In our May 2016 Investment Commentary, we stated our opinion that the price action of all three major commodity sectors (energy, metals, and agriculture) was signaling a trend reversal in commodities, and that it was a good time to reexamine commodity allocations. Crude oil, in particular, had just made a dramatic move from the lows in late January and early February, and was up over 75% from that point. That sizable a move in what is arguably the world’s largest “market cap” physical asset was, we concluded, indicative of a cyclical change in direction, sentiment and likely subsequent performance expectations for the commodities asset class as a whole. Now that we have seen a full calendar year of positive price action (+13.35% in 2016, and +1.34% YTD**), an even stronger case can be made that we have entered a period of commodity price recoveries that is unlikely to be temporary.
The most compelling evidence is simply the historical cycle of commodity prices. Commodity prices move up and down primarily due to the very normal process of supply (production) and demand (consumption) price equilibration. Over a full cycle, increasing demand leads to higher prices, which is then met with higher and more profitable production as a response. The combination of increased production and higher prices leads to a corresponding decline in demand, and possible over-production, which is eventually followed by a decline in prices. Lower prices, in turn, lead to production destruction at the same time that demand may again be building, and the cycle begins again. Although the macroeconomic environment is certainly also a driver, this cyclical movement of commodity prices over time can be thought of as mean reverting, many times independent of economic influences (2016’s commodity performance is an example of this, having occurred without the benefit of significant positive revisions to GDP or CPI).
For this reason, when commodity investments experience a protracted price decline, this has always been followed by a period of protracted price increases. This is a normal characteristic of almost every investment class, but what we’re really interested in is the persistence of the recovery. In the case of commodities, positive performance following a trend reversal has been predominantly multi-year in duration, so consistently that for the 46 year period from 1970 to 2016 (the longest available benchmark data*), there was only one year in which a previous period of benchmark price decline was not followed by multiple years of increasing prices. While that lone year (1992) was followed by a decline in 1993, it also preceded a significant rally in the years from 1994-1996.
Another important point is that when recoveries begin, despite the initial very positive performance, commodities may still be closer to cyclical low prices than previous highs. Currently, they still average over 50% off of previous highs (see pg.4). This means that significant upside potential still exists, especially given the asymmetrical nature of return percentages in a back to break even scenario.
When an asset class returns to outperformance following multiple years of underperformance, there may be a natural tendency for some investors to either be wary of a possible false rally or think that it’s too late to reallocate because they’ve missed a genuine rally with limited further momentum. Investors should gain confidence from the fact that it is historically anomalous for commodities to exhibit a single year of positive price performance and then suddenly stop.
Chief Executive Officer