2023-08-30 12:16:26 ET
Summary
- Short-term and long-term factors are driving commodity prices in the same direction, creating an opportunity for investors.
- Supply and demand imbalances driven by the transition to sustainable energy generation and demand for EV materials could drive commodity prices higher.
- Unpredictable weather, the war in Ukraine, and the potential for reemerging inflation are also factors driving commodity prices.
Commodity prices are driven by numerous factors including supply/demand, inflation expectations, and exchange rates, among others. These factors drive prices both in the short and long term, and right now both short and long-term drivers appear to be pushing in the same direction. These dynamics create an opportunity for investors that can be captured, at least in part, through a position in the Invesco DB Commodity Index Tracking Fund ETF ( DBC ).
Short-Term And Long-Term Catalysts
Some determinants are well understood like the long-term imbalance between supply and demand for hard commodities including copper, cobalt, nickel, and other industrial metals. Demand, and ultimately prices of these commodities will be driven by the transition to sustainable energy generation, construction, and improvement of basic infrastructure globally (largely power related), and growth in the EV market globally. The transition to sustainable energy generation will require both a long time and significant resources, including basic materials and traditional energy sources.
The chart below from the IMF shows the shortfall across numerous commodities that are used in sustainable energy generation and EVs. Each point on the chart represents the estimated amount of total supply as a ratio of total demand between now and 2050. This ratio includes current growth rates in both supply and demand as well as what is projected through 2050. Figures on the Y-axis below 1.0 imply a supply shortage. In other words, while we should be able to meet our demand for lead through 2050, it appears that the supply of graphite, for example, will only be about 15% of what the expected total demand will be between now and then. Adding insult to injury is that many of these materials are only available in certain parts of the world, and creating new mining and processing capacity is not a simple, inexpensive, or quick task. It is reasonable to expect constraints of this magnitude to have real impacts on prices. To read more about this from the IMF, click here .
Supply/demand ratio, energy and non-energy demand coverage (IMF, IEA, USGS)
Unpredictable and Volatile Weather
Many soft commodities, and their prices, are subject to more short-term factors. Short-term risks include heat and drought across much of the US, the recent tropical storm in California, and generally more unpredictable weather. Much of the U.S. has experienced near or record heat this summer along with long stretches of drought in the Midwest and South.
The map below provides a glimpse of how severe this issue has become in much of the country this year. The tropical storm that passed through parts of California did provide some relief in that corner of the country.
California recently experienced its first tropical storm in 84 years, bringing with it rain and flooding that may help reservoirs, but may have adversely impacted certain crops grown in the Baja region of Mexico, California, and Arizona . While most of those crops are vegetables including tomatoes, green onions, and bell peppers that aren’t included in the commodity index, supply shortfalls from harvesting and processing disruptions could contribute to overall food costs and inflation.
Ukraine and Russia
It is not unreasonable to expect the ongoing war in Ukraine to impact the wheat and energy markets, despite the minimal impact to date. According to the UN Comtrade Database, Russia is the largest exporter of wheat globally (followed by the U.S.) while Ukraine is the fifth largest . Furthermore, as we approach fall and winter, Russia’s influence over oil and gas in Europe will re-enter the news as a significant risk factor to markets.
The first chart below shows the global price of wheat. Despite Russia’s invasion of Ukraine in February 2022, the global price of wheat has fallen (since that time). The second chart shows 25 years of price history for Brent crude oil. Like with wheat, its price peaked following the invasion of Ukraine and now trades below the level at the time of the invasion. It is not unreasonable to expect these prices to creep higher over time or to spike higher on unexpected (bad) news.
Potential for Reemerging Inflation
With growth in the U.S. potentially reaccelerating, there is a risk that inflation will resume its rise. According to the Atlanta Fed’s GDPNow estimates , GDP is expected to grow 5.9% year-over-year on a quarterly basis. While tightening monetary policy has contributed to falling inflation since the peak at around 9% in June 2022, it has done little to slow the economy. Jobs and consumer spending continue to be strong, and a rebound in GDP growth could be accompanied by higher inflation.
Monetary Policy and the Dollar
The significant and brisk monetary tightening has not had the impact one would expect after reading an economics textbook: growth is robust, employment remains strong, and even housing prices have remained resilient. While this could be a setup for a “soft landing”, it could also indicate that without more drastic measures inflation will reemerge.
As many commodities are priced in dollars, any weakening of the dollar versus a basket of other currencies would create a tailwind for most commodity prices. While this relationship is important, it is certainly secondary to supply/demand imbalances in both the short and long-term.
The chart below from the St. Louis Fed shows that the dollar has been strengthening against other currencies for much of the last 12 years. However, its strength has been waning since the peak reached last year, possibly signaling the beginning of a trend reversal toward a weakening dollar.
Hedging Uncertainty
Because the factors that drive commodity prices are global and complex, investing in commodities can sometimes provide a hedge to the unpredictable ups and downs of world events. In other words, the correlation between commodity prices and U.S. stocks is relatively low, resulting in a diversification benefit for investors.
The correlation table below from JPMorgan ( JPM ) shows the correlations across numerous asset classes. While volatile with an annualized standard deviation of returns of around 17%, the correlation coefficients well below 1.0 indicate that inclusion of commodities in portfolio construction provides a diversification benefit. The table also illustrates the typical inverse relationship between commodity prices and currencies as indicated by the -0.41 correlation coefficient.
Why Buy DBC Now?
As described above, there are short-term factors that would be expected to provide strength now, including drought in the U.S. and elsewhere, the war in Ukraine, and the approaching winter. At the same time, we have visibility of long-term price drivers and secular trends that will cause long-term demand to far outpace supply, resulting in a long runway for strength in commodity prices.
Portfolio Characteristics
DBC provides investors with exposure to a diversified basket of commodities. From the Invesco website , energy represents about 52% of fund value, followed by agricultural commodities at 23.7%, industrial/base metals at 12.6%, and precious metals at 12%. All commodity exposure is gained through futures contracts and collateralized by the Invesco Government & Agency Portfolio ( AGPXX ), the Invesco Treasury Collateral ETF ( CLTL ), and U.S. T-Bills.
Digging a little deeper into each exposure, we see that the fund has nearly 12.8% allocated to NYMEX Reformulated Gasoline, followed by a 12%+ position in each WTI and Brent crude, nearly 12% in heating oil and the remaining energy exposure allocated to natural gas. Within agricultural commodities, the largest position is in sugar, followed by soybeans, corn, and wheat. Base metal exposure focuses on copper, aluminum, and zinc. And finally, the precious metal exposure favors gold with less than 2.5% of total portfolio value dedicated to silver.
This is a broad basket of commodities subject to the supply/demand dynamics and price drivers discussed above. While not a perfect way to acquire commodity exposure, it is a suitable proxy for more complex or sophisticated strategies that involve trading in futures directly.
Recent Performance
Over the last year, the fund has declined on a total return basis, and has far underperformed the S&P 500. That said, the purpose of a position in DBC is to diversify current equity holdings and to gain exposure to rising commodity prices in the future.
Risk
The risks associated with this thesis are as numerous as the potential drivers of commodity prices. The dollar could strengthen, the U.S. and/or global economy could slow drastically causing a drop-off in demand. Long-term initiatives toward energy transition, EVs, and building/improving/replacing infrastructure could be shelved due to lack of interest or lack of capital. Without that capital spending on projects by governments and companies combined with slowing economic conditions, inflation would also likely to be a non-issue.
In terms of quantitative measures of returns and risk, the chart and table below show that DBC has been able to generate risk-adjusted returns above that of other similar funds representing diversified commodity exposure. The data for both the top chart and lower table are based on the last three years of performance and are calculated by Morningstar.
Positioning
Portfolios have direct and indirect exposure to commodities through equity holdings of all types. For example, owning shares of Exxon Mobil ( XOM ) or Chevron ( CVX ) provides exposure to oil. Owning the VanEck Gold Miners ETF ( GDX ), or a company like Archer-Daniels-Midland Company ( ADM ) provides fairly direct exposure to gold and agricultural commodity prices, respectively. But all other companies that produce tangible products including Tesla ( TSLA ), General Electric ( GE ), and many businesses within the Berkshire Hathaway ( BRK.A ) (BRK.B) portfolio, for example, provide indirect exposure, both long and short, hedged and unhedged, to commodities.
Because there is already commodity exposure within portfolios, I suggest treating DBC as a satellite or alternative position within equity allocations. Carving out 5-10% of the equity bucket improves diversification, creates an opportunity for upside, and limits the downside if commodity prices trade sidewise or even lower from here. For positions like this that are intended to be small, they are most effective with active rebalancing. This means maintaining a position weight very close to the target. For example, if the target allocation is 5% and the value jumps to 7%, it should be trimmed back down to 5% in order to capture the gains and right-size the position. Similarly, if the position slips down to 3%, it probably makes sense to add to the position to align with the 5% target weight.
Final Thoughts
I generally try to avoid being overly dramatic while presenting investment ideas. Typically hype and fear are overstated and making decisions based on those feelings results in poor investment returns. While that could be the case here, the evidence is stacking up in support of ongoing pressure on commodity supplies and prices.
The current dynamics and long-term outlook for the U.S. and global economy support the thesis for adding direct, and diversified, commodity exposure to portfolios. It will not only benefit from increasing supply/demand imbalances, but can also serve as a hedge against inflation, a weakening dollar, and general economic and geopolitical uncertainty, among other considerations.
The position suggested in this article is intended to be a small allocation carved out of equity portfolios. It is not intended to be a core position that serves as the primary driver of portfolio returns. Adding a position in DBC or similar investments should be viewed through the lens of potential risk and reward and the impact on long-term expected total returns.
Thank you for reading. I look forward to seeing your feedback and comments below.
For further details see:
DBC: Benefit From Short-Term And Long-Term Commodity Price Drivers