortages, and underinvestment.

“It’s very different than in the supercycle 10 or 20 years ago, when the price of oil was $85 but no one knew where the next barrel would come from—so there was an expectation for prices to rise,” says Johnson. 

Today, the U.S. shale boom means the U.S. can increase energy supply easily, and the move toward renewables means that energy prices are headed lower in the long run.

Johnson and other managers like backwardation because prices don’t need to rise to make money—managers can earn a return just by rolling a contract over to the next one to realize an attractive “roll yield.” 

If an investor buys the front-futures contract in oil at $80 but the one-year is trading at just $74, they can buy it for $6 less, so even if the price remains the same, they have banked a 8% return. 

The average roll yield for the Bloomberg Commodity Index is about 3.3%.