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November 30, 2015 at 07:00 PM
Commodities have been stuck in an eight-year bear market. While the total U.S. stock market is up 68% and U.S. bonds are up 35% over that period, commodities as a group are down 37%. Still, commodities remain a major asset class with important diversification benefits.
Research magazine talked with John Love, CFA and chief executive officer of United States Commodity Funds. The firm has close to $4 billion under management.
Research: The global crash in oil prices has put a damper on oil-focused ETPs like USO. For bottom feeding contrarians, the oil market seems like an attractive area.
John Love: In the long run, supply and demand will balance and prices will start to rise again. The near term is harder to predict. Analysts were calling for the market to balance in the fall, and we’re obviously not there yet.
There is still a historic surplus over rolling five-year average inventory levels. In the U.S., producers have been cutting projects and the rig count has crashed at least as hard as oil prices, but production hasn’t decreased all that much yet. The drop in production so far — about 5% since the peak — is a blip compared to the drop in rigs. Production needs to come down a good deal more, at least another 5%, to get us back to where we were when prices began to decline in mid-2014. It seems apparent that if demand at least remains steady, the excess will start to go down, but if the global economy weakens, that could be a headwind.
In the meantime, expect continued volatility. Sophisticated traders have an opportunity to ride the ups and downs. However, I would caution investors against trying to pick an absolute bottom, especially if your view is longer term. The last few times oil prices have shown declines of this magnitude, it was a demand shock, and recoveries were v-shaped. This is a supply shock and its effect on prices has and will continue to persist longer. Also, even if we are near the bottom, establishing a position in crude oil can become more costly the longer the position is maintained. There are forces in futures markets (and corresponding costs in physical markets) that can erode returns over time.
Contrarians might be better advised to make a bet on a basket of commodities.
How has the bear market in commodities influenced people’s view of commodities investing?
Without a doubt, it has soured some people on the potential benefits of commodities. As with any asset class, people tend to overweight recent trends in their outlook for future performance. So, for example, they noticed that the typical low correlations of commodities with other asset classes broke down in the wake of the financial crisis and presumed that trend was going to continue. In fact, correlations have just about returned to long-run averages. And correlations among asset classes typically increase during times of turmoil.
Another example, in the previous decade, China seemed unstoppable and some people expected its increasing demand for commodities to never let up. That, of course, hasn’t been the case. So I wouldn’t expect the bear market to go on forever. That may seem obvious, but of course it’s harder to make an allocation to a beat-up asset class while it’s still lying unconscious on the ground. True believers in the space have hung in there as they know what commodities and smart commodity strategies can do for portfolios in the long-term.
How much of an influence are emerging markets on U.S. commodity prices?
Not as strong an influence as commodity prices are on emerging market economies and their currencies. Look at the oil-linked currencies like the Russian ruble and Brazilian real and how they’ve fared over the last year or so. But to your question, at times, emerging market struggles have certainly weighed on commodity prices in recent years. They are a significant influence, especially as a source of marginal demand. While they have shown strong correlations to commodity indices over the last ten years, returns to emerging and commodities over that time frame are very different. Some commodity indices outperform emerging markets and some underperform. It’s important to remember that emerging markets — just like commodities — are not homogenous, so you’ll have different pockets of demand for different commodities at different times. Even as China reduces demand for some commodities, India may pick up the slack and even exceed China’s demand for a number of things. Meanwhile, China’s growth may slow, but it’s not stopping in its tracks.
Commodity ETPs do not use the same product structure as traditional ETFs. Why does it matter? Tell us more.
