What are commodities?
There are many types of commodities, each with different functions and properties. In Table 1, we examine some of the different types of commodities that make up the Bloomberg Commodities Index,1 which represents the broad commodities market. The index includes six unique sectors and 23 individual commodities.
Table 1: Types of commodities
Why consider commodities?
Broad commodities could be attractive to investors for several reasons.
- Potential portfolio diversification and risk management – commodities tend to have a low correlation with other asset classes, so they can help balance against the types of risks associated with equity and fixed income investments.
- Intra-asset-class diversification – broad commodities investment doesn’t rely on any single commodity. Remember that the Bloomberg Commodity Index, for example, is diversified across several sectors and many different individual types of commodities.
- More inflation resistant – commodities tend to thrive in inflationary periods, so they may offer an alternative inflation hedge to equities and fixed income, which tend to represent the majority holdings of a typical investment portfolio.
This third benefit could be especially timely considering the current US inflationary environment. Inflation has been high and rising for several months, thanks to pandemic-induced supply shocks, raw material nationalism, structural increases in demand for renewable energy metals, a decline in fossil fuel supply and, partially because of the ongoing conflict in Ukraine and resultant sanctions against Russia. While the US Federal Reserve has, and will continue to, implement interest-rate hikes in a bid to bring down inflation, it won’t disappear overnight.
When considering commodities, it’s also important to remember the risks. Supply and demand relationships with commodities may be impacted by weather, agriculture, currency movements, trade, changes in interest rates, technological developments, and political and economic events.
Overall, however, we think commodities have unique properties that make them a potentially attractive investment opportunity. And, on top of this, there are several relevant themes that could make them stand out today.
Themes that impact commodities markets
There are five important themes right now that create disruptions and opportunities in different sectors of the commodities market — the pandemic; capital access; global weather; environmental, social and governance (ESG); and Modern Monetary Theory2 (MMT).
- Pandemic: Covid-19 disrupted this sector across the board as the rapid shutdown of mobility and subsequent reopening occurred at a rate in excess of the industry’s capacity to respond.
- Capital access: investors have restricted capital access to this sector, which constrains the growth of supply and has reduced the global oil inventory, and spare production capacity.
- Global weather: extreme weather lowered hydroelectric and wind power generation and the risk remains until more progress is made on climate change mitigation.
- ESG: ESG policies could also disrupt this sector depending on whether they reduce demand for oil (from electric vehicle (EV) substitutions) more quickly than government policies discourage oil production.
- MMT: no impact at this time, however several countries are discussing large consumer handouts to offset higher fuel costs (increasing demand) and more are considering large subsidies for EV purchases.
- Pandemic: no impact.
- Capital access: no impact.
- Global weather: as major weather events become more common amid global climate change, they have the potential to disrupt supply in this sector. For example, at the time of writing, agriculture prices are near the 2011-12 highs as back-to-back years of La Niña3 (drought) conditions persist.
- ESG: more than 40% of the US corn crop is used to produce ethanol, and biofuels are a growth industry that can increase the demand for grains. Also, the push for non-chemical pesticides can lower crop yields in developing countries.
- MMT: no impact.
- Pandemic: Covid-19-related restrictions impacted both the gold and silver markets. For example, on one hand, demand for these precious metals took a hit as festivals and weddings that traditionally call for them were postponed or called off amid lockdowns. On the other hand, in light of volatility and uncertainty, demand for gold and silver increased since some investors may see these precious metals as a “haven” type of asset.
- Capital access: there are also capital access pressures on mining companies, which constrains the growth of supply.
- Global weather: no impact.
- ESG: silver is a key component in many batteries and photovoltaics, which is used to make solar panels. This theme also suggests opportunities for platinum, an important part of EV construction, and palladium, which is commonly used in automobile pollution-abatement technologies. Note that platinum and palladium are currently not in the Bloomberg Commodity index.
- MMT: the creation of money via MMT dilutes the value of that money, which can cause inflation and raise the price of gold.
- Pandemic: the Covid-19 crisis impacted all of the industrial metals early on, as manufacturers demanded less metals while they were closed and via lower metal supply as the mines shut.
- Capital access: there are also capital access issues with mining companies, which constrains the growth of supply.
- Global weather: no impact.
- ESG: transitioning toward less-fossil-fuel-dependent energy creates massive demand for copper, aluminum, nickel and zinc all of which are critical components of renewable technologies, such as EVs, wind turbines, solar panels.
- MMT: as large stimulus packages were given to consumers, they shifted demand away from services toward goods, in particular durable goods which are more metals intense.
- Pandemic: the pandemic impacted sugar, coffee and cotton by changing consumption trends. All three saw demand drop as large portions of the globe purchased less due to working from home.
- Capital access: no impact.
- Global weather: changes in global weather patterns and major weather events can disrupt the production and distribution of both sugar and coffee.
- ESG: no impact.
- MMT: no impact.
- Pandemic: for a period of time meat processors were severely understaffed due to the virus.
- Capital access: no impact.
- Global weather: disruptive weather patterns can raise animal feedstock prices causing ranchers to artificially reduce their herd.
- ESG: similar to oil, ESG policies may constrain supply. The extent that ESG reduces supply by a different amount than it reduces demand can impact price.
- MMT: no impact.
Are commodities poised for a comeback?
As the chart below shows, compared to core asset classes, broad commodities had been out of favor for the decade preceding the pandemic. However, during that time, very little was invested in future production, leaving large portions of fossil fuel and mining industry incapable of responding quickly to increases in demand.
Additionally, with major themes of raw material nationalism and increasingly volatile global weather, a diversified investment portfolio may benefit from an allocation to this alternative asset class. With continued uncertainty and persistent inflation, conditions may be in place for sustained growth that could enhance risk-adjusted returns of a portfolio.
Chart 1: Growth of $10,000 — Commodities versus other asset classes
Source: Morningstar, abrdn. Data from June 1, 2002 - May 31, 2022. Bloomberg Commodity Index = BCOM Index, S&P 500 = SPXT Index, US Bonds = Barclays US Aggregate Bond Index, MSCI World = MXWO Index. Bloomberg Commodity Index (BCOM) is a broadly diversified commodity price index. S&P 500 Index is a capitalization-weighted index of 500 stocks designed to represent the U.S. economy. Barclays US Aggregate Bond Index is a broad-based flagship benchmark measuring investment grade, US dollar, fixed-rate taxable bond market. MSCI World Index is an equity index that captures large and mid-cap representation across 23 developed markets. Past performance does not predict future performance. One cannot invest directly in an index. The performance table and graph do not reflect the deduction of taxes that a shareholder would pay on any Fund distributions or the redemption of any Fund shares. For illustrative purposes only.
1 Bloomberg Commodity Index (BCOM) is a broadly diversified commodity price index.
2 Modern Monetary Theory - The central idea of MMT is that governments with a fiat currency system under their control can and should print as much money as they need to spend because they cannot go broke or be insolvent unless a political decision to do so is taken.
3 La Niña - weather pattern that is characterized by unusually low temperatures in the equatorial Pacific Ocean and is linked to floods and drought.
*More information regarding Table 1:
- West Texas Intermediate (WTI)- refers to a specific grade of crude oil. It’s one of the main three benchmarks in oil pricing, along with Brent and Dubai Crude. It is the main oil benchmark for North American oil.
- Brent crude refers to oil that originates from oil fields in the North Sea between the Shetland Islands and Norway. It’s one of the main three benchmarks in oil pricing, along with West Texas Intermediate and Dubai Crude. It’s the most popular oil pricing benchmark.
- Reformulated Gasoline Blendstock for Oxygenate Blending (RBOB) is motor gasoline blending components intended for blending with oxygenates to produce finished reformulated gasoline.
- Ultra-low sulfur (ULS) diesel is a cleaner-burning diesel fuel that contains 97% less sulfur than low-sulfur diesel (LSD). ULS diesel was developed for improved pollution control.
- Sources Include: U.S. Energy Information Association, U.S. Department of Agriculture, Sciencenotes.org, Aluminum.org, Sugar.org
The statements and opinions expressed are those of the author and are as of the date of this report. All information is historical and not indicative of future results and subject to change. Reader should not assume that an investment in any securities and/or precious metals mentioned was or would be profitable in the future. This information is not a recommendation to buy or sell. Past performance does not guarantee future results.
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