Commodities starting to pull away from market bottom

The saying that everybody has a price is beginning to ring true in the commodities sector, with some investors convinced the asset class is, in parts, becoming attractive.

Commodities have rallied so far in 2016. The Bloomberg Commodities index returned 9.12% for the year through Aug. 16, a significant turnaround from the 24.7% loss the index produced in all of 2015.

And it seems institutional investors have taken note. Data from provider EPFR Global show institutional investors pumped $37.7 billion into commodity funds in 2016 through Aug. 12, compared with net outflows of $6.7 billion in all of 2015, and $5.8 billion in 2014. The year before, 2013, was even more spectacular, with institutional investors pulling a net $35.8 billion from commodity strategies.

While sources acknowledged a lot of the investment so far in 2016 will have been related to gold, and its reputation as a safe place to hide as central bank policy drags returns and interest rates further toward zero, some said pockets of opportunity are appearing.

“Things are shaping up significantly whereby a bull market will begin to gain momentum in the next six months to a year,” said David Donora, London-based executive director and head of commodities at Columbia Threadneedle Investments. “From a fundamental perspective right now, it is hard to find commodities that we want to underweight — there are bull stories across energy, metals and agriculture.”

While Mr. Donora is positive for the future, he thinks it will be awhile before investors can truly put the downturn in the commodities cycle behind them.

“It has been my view for the last year that we are in the bottoming phase of the commodities cycle, and while commodities bounce along at the bottom, low prices destroy future production. Low prices also create new demand. We have seen that happening in metals, agriculture and oil. That is the place we are at now.”

Matthew Tillett, London-based U.K. equities portfolio manager at Allianz Global Investors, said there are two factors in thinking about commodities: supply and demand. A number of elements contribute to those factors, particularly on the supply side — such as the abundance of the resource in the earth's crust, technological advances and the quality of assets.

“The historical drivers on the demand side are much easier to understand; they have always tended to go up with more economic growth and more industrialization,” said Mr. Tillett. Some of the demand element is commodity specific, such as copper, which will be in need as electric vehicles become more mainstream. “I think about all those factors and try to look at individual commodities and where they are in relation to those different factors. I have been arguing for a couple of years that the outlook is quite different depending on where you look. Historically, all commodities tended to move in tandem with each other, but going forward I can see different outlooks. Looking forward, the demand side is harder to understand due to the distortion of Chinese demand, which affects bulk commodities like iron ore more than it does for oil.”

But there is also disparity in outlook on the supply side, with oil a prime example. To say the price has fluctuated is an understatement: Currently hovering around the $40-a-barrel mark, the price of oil hit $108 per barrel mid-2014, and fell to below $30 per barrel in February.

“We see a deficit coming soon with oil as (capital expenditure) has been cut,” in particular as producers were battered by competition from advances in the technology to obtain shale, said Mr. Tillett. “It is difficult to see how the market will not go into deficit soon, and when it does the oil price will need to move to a level that incentivizes supply. It is important to understand that if you have a depleting asset and need to meet future demand, you have to have a price in the market that works for the providers of capital” to the producers. “That is why ... I am more confident we are through the bottom in oil than any of the other commodities.”

The strategies Mr. Tillett runs — which have a combined £60 million ($78.4 million) in assets — reflect the better outlook for oil. These portfolios have maintained a “relatively high” allocation to oil companies, at 15%. “In contrast the allocation to mining companies has been reduced into the strong rally this year and now stands at around 3% to 4%,” he said.

Concern over an oil deficit is shared by Matthew Michael, product director, emerging markets debt and commodities at Schroders PLC in London. “We expect a deficit in the oil market at some point — probably by midpoint next year. That is being increasingly acknowledged. It is not that difficult to conclude we are heading to a point in time where the oil price will have to rise to $65 or $70 a barrel in the coming months to sustain future investment. These are exactly the times when investors probably want to start looking to commodities,” said Mr. Michael.

However, T. Rowe Price & Associates Inc.'s Shawn Driscoll, Baltimore-based portfolio manager, global natural resources strategy, said in an August analysis note that the commodity down cycle might have another decade or more to run, notwithstanding the recent rally in energy prices and stocks. Of oil, he doesn't see a rebound in price. “While nominal prices below $40 per barrel are probably unsustainable for many producers, the all-in breakeven costs of the lowest-cost producers are in the $50 per barrel range and falling, so the supply destruction needed for a sustained oil price recovery will not be easily achieved,” Mr. Driscoll wrote. He said T. Rowe executives believe the current situation for oil and commodity prices “resembles the 20-year bear cycle in the 1980s/1990s,” due in part to North American shale.

But sources said interest in commodities is increasing, with macro issues potentially pushing investors toward the asset class.

Koen Straetmans, senior strategist, multiasset, at NN Investment Partners, The Hague, Netherlands, said the firm's multiasset strategies moved to a neutral position on commodities a couple of weeks ago, from underweight.

Other money management executives said that while they have seen a lot of interest in commodities strategies, they have not seen the inflows.

“We have seen a pickup in conversations, but not really any sign yet that the change in allocation has started to occur,” said Schroders' Mr. Michael “That is partly because people believe the prices are up and it is done, and maybe that” they were burnt in the previous cycle.

But a pickup in the global economy could bolster interest in the asset class, especially as fears of inflation begin to creep back onto investors' radars. “In terms of real assets or inflation hedge, (commodities) is probably the best opportunity. It is liquid, transparent and functions well, and there are lots of routes into the asset class. There is a growing interest, but in my mind it will probably take a little more of markets going up before we see people allocating once again,” said Mr. Michael.

Columbia Threadneedle Investments' Mr. Donora expects to see a rotation out of bonds and into commodities, especially given that commodities are negatively correlated with bonds. “(Investors) are getting increasingly worried about distortions around the world that central banks are creating ... It is a pretty obvious trade to reduce allocation to bonds, and put in some hard assets - and that includes commodities,” he said.

NNIP's Mr. Straetmans said a move toward fiscal policy measures to bolster global economies, rather than the current monetary stimulus provided to the markets, “could lead to a broader improvement in the macroeconomic backdrop, and there commodities could benefit. And in our indicators momentum is improving in emerging markets, and that is also a more favorable backdrop for commodities.” n