The popular commentary surrounding commodities is overwhelmingly negative. In the same way that investors could only imagine prices going higher in the midst of the “supercycle” — last decade's belief that the world had a structural deficit of raw materials — today the general sentiment comprises mostly fear and negativity.
Let's not forget, however, commodities is the ultimate cyclical asset, prone to dramatic booms and busts. And it has been like that for centuries: think about the tulip mania in the 1630s. But, with the right skills, one can succeed in the commodities sector. Combine a flexible approach to investing, a deep knowledge of the many distinct markets within the commodities sector and an ability to manage risks well, and the opportunity is there.
Contrary to popular belief, now is actually a great market to make money — big money.
Trends are persistent: WTI Crude (the main North-American crude benchmark) had both nine consecutive positive weeks and 10 consecutive negative weeks in the past six months. At the same time, volatility is high: WTI price volatility is in the 97th percentile since 1988, according to commodities research firm Blacklight Research. Additionally, there are fewer large market participants than in the past. Commodities hedge funds like Clive Capital, Vermillion or Armajaro, among others, have shut down or significantly reduced their involvement. Moreover, banks such as Deutsche Bank, Barclays and Credit Suisse have closed their commodity units. As a result, the pickings are richer for those who remain involved in the sector; less participation leads to more market inefficiencies. But the “long only” mentality — the idea that only rising markets are good for returns — is very prevalent and is acting as a smokescreen, preventing many from seeing the opportunities.
Today the pain inflicted by the bear market is higher than it has ever been before. On the back of the “supercycle” beginning in the early 2000s, a belief started to spread among investors that they could think about commodities in the same way they do equities or bonds. That is, that investors could allocate capital to commodities through long-only, passive strategies, because commodities — they believed — have an expected positive return over the long term similar to equities. In that manner, commodities would hedge against inflation and introduce diversification in portfolios.
While the diversification effect of this approach is close to the truth, the remainder of this strategy was misconceived and led to massive losses. To put this in perspective, the assets under management linked to commodities indexes have declined around 45% from a peak of more than $250 billion in 2011 through a combination of losses and outflows, according to Barclays Capital.
Equities and bonds are, in contrast with commodities, an exchange of cash today for an expectation or promise of cash in the future. There is a risk premium, or discount factor, that becomes the investor's expected return over the long run. And as an investor, you generally get paid for waiting.
This is less so with commodities. They are more akin to cars, or computers; they are “things.” Some of them decay, which costs money. They need to be stored somewhere and carried from place to place, which also costs money. Granted, the price might increase with inflation, just like the price of “stuff” does, but that does not mean an investor will cover the costs of carry to generate a positive return. As a reference, the total cost of carry of the Goldman Sachs Commodity index has been around 8% a year for the past 10 years.
In addition, a passive long-only investor in commodities is selling short human ingenuity. As a society, we are always looking to be more efficient, to spend less and get more. Both consumers and engineers are constantly discovering new ways to either use less of something, or to produce it at a lower cost. As a result, there is a persistent downward pressure in prices coming from progress. In the energy industry for example, the shale revolution is a great case study in which producers created a technology to economically produce oil out of fields that were not economic with the old processes. At the same time, auto manufacturers are constantly improving the fuel efficiency of the vehicles they produce. The bottom line is that passive investors in commodities pay for waiting.
