The Long And Short Of Commodities

Summary

• Commodities are up sharply this year, but several short-term indicators flash caution.
• The medium-longer term bull case remains compelling.
• The chart of commodities ex-gold versus gold offers clues to near-term price action - suggesting a possible pause or correction.

Schroptschop/E+ via Getty Images

Commodities are on pace for their best annual performance of the century. 2021 has not been a straight line higher, however. There was a period of consolidation during late Q2 through much of Q3. August through mid-October featured another explosive move higher, bringing the GSCI Light Energy index to its highest level in more than seven years.

While we are long-term positive on the commodities space, there are mixed signals in the near term. Breadth has deteriorated while the chart of commodities ex-gold versus gold has gotten extended after dropping to extremely cheap readings last year. It might be time for a pause.

Featured Chart: Commodities Ex-Gold vs. Gold Comes Full Circle

Sentiment & Positioning Have Soured

Another feature that takes away from a positive near-term stance is a drop in bullish sentiment and traders’ positioning. The GSCI Light Energy Index’s consensus bulls reading was nearly two standard deviations above the long-term average at its Q2 peak. Today, the market is less frothy with consensus bulls sporting a Z-score under one. So, while prices have gone up, there is a negative sentiment divergence.

Futures positioning shows a similar decoupling. There are fewer speculative net longs in commodities today versus the middle of the year. Excitement has dropped. Perhaps traders are losing interest in commodities as the supply disruption narrative (short-term spike) overshadows the supercycle narrative (longer term bull market).

Long-term Upside Remains Likely

So, while the near-term picture has turned less encouraging, we are still bullish long term. Technically, the big breakout that took place a year ago remains alive. A similar breakout occurred in the early 2000s which led to a massive bull run, eventually taking the GSCI Light Energy Index from under 200 to 650. For perspective, the index finished October at 520 as it ventures back into the range from 2010 to mid-2014.

Valuations remain compelling, too. Our Commodities Composite Valuation Indicator dropped nearly two standard deviations below its long-term average last year and has now recovered back to neutral. That suggests no barrier to higher prices based on a valuation argument despite the 46% year-on-year rally.

The Supercycle May Be Just Beginning

We assert the supercycle thesis is intact. The 10-year moving average of year-on-year returns (using the Refinitiv Equal-Weight Commodities Index) dipped negative in 2020—a dismal feat rarely seen in the EW commodities index’s 120-year history. While the 10-year moving average has crept higher in 2021, projections based on our Capital Market Assumptions dataset suggest further upside in the coming decade.

Fundamental Factors

Finally, a significant macro theme we’ve detailed this year is the dearth in commodities capex which endured a double-dip recession in 2020. While there are one-off supply disruptions in play, the bigger picture theme of extended underinvestment in commodity supply persists. A capex boom—driven by energy firms themselves, the green & EV movements, and increased public infrastructure investment—is likely, which is a source of demand for commodities.

Bottom line: We took a bullish stance on commodities in March 2020 with a timeframe of 3-5 years. Our latest Weekly Macro Themes report reiterates the stance but reduces the conviction level based on some near-term mixed signals. The long-run bullish drivers are still there: underinvestment in supply, a robust capex outlook, and continued improvement in global demand for commodities.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Comments

[oilisgoingupsoon]

Remember the long cycle investments in oil and gas have not started back. Long cycle means new exploration and production (from new offshore discoveries and LNG facilities and anything needing a new pipeline or tanker) is more than 4 years away. Even short cycle projects in shale take 6 months to ramp up. Russia/Qatar now in control of world wide gas prices and OPEC back in control on crude prices. US shale are price takers and activity will respond once balance sheets are repaired...but with no wall street loans, ramp up will be tied to cash generation. But because many small producers hedged away profits...cash gen will not improve for at least 6 months.

[Topdown Charts]

@oilisgoingupsoon Indeed, and similar situation for metals, etc. Along with that you now have ESG/political constraints that will no doubt slow down or complicate approvals of new projects

[DrT]

Your articles keep getting better and are essential reading. I've noticed other authors incorporating you charts into their columns.

[Topdown Charts]

@DrT awesome, love to hear this. Thanks!

[naples]

Everytime we r in late stage bull cycle...we get the commodities super cycle talk.. was more convincing last time w China industrialization

[Topdown Charts]

@naples fair call. I have been talking about the capex aspect for a while, but I still think it's important. Meanwhile, paying attention to technical risk indicators like today's chart