Precious metals, such as gold and silver, and industrial metals, such as aluminium and copper, are down 15.7% and 12.3% respectively, while energy prices are up 4.5%. Despite this recent weak performance, commodities still have a role in multi asset portfolios, but given the negative momentum, we now hold only a marginal allocation.
Hurdles
Investing in physical commodities has always presented three major obstacles: they do not generate income, they are difficult to value, and investors have to pay to store them, which eats away at the potential returns. So why invest in them?
Historically, the opportunity cost of investing in commodities has been high due to more favourable cash rates; given today’s low interest rate environment, however, this opportunity cost is now much lower. Since 1945, the average cash rate has been 6%. It currently stands below 0.5%. Furthermore, although commodities cannot be valued using traditional methods, momentum-based strategies do provide a way to establish positive and negative trends.
Since 1991, a buy-and-hold strategy investing in commodities would have generated an annual return of approximately 4.8 per cent. A momentum-based strategy, on the other hand, would have generated approximately 6.2% over the same period, and with a lower level of volatility. Finally, although storage costs can be significant, they are factored into market prices and, relative to price movement, they can be comparatively small.
Although there are many risks to investing in commodities, there are also many benefits.
Benefits
First, owning commodities in multi-asset portfolios offers beneficial portfolio diversification. Over the past five years, some commodities have had a low or negative correlation to bonds and equities. Second, commodity prices have a positive relationship with inflation. Since 1960, high and unexpected inflation has occurred nearly half the time and, over those inflationary periods, commodities have performed significantly better than equities and bonds.
Third, commodities continue to benefit from the economic growth in emerging markets. Energy consumption in Asia has been rising at 4% a year on average since 1990, and China, one of the fastest growing economies in the world, has been the largest global energy consumer since 2009; it now accounts for over a fifth of total energy consumption.
Shale changes the rules
When it comes to global energy markets there is one elephant in the room that cannot be ignored: shale energy. Shale is a non-porous rock that can be broken up by pumping in a mixture of water, sand and chemicals at high pressure to release trapped pockets of hydrocarbons (i.e., oil and gas).
Some pundits claim the rapidly growing production of shale energy in the US is a game changer for global energy markets. Recent advancements in the extraction of energy from shale have led to an explosion in US oil and gas production. Gas production has climbed by 30% since 2006, resulting in a dramatic decline in prices (from $13 per million Btu in 2008 to $4 currently). Remarkably, the International Energy Agency expects the US to overtake Saudi Arabia as the biggest energy producer by 2017, and also predicts the US will be energy independent by 2035.
Promising as that may be, there remain major challenges ahead for the shale miracle. Extracting energy out of shale requires one to five million gallons of water per shale well, raising a significant environmental issue due to the potential for shale drilling to contaminate groundwater. Another issue is shale production is generally only suitable in areas of low population density, further limiting the opportunities.
Without a doubt, the emergence of shale-derived oil and gas will have a massive impact on the energy markets. However, it is impossible to predict what that outcome will be. In energy markets, history is full of failed predictions. In the late 1990s, there was much media hype that the world was “drowning in oil” and that the oversupply would crush oil prices.
That hype proved completely inaccurate: from the late 1990s, oil prices surged from $15 a barrel to $145 a barrel over the next ten years (a +866% increase). A key lesson from this is that basing investment decisions on hype and predictions is not a prudent way to invest.
Investment implications
Investing in commodities is risky. The average swing in prices since 1991 is 3% per month. Commodities also suffered a large peak-to-trough loss of 54% during the credit crunch in 2008. While that sounds like a bumpy ride, it is not too dissimilar to that experienced by investing in equities. Irrespective of risk tolerance, preserving purchasing power should be the number one objective for all investors.
That means if inflation rises, the value of investment portfolios should also rise in order to preserve purchasing power over the cycle. As energy prices affect approximately 25% of the UK inflation basket, higher energy prices, in turn, lead to higher inflation.
Therefore, owning commodities in multi-asset portfolios helps to protect portfolios from unexpected higher inflation. As such, we would recommend holding a position, although recent negative momentum in commodities has led us to maintain a cautious view on the asset class. Should that momentum turn positive, we would look to increase our exposure.
