Is there a road to recovery for commodities?

Posted by Fiona Liu in Portfolio management category on 21 Oct 15


Commodities

When we think about what to invest in, what’s the first thing that you think of? For me, it would either be in shares of a FTSE 100 company or a popular fund. I certainly wouldn’t say to myself “today, I’m going to invest in a barrel of oil”! You may have seen (and it’s not hard to miss given the coverage!) that oil prices have hit a new six year low. Oil is part of the commodity community and in recent years we have seen a decline in oil prices. At the first instance, you may welcome this with open arms as it means cheaper petrol, but have we thought about how oil and other members of the commodity community can affect your portfolio?

What’s all this fuss about commodities?

Broadly speaking, commodities can be split into the Energy (oil, gas), Hard (non precious and precious metals) and Soft (agricultural goods) category. The prices are reliant on the supply and demand momentum but energy and hard commodities are also affected by economic conditions. Commodity is often known as the fifth asset class (behind Equities, Government bonds, Cash and Property) and although there are specialised commodity funds such as the JP Morgan Natural Resources fund, it’s a small population in the universe of funds.

If it’s not that popular, why do oil and metals receive that much coverage? One of the reasons is that the oil and mining sector makes up around 20% of the FTSE 100 index – Royal Dutch Shell, BP and BG Group alone makes up around 13% of the FTSE 100*. Therefore, any price movements in the commodity itself can have an affect on your portfolio.

But what causes the volatility in the price?

It would not be impossible to cover all the factors that affect the different types of commodities in this blog. But to illustrate and provide a snapshot of factors that can cause volatility with regard to hard commodities, I will use Gold as a shining example.

Gold is a special metal – although you can directly invest in Gold bullion, it doesn’t pay out dividend or interest. But investors are content with buying it because it’s considered as a safe haven and so it is used as an alternative asset class or an inflation-hedging strategy. Typically, Gold prices flourish when there is global economic turmoil or political fears e.g. slow global growth or a civil war, as people flock to Gold for safety. As shown in the graph below, from the beginning of 2008, there was a continual increase in the performance of Gold shortly after the 2007/2008 financial crash.

Commodities Graph

There is usually a negative correlation between interest rates and Gold prices – when interest rates are high, investors are likely to invest in other assets classes or savings accounts as commodities such as Gold don’t pay interest. When the US cut its interest rate to 0.25% in December 2008, this would have likely contributed to the Gold price rally.

Gold (and most commodities) are priced in US Dollars. As the American economy begins to recover – (with a potential rate rise on the horizon) and the US Dollar strengthening against other currencies, this, coupled with confidence returning to the market, results in the price of Gold declining (demand falters as a stronger USD means it is more expensive to buy Gold from other currencies).

In addition to this, China’s economy (the world’s largest commodity consumer) is showing signs of slowing down which has led to reduced demand for commodities such as copper and as a domino effect prices have been driven down. The lower demand for these metals is likely to continue as China moves from a manufacturing-dominated economy towards a consumption and services led economy which suggests there may be further uncertainty concerning the prices of commodities.

The sticky situation with Oil

In recent years we have seen an over production of oil. The Organisation of the Petroleum Exporting Countries (OPEC) are big players in oil extraction – they produce approximately 40% of the world’s supply of crude oil and account for 60% of the crude oil traded worldwide**. The growth in US shale oil production has allowed the US to ramp up its oil supply – it is estimated that in 2014, shale oil production resulted in 4.2 million barrels of oil** being produced per day. As more oil is being produced (with OPEC unwilling to cut production), oil prices have been become more competitive.

As well as the increased supply of oil, demand has also been slowing down from China and other countries that are experiencing slow growth. In addition, the majority of the crude oil produced in the US is now being used to satisfy domestic demand which means that it is gradually importing less oil from other countries. The double whammy of increased supplies and reduced demand has contributed to the recent sharp falls in oil prices.

How can it impact me?

Passive funds such as the HSBC FTSE 100 Index aim to replicate the performance of the index by investing into its constituents. Due to the high weighting in oil and mining companies the performance of these sectors will have a significant impact on the overall returns of the FTSE 100. Therefore, those who have invested in a passive fund that tracks the performance of the FTSE 100 index will inevitably be affected by any movements to the oil and mining sector.

Apart from passive funds, fund managers may also decide to have weightings in the oil and mining sector in their funds. For example the Standard Life Investments UK Equity Recovery fund invests 5.5% of its asset into the Oil & Gas sector and holds Glencore and BP in its top 10 holdings. The name of the fund may not indicate that they invest in commodities so it’s worthwhile looking at the factsheets to see what they have invested in.

Emerging markets that export oil and metals will also be affected by the decrease in demand and price of commodities. For example, Brazil exports commodities such as iron ore to China and Russia is a major oil exporter. Therefore, commodities can also affect investors who have invested in emerging market funds in their portfolio. Due to the recent slide in commodities prices, the Brazilian Real and Russian Ruble have weakened against the USD.

If you want to avoid the oil and mining sector, you may wish to look into ethical funds – these funds will not invest into companies that don’t pass a green screening. Consequently, they only invest in companies that are classified as ethical and oil companies typically do not make it into these types of funds.

The future of commodities

It is hard to predict when oil and metals will recover to their peak prices (if ever), but it will depend on political stability, economic growth and outlook, and the supply and demand balance. So whilst we take advantage of the cheaper petrol, don’t forget that the wider world of commodities can be a significant game player in your portfolio.


*source: FTSE group
**source: U.S Energy Information Administration

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.

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