Given the Sharp Fall in Commodity Prices, Should Investors That Have Been Avoiding Commodity Futures Now Reverse Course?

Not yet. Commodity prices have indeed tumbled this year, with crude oil falling by one-third while prices of copper, corn, and other key commodities also declined. And while as value investors we typically look to increase exposure to an asset as prices fall, in this case it is useful to review the broader picture, including what factors drive commodity futures returns, and what factors are causing commodity prices to fall. And that broader picture (which we will sketch out below) points us toward a more neutral, less pessimistic stance on commodity futures, rather than to an outright bullish view.

We have warned for several years that commodity futures investments faced poor return prospects due to (1) overvalued commodity prices, (2) a headwind from rolling futures contracts, and (3) a lack of collateral yield. We noted in March 2011 that commodities were overvalued, and in our February 2012 market commentary Commodities: Sitting Out the Next Round? we warned that “the return prospects from commodities are unappealing” and that “investors should pare back commodity exposure from strategic target levels, in favor of natural resources equities.” Since then, both assets have been money-losers, though commodity futures have certainly delivered more pain (returning -9.3% annualized versus -3.2% annualized for the MSCI World Natural Resources Index).

So where are we now on the key factors impacting commodity returns?

1. Moderation of rich spot prices? Prices of a diversified commodity basket were roughly a full standard deviation above their post-1900 inflation-adjusted average level when we began warning about return prospects. Now the basket is sitting atop its long-term average. Check.

2. Roll-yield headwind abated? The annualized toll from rolling contracts before delivery or expiration was punitive for several years, running in the mid-to-high single digits. Over the past 12 months, it has been roughly flat. Check, sort of—with the oil futures curve having now switched back to contango, negative roll yields could return for diversified commodities indexes, and in any case substantially positive historical roll yields were a key attractant for the asset class when institutions began allocating to it a decade ago.

3. Contribution from cash collateral yields? The yield on cash remains infinitesimal. Since 1970, the S&P GSCIâ„¢ Commodity Index has returned 8.4% annualized, yet the excess return (excluding cash collateral yields) is less than 3%—this is a return stream that’s dependent on the yield from cash for long-term return generation. Fed tightening would bring higher cash yields for US investors, but the timing of this is uncertain.
Not there yet.

Setting aside the asset class’s key return drivers, what about the macroeconomic environment? Despite the unappealing return drivers in 2012, commodity demand remained intact, and supply remained tight. Today that has largely reversed. Demand growth from China is now limp for key industrial metals, while efficiency gains and tepid growth in developed markets have whacked oil demand growth. Ideal weather in the US corn belt has silos full of grain, fracking and horizontal drilling have boosted US oil production by more than 50% over the past three years, and years of robust mine development during the commodity boom could cause oversupply for copper as well. While a few years ago high prices caused some end users to ration demand and spurred production and technology investments, today’s low prices may cause some production to become uneconomic, eventually curbing supply and bringing the market back to equilibrium.

Summing up, two of our three key return drivers—spot-price valuations and roll yields—have improved materially, while cash collateral yields remain nil but might inch up in the next year or so. The macroeconomic picture is gloomy, but perhaps not gloomy enough to suggest prices of many commodities are bottoming.

Rolling these factors up, we are no longer particularly negative on commodity futures. That said, we still cannot underwrite returns that come even close to compensating investors for the volatility of the asset class (which tends to be similar to equities), and we remain unconvinced that commodity futures represent a reliable inflation hedge. While we are moving toward a neutral view on commodity futures today, rather than the explicitly pessimistic view that we have held in recent years, natural resources equities continue to offer stronger long-term expected returns from this starting point.

Sean McLaughlin is a Managing Director on the Cambridge Associates Global Investment Research team.

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