By Jon Ruff
Commodity prices soared during the first decade of this century. But now the party’s over: new sources of supply are coming on line just as demand from China is slowing, leading to expectations of price declines. So should investors shun commodity-related investments?
We don’t think so. But it will take a more focused approach to extract commodity returns in the new environment.
From 2001 through 2010, commodities posted double-digit price increases, year after year, with only a brief pause during the global financial crisis. Those days are over. Decades of underinvestment along with China’s unexpectedly strong emergence, which drove the so-called supercycle, have given way to new dynamics.
New Dynamics Prompt Price Declines
Today, significant investment combined with China’s growth slowdown has fueled expectations of supply surpluses and spot price declines. While each commodity faces a unique supply/demand situation, the cases of iron ore and crude oil highlight how investors can effectively navigate a more challenging pricing environment.
Iron ore is the poster child for commodity oversupply concerns. As iron is the fourth most common element in the earth’s crust, it is merely a matter of time before investment allows lower-cost supply of the ore to catch up with demand—likely around 2017, according to Macquarie. In the meantime, however, higher-cost supply from China’s coast and smaller non-Chinese producers must plug the gap between lower-cost supply and demand. These higher-cost mines require prices of around $120 per metric tonne (MT) to break even on a cash basis. If prices fall too far below that level for too long, these mines will simply shut down.
With spot iron ore prices averaging over $130/MT so far in 2013, we expect prices to fall towards this $120/MT marginal cost over the next couple of years. But despite the likelihood of falling prices, iron ore is still an attractive investment, in our view.
Here’s why. Direct exposure to iron ore prices is taken through futures contracts. Today, futures contracts for the average spot price of iron ore in 2016 are trading at around $100/MT. This pricing structure means that, if spot prices fall to the $120/MT marginal cost and stay there for all of 2016, an investment in the 2016 futures contract at current levels will produce a 20% gain. The investment would only lose money if spot prices were to average less than $100/MT in 2016, which the consensus believes but our analysis suggests is highly unlikely.
Crude Oil: Opportunity to Benefit from Inflation Surprises
Crude oil also faces oversupply concerns. The application of hydraulic fracturing and horizontal drilling to shale formations, commonly known as fracking, is revolutionizing the crude oil supply picture. In the US alone, crude production from shale is expected to reach 5 million barrels per day (bpd) by 2020; that’s more than the current total production of any other country except Russia, the US and Saudi Arabia (Display). What’s more, this and other marginal sources of supply are profitable at an oil price of $85 per barrel (bbl). Modest cost inflation brings the break-even cost to around $95/bbl by 2016.
So with spot Brent crude oil prices currently averaging about $110/bbl, we expect prices to fall toward the $95/bbl marginal cost over the next couple of years. This $95/bbl level also happens to be the 2016 futures price for Brent crude. And we think this creates an interesting opportunity to benefit from potential price shocks with relatively little downside.
The downside is limited because we think the $95/bbl cost is more of a floor than a target price. Shale well producers are able to quickly curtail production if oversupply pushes prices to uneconomic levels. In the event oil is abundant, the 2016 futures are unlikely to appreciate, but are also unlikely to fall in value.
But the 2016 futures stand to benefit significantly in the event that oil prices rise above $95/bbl because of supply disruptions, geopolitical risk or general cost inflation. Furthermore, such inflationary shocks would likely hurt most equities and fixed-income investments. This makes the 2016 oil futures quite attractive from an overall risk/return perspective, in our view.
Commodities Still Combat Inflation
These examples show how investors can seek to generate returns from commodities with ample medium-term supply and probable declines in spot prices. Meanwhile, other commodities such as copper and natural gas, with different supply/demand dynamics, should see spot price increases, though perhaps not on the scale of those of the past decade.
While each commodity has a unique profile, there is a common denominator: commodities in general tend to perform well during inflation spikes, when both stocks and nominal bonds often face headwinds. Even after the supercycle, this is still the most important role of commodities in an overall portfolio allocation.
Jon Ruff is Lead Portfolio Manager and Director of Research for Real Asset Strategies at AllianceBernstein. Seth J. Masters is Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.
Disclaimer: The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio- management teams.