Conal Gregory: Prepare for a white knuckle ride in world of commodity markets

One of the key ways to invest in the infrastructure of global economies is through commodities. They are the building blocks of an industrial society and should form part of any balanced portfolio.

The Buzzard oil field in the North Sea   Photo: Danny Lawson/PA Wire.
The Buzzard oil field in the North Sea Photo: Danny Lawson/PA Wire.

The term is obviously a catch-all which spans a wide range of underlying assets which have different characteristics. From base to precious metals and oil to soft commodities, it can be an exciting if often volatile sector.

The most popular investment routes are:

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Individual quoted companies

Collectives, notably investment trusts

Trackers which replicate an index.

“Commodity markets have certainly provided investors with a white knuckle ride in recent years with significant volatility in energy and metal prices,” says Jason Hollands from Tilney Investment Management.

When investing in commodity equities, not only is this a directional bet on the commodity price itself, but also the ability of management teams to generate positive returns and free cash. “Commodity equity valuations have rarely looked so cheap compared to the broader market,” says Phillip Wond, investment manager at Leeds stockbroker Redmayne Bentley.

China is the key nation regarding commodity markets and the driving force behind the so-called ‘commodity super-cycle’ which ran from 1999 to 2008. This phase of rapid industrialisation with an associated massive expansion of infrastructure and housing required the voracious consumption of resources and commodities.

However, as Chinese growth rates have decelerated since 2010, combined with a transition away from internal investment and manufacturing, the effect has been a deflationary impact on commodity prices.

At the same time, the growth of the US shale oil and gas industry has had a massive effect on energy prices, curtailing the influence of the OPEC cartel to control prices. While demand and supply in energy markets is gradually rebalancing with the scope for more stability in energy prices, a return to the days of US$100 a barrel for oil appears a long way off.

“Private investors obviously struggle to invest in physical commodities. Few have space for a hundred barrels of oil in their back garden,” quips Nick Keenan, Barclays director for wealth management. Instead he suggests a range of instruments and assets, notably oil and gas drilling firms and exchange traded funds (ETFs).

Probably most investors will have sufficient exposure to energy through their equity portfolios with Royal Dutch Shell and BP the first and third largest respectively of all UK listed companies.

Carolyn Black, associate director at investment managers Myddleton Croft, says that in terms of general commodity exposure, they are “overweight” although this is specifically in relation to gold and oil. They also favour soft commodities, meaning agricultural products.

Some argue that oil is an outdated investment and that alternative energies are the place to be. They could certainly make a good long-term strategy but oil will still be in demand for at least a decade.

Gold is still seen as a safe haven when stock markets wobble. “Given the current economic backdrop, we see gold playing a vital diversifying role in portfolios over the next 12 months,” says Black. She takes two routes: the passive physical gold ETF, which tracks the price of gold, and the more active Smith & Williamson Global Gold & Resources fund.

“There is perhaps a case to hold gold as a hedge against human stupidity – in case something unpleasant happens in the world,” says Peter Sleep, senior investment manager at Seven Investment. His firm has trimmed its gold position from five to two per cent in its 71M Balanced fund.

Darius McDermott of Chelsea Financial Services believes gold equities are still lower than they ought to be. He favours BlackRock Gold & General and Old Mutual Gold & Silver funds. To show volatility, the former is up 21.6 per cent over three years but down by 24.5 and 16.9 per cent over five and 10 years.

For security, it is always better to buy actual gold as opposed to computer-generated vehicles which simply track a price. One reputable example is the Source Physical Gold Exchange Traded Commodity, which invests in bullion housed in a secure site.

Martin Payne, chartered wealth manager and director at Brewin Dolphin in Leeds, says the mining sector is in quite a strong position at present. As a consequence, companies have been able to commit to returning cash to shareholders through share buybacks and increased dividend payments.

Yet Payne is cautious as “there remain risks that the sector could be oversupplied in the medium to longer term and therefore lower prices may be required to balance the market”.

UK-listed mining firms have also been the beneficiary of weaker sterling but with the pound beginning to make up ground against the US dollar, there is the potential for some of this strength to be reversed.

Payne’s preferred stocks in this sector are Rio Tinto and BHP Billiton as they are “more robust than their peers owing to their lower leverage (borrowing) and lower cost operations.”

Rio Tinto owns the single best large mining asset in the world at Pilbara in Australia. It should be able to show continued productivity gains. Rio currently pays a four per cent dividend yield and BHP Billiton 3.2 per cent.

Despite reports from emerging markets that demand for protein and grain is rising as their populations demand higher quality food, soft commodities have not enjoyed the strength shown by industrial ones. High inventory levels and strong seasons for crops have driven grain prices down.

As dietary patterns change, demand for meat and grains will increase but can be hit on the supply side by poor farming conditions and natural disasters.

An active fund which targets energy, metals, agriculture and livestock broadly, while being tactical and selective, is the recommended approach of Markus Stadlmann, chief investment officer at Lloyds Bank Private Banking. He tips Threadneedle Enhanced Commodities fund, which is run by a very experienced team.

Stadlmann says the consequence of three years of unproductive mines, refineries and other production facilities closing, combined with investment by oil, metal and gas producers cutting to almost zero, has reduced supply which “suggests a rise in commodity price is on the horizon”.

The metals market is excited by the emergence of electric cars as component parts are heavily dependent on specific metals.

Hollands is wary about specialist commodity funds, particularly those exposed to mining stocks as they “tend to exaggerate the swings in underlying prices as such businesses are operationally leveraged”.

He says extraction costs are high and so a modest swing in prices can lead to a far larger swing between profit and loss. Instead he favours the Investec Enhanced Natural Resources fund.

To gain flexibility, this collective can take both long and short positions and buys both shares and derivatives.

BlackRock’s Natural Resources Growth & Income with its access to a large team of analysts is tipped by Adrian Lowcock, investment director at fund manager Architas.