In the following Q&A, David Donora, Head of Commodities for Threadneedle Investments, addresses some of the key concerns currently facing investors in commodity markets, and explains his view of the outlook for the market.
What is your outlook for commodities for the remainder of 2014?
We are bullish on the macro outlook for the rest of 2014. The OECD countries and in particular North America, the region where economic growth is currently the strongest, and where growth is accelerating, will drive the expansion. Unless there is a significant escalation of geopolitical events we expect global growth to improve. Given that the developed world is leading the global economy, we anticipate that the expansion will be more energy intensive, and less intensive in terms of its consumption of industrial-type commodities, than if it were led by the emerging economies.
Could you elaborate on developments in the energy complex, including how the Iraqi conflict is affecting oil and how the situation in Ukraine is impacting natural gas?
We anticipate that the price of Brent will remain high at about $110 to $115 a barrel by the year end. We also foresee a continuing dislocation between Brent and West Texas Intermediate (WTI) with the latter continuing to trade at a discount of around $7-$15 a barrel to Brent.
In terms of curves this means that we expect Brent to remain in backwardation, that is to say that the prices for immediate delivery will be higher than the prices for oil five to 10 years ahead, and similarly in the short term we recognize that prices for WTI will also be in backwardation. But as oil production continues to increase in North America, we would expect to see that curve eventually flatten out.
Interestingly, when these curves are persistently in backwardation, as in the case of WTI, they tend to be a little bit more volatile than we would otherwise expect. We are seeing this phenomenon across the entire commodities spectrum. Markets are more prone to backwardation and we are long past the time of supercontango (an extreme case of contango, which is when the future price is below the current spot price). For the first time in nearly 10 years, the roll return on commodities is consistently positive.
Year to date, as of June 27, the positive roll return on the Dow Jones UBS Commodity Index was significant at +1.7% and reflects the changing shape of the commodity curves. This in turn reflects underlying demand as well as supply challenges across a number of markets, most notably energy.
Could you elaborate on how you see the natural gas market developing?
Natural gas is a component of the Dow Jones UBS Commodity Index but it is not a unified global market. Thus, the price of U.S. natural gas has no bearing on the price of international natural gas because the U.S. is unable to export natural gas into the global market. Consequently, developments in the Ukraine, for example, have no bearing on the U.S. natural gas market. The European natural gas market certainly is affected, however. But overall we believe that Europe and Russia’s interdependence is too great for there to be any long-term impact from the problems in the Ukraine, where we anticipate that the situation will be resolved diplomatically without any serious disruption to supplies from Russia into Europe. However, it could easily take the remainder of the year or longer for the crisis to be resolved.
What is your view of base, industrial and precious metals?
At the sector level we are positioned in line in base metals, as opposed to oil-based energy where we are as overweight as possible. Although we have a market weighting overall in base metals, we are significantly overweight lead and nickel and underweight copper and aluminium.
We believe lead and nickel face challenges in terms of supply and supply disruption. Lead is often mined as a by-product of gold and silver and as there has been a significant decline in the price of both precious metals, lead production has been under pressure. The price of nickel, meanwhile, has gained support from Indonesia’s decision in January to implement a ban on the export of a range of mineral ores. We expect the upward pressure on prices to continue for some time.
While we hold overweight positions in some sectors we have to hold underweights in others, since we are always fully invested in commodities. Our significant underweight in copper and aluminium results from the negative news flowing from China, whether it concerns the economy, the housing market or the financial sector. Prices are unlikely to pick up until this negative newsflow abates and there is a change in the demand dynamic in China.
However, we would expect that our underweight stance on copper, which we have held for over a year, will have run its course by the end of 2014. Indeed, longer term we believe that China will resolve the problems facing the economy and that we will consequently adopt a positive view of copper prices at some point in 2015.
We also remain underweight in aluminium because there is a significant amount of spare capacity globally. Indeed, there is the potential to boost global production by the equivalent of around 20%-30% of global demand in a relatively short period of time. Aluminium is one of the few commodities where this could be achieved.
In precious metals, we have an underweight stance towards gold and are market weight in silver. Our underweight in gold is not so much a reflection of a bearish view on the precious metal itself but more because we are increasingly bullish on the broader range of commodities and because we would expect gold to lag commodities in general in the current environment. Gold does best when, not only is there geopolitical risk, but also when we have questions about whether the U.S. dollar is functioning as a credible reserve currency. At present it is, given that the U.S. is enjoying relatively strong growth and investment is flowing into the country to fund growing manufacturing and energy production. Thus in 2013, $200 billion of investment flowed into oil production in the U.S. alone.
As a result, those investors who are looking for some form of insurance or to diversify against their own currency risk are less concerned about buying the U.S. dollar than was the case. This is certainly true of the emerging markets. Just a few years ago central banks in emerging markets were buying gold as a diversifier. However, in the past year or so emerging market central banks have focused on addressing domestic problems and have required dollars, rather than gold, to support their currencies. The amount of money withdrawn from gold ETFs over the last 12 months also indicates that investors feel increasingly confident about global growth and about the dollar’s role as the global reserve currency and thus do not require so much of the precious metal in their portfolios.
Are you anticipating continued U.S. dollar appreciation? How is/will this affect portfolio construction?
Over the past couple of years, people have been concerned about a strong U.S. dollar, which generally means weak commodity prices. But we believe this is a fallacy. North America is now virtually energy independent since oil production is increasing and demand is also flat. Consequently far fewer dollars than was the case are flowing out of the U.S. to pay for energy imports. This situation last occurred in the early 1970s and you thus need databases that run back for 40 or 50 years to have an informed opinion on likely developments going forward. We do like to look at very, very long-term trends and identify events that are significant and change commodity markets on a global basis. We believe the shale energy revolution in North America is one of those events.
At the same time as the flow of dollars out of the U.S. is slackening, there is massive demand for dollars to fund the aforementioned investment in the U.S. energy and manufacturing sectors. There is thus strong support for the dollar. However, we do not believe that this means weaker commodity prices because improving global growth, driven by the developed world with the emerging economies benefitting later, will also support commodities.
From a historic perspective how are institutional portfolios currently allocated to commodities? Are you seeing a shift towards higher allocations to commodities in institutional portfolios?
On a historical basis, I think institutional investors are currently underweight. From the European point of view that is understandable because of concern about deflation. A number of the commodity markets that took off in the first few months of this year were North American, e.g., natural gas and livestock has gained 30% this year. Thus North America, from the point of view of both consumers and industry, is beginning to experience inflation. That has not really happened in Europe yet. Consequently, we are seeing a significant increase in interest in commodities from North American institutional investors and these are investors that have historically have had between 3% and 10% of their portfolios invested in commodities. Given that U.S. equities have performed very strongly in recent years, and given that the 10-year U.S. Treasury is yielding just 2.6%, they are looking more favourably at commodities and want to increase their investment to provide an inoculation against higher inflation, to hedge against geopolitical risk and to provide diversification. In the latter respect, now that we are moving towards the end of quantitative easing, we have seen a significant decrease in the correlation of commodities to other risk assets and thus it is becoming clear once again that commodities are uncorrelated with equities and negatively correlated with bonds.
Commodity investments may be affected by the overall market and industry- and commodity-specific factors, and may be more volatile and less liquid than other investments.
Threadneedle International Limited is an FCA- and a U.S. Securities and Exchange Commission registered investment adviser based in the UK and an affiliate of Columbia Management Investment Advisers, LLC.
The Dow Jones-UBS Commodity Index DJ-UBSCI, was renamed on July 1, 2014 to the Bloomberg Commodity Index, BCOM. The Bloomberg Commodity Index is a broadly diversified index that allows investors to track commodity futures through a single, simple measure.