Knowledge Center Archive
Commodities: Be Patient, We Expect it Will Get Better
- Commodities, led by crude oil, have experienced a historically challenging environment, but over time the situation is expected to improve.
- Supply and demand imbalances in commodities are expected to self-correct over time, with many metals and soft commodities further along than energy in the process of reaching an equilibrium state.
- SEI sees conditions improving and remains confident in diverse strategic asset allocations which include commodity exposure.
While much of the attention has focused on crude oil, commodities as an asset class have experienced one of their most challenging environments in more than 30 years. Production capacity developed during the build up to the financial crisis turned out to be excessive when global growth and demand did not bounce back to pre-crisis levels and remained sluggish for much of the following expansion. Other factors that exaggerated supply-demand imbalances include:
- Chinese demand for commodities remained strong for a period of time after the financial crisis, propping up demand and allowing imbalances to worsen. However, demand from China eventually fell away as their growth also slowed, and the Chinese economy itself entered a rebalancing phase, away from manufacturing and other commodity-intensive activities.
- New supply of oil and natural gas came online as a result of the energy boom in the U.S.
- A steadily appreciating U.S. dollar has made for an additional headwind as commodities are generally priced in U.S. dollars.
The Crude Reality
The collapse in oil prices should eventually serve as a self-correcting mechanism by reducing the current supply glut, but the path probably won’t be smooth. Major oil benchmarks have rebounded sharply since hitting lows on February 11, although it remains to be seen if the gains will be held. While it may take some time, the supply-side of the equation should correct, as the higher-cost producers scale back operations. The pace of the equalization is likely to be dictated by Saudi Arabia, as it has the greatest capacity for low-cost oil production. Oil will likely remain at a lower price as long as the Kingdom continues to pump as much oil as it can – leaving supply and demand out of balance until more producers are squeezed out.
U.S. oil production has begun to inflect lower as several higher cost shale oil producers have scaled back operations and more output declines can be expected in the months ahead, especially if prices reach a lower equilibrium. Still reduced U.S. output likely won’t move the price of oil significantly higher on its own. Of course, there is always the possibility that the Organization of the Petroleum Exporting Countries (OPEC) could reach an agreement to cut production. Indeed rumors to that effect have given support to the rally off of February’s lows. However, SEI is skeptical that a deal which cuts overall OPEC production is on the near horizon, in light of the expected expansion of output from Iran. Meanwhile, talks seem to be moving in the direction of potentially capping output at current levels. Given that production is at or near all-time highs for a number of producer countries, any potential freeze is likely to be ineffective in materially boosting prices.
In the meantime, the transfer of wealth from producers to consumers should be positive for global growth and the demand-side of the equation.
Commodities Ex-Crude Oil
Outside of oil, corrections to supply-demand imbalances are further along. Many commodities are trading below or near their cost of production. There’s compelling valuation support across every sector, and as producers continue to cut costs, reduce capital investments and delay or abandon new supply projects, the market should continue to rebalance in search of equilibrium. Production capacity across many metals has been cut, and the El Nino weather pattern has led to lower-than- usual production in many soft commodities. Prices for many of these commodities may be forming more durable bottoms. Many commodity-linked currencies also appear to be stabilizing, adding support to this view.
To put this in perspective we can look at the current valuation of commodities, in a historical context, relative to other major asset classes. Exhibit 1 shows a comparison of where commodities are currently (as of 1/31/2016) trading versus where they have historically traded, relative to expectations according to historical relationships with other assets. Based on these estimated historical relationships, the returns on commodities have fallen well below expectations in recent years. If those historical relationships still hold true, then commodities may be undervalued at current levels.
Exhibit 1: The Value in Commodities
Source: SEI, MorningStar. This represents the differential, in number of standard deviations, between actual commodity performance (as measured by the S&P GSCI Light Energy Total Return Index) and expected commodity performance. Expectation for commodity performance is based on historical relationships with other major asset classes as measured by representative Indexes. Historical relationships estimated by regression analysis of monthly data back to 1/31/1970 and as of 1/31/2016. Please see Regression Analysis Disclosure for more details.
Less Trouble in Little China
Slower growth in China has collided with the expansion in supply of commodities. While we will likely have to get used to lower Chinese growth rates, there are early signs that China’s economic slowdown is bottoming out.
- Industrial output seems to be stabilizing around 6% annualized growth.
- Property markets appear to be healing. Although new construction remains depressed due to high inventory levels, home sales recorded a double-digit gain in 2015 and prices have turned higher in a number of cities.
- China may even be having some success in balancing its economy. Retail sales growth has been running close to 10%, and although this is a slower pace than prevailed earlier in the expansion, it is still robust compared to the manufacturing sector. Auto sales recently hit a new record high of 24 million units over the 12 months ended November, representing a jump of 30% since the end of 2011.
Evidence of economic improvement in China could serve as a catalyst for a rebound in commodities later in the year.
We believe there is light at the end of the tunnel. As the impact of lower prices filters through the production side, we may see a modest recovery in commodity prices this year. 2016 will likely be an important transition year for commodities, and our confidence for a more sustained price recovery grows as we move into 2017.
Leaving the shorter-term outlook aside, SEI continues to believe that commodities have an important role to play in strategic (long-term) asset allocation. Commodities have demonstrated low correlation to many other asset classes, providing improved portfolio diversification, and the ability to hedge somewhat against unexpected inflation and event risk. While SEI’s central expectations for inflation are benign, at the moment, we also believe that the potential risk for a significant surprise in inflation is elevated. This belief, along with the overarching principles of diversification and having a realistic appreciation for the uncertainty of any outlook or forecast, may provide ample justification for maintaining commodity exposure as part of our long-term asset allocation.
Glossary of Financial Terms
- Soft Commodities: Soft commodities are generally grown (such as corn, wheat, soy beans, livestock, etc.) rather than hard commodities (oil, gold, silver, etc.) which are typically extracted.
- Standard Deviation: Standard deviation refers to a formula used to predict potential future volatility of performance. High deviation suggests the outcome could be very different from historical averages, while low suggests the outcome could be closely matched.
Regression Analysis Disclosure
Regression analysis is a statistical process that can be used to estimate the relationship between variables; in this case the relationship between commodity prices and major asset classes that represent capital markets. Regression analysis can help investors understand how the typical value of a variable (in this case commodity prices) changes when other variables (various capital markets) are varied.
SEI selected the following indexes with the intent of providing a comprehensive representation of the capital markets and commodities:
Capital Markets Indexes:
The S&P 500 Index is an unmanaged, market-capitalization weighted index that consists of the 500 largest publicly traded U.S. companies and is considered representative of the broad U.S. stock market.
The MSCI World ex U.S. Index includes developed countries, excluding the U.S.
The MSCI All Country World ex U.S. Index includes both developed and emerging-market countries, excluding the U.S.
The IA SBBI U.S. Intermediate-Term Government Bond Index is an unweighted index that measures the performance of five-year maturity U.S. Treasury bonds. Each year a one-bond portfolio containing the shortest non-callable bond having a maturity of not less than five years is constructed.
The Barclays U.S. Aggregate Bond Index is an unmanaged benchmark index composed of U.S. securities in Treasury, Government-Related, Corporate, and Securitized sectors. It includes securities that are of investment-grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $250 million.
The Barclays U.S Corporate High-Yield Bond Index is composed of fixed-rate, publicly issued, non-investment-grade debt.
The BofA Merrill Lynch U.S. High Yield Master Index tracks the performance of below-investment grade, U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
The IA SBBI U.S. 1-Year Treasury Index is an unweighted index that measures the performance of one-year maturity U.S. Treasury bonds. Each year a one-bond portfolio containing the shortest non-callable bond having a maturity of not less than one year is constructed.
The Barclays U.S. Government 1 – 3 Year Bond Index includes U.S. dollar-denominated, fixed-rate, nominal U.S. Treasury and U.S. agency bonds with maturities of 1 – 3 years.
The S&P GSCI Light Energy Index, a sub-index of the S&P GSCI, provides investors with a reliable and publicly available benchmark for investment performance in the commodity market and has less of a focus on energy than the S&P GSCI.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice and is intended for educational purposes only.
There are risks involved with investing, including loss of principal. Diversification may not protect against market risk.
Index returns are for illustrative purposes only and do not represent actual fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company. Neither SEI nor its subsidiaries are affiliated with your financial adviser.