Commodities & energy: Approach with caution

FE Analytics defines funds within the ACS Commodity & Energy Sector as those which invest the majority of their assets in commodity/energy-based securities such as precious metals, coal, gas and oil.

Since its nadir in February 2016, the sector itself has risen a very impressive 44 per cent, while over the past three years there have been three standout performers within this sector.

These are the Terra Capital - Natural Resources strategy, which has returned a whopping 105.54 per cent, the Select - Baker Steel Gold fund, which has returned 77.97 per cent, and the BT - Classic Investment BT Natural Resources strategy, which has returned 70.85 per cent.

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But what have been the drivers behind this impressive performance within the energy and commodities space?

According to Ben Goodwin, a portfolio manager/analyst at Merlon Capital Partners, the upswing in the commodities sector has been driven by a combination of Chinese credit stimulus, coupled with policies driving supply discipline.

“Chinese credit stimulus was driven as a relatively standard response by Beijing, which has now seen three strong credit impulses since the Global Financial Crisis,” Goodwin said.

“Supply policies within China have also been a significant driver of stronger commodity markets, in particular steel and coal. China has removed around 150mt of steel capacity, which enables stronger pricing, exacerbated by the removal of more than 50mt of previously unreported induction furnace production.

However, the outlook for commodities, over the near term at least, couldn’t exactly be described as rosy. Following a strong start to the year, the outlook for commodities has become increasingly challenged as multiple headwinds have started to emerge, according to Saxo Bank.

Saxo’s head of commodity strategy, Ole Hansen, said in the bank’s most recent quarterly outlook that the second half of 2019 could see crude oil initially supported by strong demand as well as continued geopolitical risks related to supply concerns from Venezuela and Iran as the deadline for the implementation of US sanctions approaches.

These concerns may, however, eventually be replaced by a shifting focus towards demand growth, which could begin to slow down among emerging market economies, Hansen said.

Merlon Partners’ Goodwin also pointed out that China’s economy, and particularly fixed asset investment, is slowing.

“Fixed asset investment has grown by 6.1 per cent year on year, which is the slowest rate of growth since 1996. Driving this is China’s desire to deleverage, with debt to GDP at levels approaching 300 per cent, which is high even for developed markets,” he said.

“Should this deleveraging effort be maintained in the face of slowing GDP growth, we can expect demand growth for industrial commodities such as iron ore, copper and aluminium, to continue to moderate.”

When it comes to gold, Saxo’s Hansen said the precious metal’s performance turned sharply lower during June as it struggled to find a defence against the stronger dollar and as Fed chair Powell maintained his hawkish stance on the continued normalisation of US rates.

Three quarters of gains were reversed after traders grew frustrated following the yellow metal’s inability to break key resistance above $1,360/oz on multiple occasions.

However, Hansen said the deteriorating outlook during June has challenged but not destroyed the bank’s positive outlook for gold.

“Gold’s negative correlation to the dollar remains a key challenge in the short term but given the short- to medium-term dollar-negative outlook, we believe this headwind will fade over the coming quarter.”

But regardless of the both the headwinds and tailwinds that may be blowing within the space, Goodwin cautions that even the largest, and most highly regarded companies operating in the commodities and energy sector can be highly cash destructive at times.

Caution is therefore warranted.

However, he said there are times when companies are trading at levels below which they do not reflect the level of cash that they can generate in normal economic conditions. And when trading at these levels, this may provide a strong rationale for investing.

Regardless, it is Goodwin’s belief that a minimum sustained exposure to the sector, without regard to valuation, volatility and its periods of cash destruction, is not an appropriate strategy.

Goodwin also pointed out that energy consumption tends to rise over time, even as economies mature. In contrast, many industrial commodities tend to require heavy fixed asset investment in infrastructure and real estate to drive growth.

“Once such a development phase is over, these commodities tend to move into oversupply, while demand for energy, such as gas and oil, can continue to rise,” he said.

“As such, a passive exposure to both can result in inferior long-term returns to investors.”

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