Commodity prices will likely show wider swings from here
September 3, 2024
Key Observations:
With the year 2024 now two-thirds complete, the S&P GSCI has produced a +5.3% total return, trailing EM bonds at +6.1% but beating world bonds at +3.3%. U.S. large cap is at +19.5%; world equities are at +16.5%.
More importantly, the S&P GSCI ends August with its strongest negative correlation against financial assets in years, as measured by the rolling two-year correlation of monthly total returns. Those coefficients are –0.24 against world equities and –0.60 against world bonds.
What does this mean? Commodities are working as a portfolio hedge against inflation and hostile markets (Gold likely works whether inflation slides, ranges, or surges, 15-Mar-2023). As global markets now warily approach the Sep 18 FOMC decision on policy rates, we continue to believe asset allocators will want to overweight commodities as a portfolio optimizer through that date and beyond. Gold, crude oil, and copper are and will continue to be the strongest drivers of commodities’ diversification benefits in what are likely to be more volatile markets than investors have become accustomed to.
Within the S&P GSCI, 16 of 24 components (67%) have produced positive ytd returns. No surprise, inflation-geared commodities are leading growth-geared commodities. The strongest performers are cocoa (+179%) and coffee (+40%), followed by gold and silver (each about +20%), and lean hogs (+19%).
WTI crude oil is next with a +12% ytd return, for 6th place out of 24 components. The oil products lag with about +4% total returns. These results reflect the precautionary boom in crude demand by refineries to make and stockpile gasoline, diesel, and other products in the event of storm-driven disruptions in an active Atlantic hurricane season. The soft returns in oil products also reflect the hot 2023-24 winter and the weak growth environment for end use, especially since mid-June.
The weakest performers in 2024 have been the row crops: corn, wheat, and soybeans (–12% to –20%). We had been sellers of those markets for several years until June; however, they are “bearish stories now becoming less bearish” as the supply-driven factors that have burdened them are now fully priced in and the risk-reward tradeoff now offers little reward for shorts or underweights. Owning them brings additional diversification benefits in equity-dominated portfolios.
Likewise, a backup in natural gas supply in the Permian Basin has caused the benchmark U.S. Henry Hub price to slump from its June high following its spectacular 100%+ advance in Spring 2024. The S&P GSCI natural gas total return is now down 28% ytd, with flat price fetching about $2.20 per MMBtu (which is also the ytd average for NG1). Be careful about complacency here. European and Asian gas markets are far stronger: they are posting new highs above $14 per MMBtu. Natural gas is likely to remain a highly volatile market as seaborne LNG channels arbitrage those geographical differences through winter 2024-25. (Implied vol in the Oct-24 (NGV4) 25-delta put is about 65%. The strike on the NGV4 25-delta call is low: $2.40.)
Absolute return PMs will still prefer to implement long strategies through commodity-related equities rather than commodities. For example, we continue to spotlight the extraordinary outperformance of the best oil and gas midstream firms in the United States. These are the operators of “the conveyor belts” now routinely shipping more than 11 million b/d of petroleum and 13 Bcf/d of natural gas into world markets, in addition to the enormous quantities of molecules they are simultaneously delivering to domestic consumers. In metals, the shares of Canadian juniors like Ivanhoe and Lundin are up 40% and 29% ytd respectively.
Compare those results to the ytd price changes in these Dec-24 futures contracts: LME Copper (+7%), CMX Gold (+17%), CMX Silver (+16%). As we have noted many times previously, miners’ shares tend to outperform the underlying commodity price changes by multiples of about 2x to 3x at this stage of the macro cycle. Current behavior across asset classes is consistent with that history for well understood economic reasons. An investor seeking to minimize idiosyncratic risk could look at the Global X Copper Miners ETF (COPX, $2.26 Bn marketcap), up 16% ytd.
In energy, generalist investors should be aware of the strong downward seasonal in gasoline prices that emerges after the U.S. Labor Day holiday. U.S. environmental regulations ease materially following the demand-intensive summertime driving season. Within the next two weeks, U.S. refiners will shift their slates toward winter-grade gasoline, which will boost available supply through increased blending of butane.
This seasonal effect is already built into the NYM RBOB futures curve. For example, on Friday Aug 30 the active Oct-24 contract closed at 209.32 cents per gallon, while the Jan-25 contract in that curve settled at 200.78 cents per gallon for a 4% discount to prompt. Retail gasoline prices at the pump typically dive by at least 10% in 4Q.
But this seasonal always seems to catch equity markets off guard. In the context of the U.S. presidential context this year, a regulatory-driven increase in gasoline supply—and attendant gasoline price decline—may attract more notice than usual among investors eager for signs of (1) easing inflation, (2) justification for a 50bp U.S. rate cut, and (3) receding strains on credit and labor.
In our conversations with clients, we also find many investors believe OPEC+ (led by Saudi Arabia) will persist in its plan to bring back idled oil supply from Oct 1 (+540 thousand b/d by end of year), in part to push down oil prices ahead of the U.S. presidential contest in exchange for a security pact or some other objective. Maybe. Whether for that reason and/or another, the options market has been assigning a 20% probability to a sub-$65 price at the Dec-24 (CLZ4) expiry. Our work has assigned about 40%, in part because we have been tracking the softness in Chinese crude runs through the medium sour physical market since late June.
Looking prospectively, the bid for physical gold is presently rooted in fear not greed. The marginal ounce of tangible demand still resides in defensive, wealth-preservation transactions in the retail markets in China. This preference for real, mobile assets is in turn lifting the CMX gold price (GC1) through the Shanghai gold futures. Gold as leader of the commodity complex (instead of energy or base metals) is not a confident setup for financial markets, underscoring the value of commodities as a portfolio hedge at this juncture.
At the same time, we are tracking new and encouraging signs for manufacturing growth. (1) There has been an incremental impulse in physical zinc demand in the past week (and further pressures to curtail physical output in China). Futures traders have noticed. They have already begun increasing their exposure to that market. (2) The global secondary balance in copper (the scrap market) is also continuing to tighten, supporting the case for owning copper. (3) In crude, the risk premia for immediate delivery of physical barrels have pulled back in the past week on the approaching seasonal drop in Northern Hemisphere refinery runs. But they are still worth more than 100 bps at the front end of the NYM curve. That’s sufficient monetary incentive for speculators to take producers’ risk off their hands.
As gasoline starts to lead lower the flat prices in the petroleum complex, remember to interpret commodities through the FICC lens not the equity lens. Term structure and the exchange of risk premia between the physical market and the paper market are why institutional investors will want to maintain net length in commodities.
Source: S&P Global, Bloomberg, Barclays, MSCI, J.P. Morgan, Russell, CME, ICE, LME, Blacklight Research.
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