- Commodities prices have soared since early 2021 as demand for products and supply disruptions affected the market.
- This part of the market is subject to significant price volatility, which occurred in recent times.
- The outlook for commodity prices going forward is mixed, but there may be ways to position your portfolio to benefit from the current environment.
You may be reading more stories about inflation as we experience higher-than-average increases in living costs, and these stories often refer to “the volatile food and energy sectors.” Prices in these categories tend to be less consistent than other components of inflation because they’re tied to worldwide commodity market trends. Commodity prices have played a major role in the surging inflation rates that emerged beginning in 2021.
Commodities include a range of raw materials such as:
- Energy products including crude oil and natural gas
- Metals such as gold, silver, copper and platinum
- Agricultural products including wheat, corn, sugar and coffee
Commodities represent close to 40% of the Consumer Price Index (CPI) calculated by the U.S. Bureau of Labor Statistics. More specifically, energy represents about 7.5% of the index and food close to 14%.1 Commodity prices can add significant volatility to headline CPI numbers. At the same time, expenses like groceries, gas to fuel motor vehicles and home heating and cooling are essential costs facing consumers. Justifiably, commodity prices garner significant attention.
What is the likely direction of commodity prices going forward, and should your portfolio reflect these trends?
The fall, rise and fall of commodity prices
Commodity price trends dating back to 2020 provide a prime example of the volatility that can impact this segment of the economy. For example, crude oil prices closed at $10.17/barrel in April 2020, just as the global economy was in the midst of a virtual shutdown in the COVID-19 pandemic’s early days. That unsustainably low-price level reflected fears of far-reaching economic fallout arising from the pandemic and activity restrictions. However, emergency monetary and fiscal stimulus measures and gradual reopening resulted in an economic rebound. Oil demand steadily rose while supplies remained relatively stagnant. In early June 2022, the price of a barrel of crude oil topped $120. That lofty price level did not hold. Within two months, the price of oil dropped more than 25%, to under $90/barrel.2
“Trends in oil prices reflect supply and demand expectations for the global economy,” says Tom Hainlin, national investment strategist at U.S. Bank. “The sudden decline in the summer of 2022 demonstrated that many traders, who drive prices on the futures market for commodities, anticipated an economic slowdown in the coming months.”
Whether we realize such a slowdown, or significantly diminished demand for oil, is an open question. Other commodities, such as agricultural products and metals, followed a similar trend. “The recent slide demonstrates markets removed a ‘war premium’ related to Russia’s invasion of Ukraine,” says Rob Haworth, senior investment strategy director at U.S. Bank. “We’re also seeing signs of some decline in demand, driven by the Federal Reserve’s (Fed’s) significant interest rate hikes that began in March.” The Fed’s actions are designed to slow economic growth to combat the recent inflation surge. As an imbalance between supply and demand drove inflation higher, the Fed seeks to resolve it by creating conditions that slow demand, primarily from consumers.
The Russia-Ukraine war created a notable surge in prices for agricultural commodities. Both Russia and Ukraine are major exporters of wheat and other farm products. “A war premium occurred with the conflict,” says Haworth. “In normal times, agricultural prices are typically on an annual cycle, with prices driven by the quality of the growing season for different crops.” The “war premium” tapered off in recent months, and Haworth says the markets are now paying close attention to results of the harvest season.
“Investors are as negative about commodities right now as they have been in the last three years.”
- Rob Haworth, senior investment strategy director at U.S. Bank
Hainlin points out the geopolitical event risks relative to food supplies. “The United Nation’s World Food Index last peaked during the outbreak of the Arab Spring in 2010-2011, which accompanied significant unrest across northern Africa and the Middle East.” While the causes of the Arab Spring revolts are more complex than food prices alone, the region’s consumers are much more sensitive to food prices than in the United States, according to the U.S. Department of Agriculture. “Africa remains heavily reliant on food shipped from Russia and Ukraine, creating the potential for unrest if transportation of those supplies is disrupted,” says Hainlin. By early August, a backlog of grain stuck in Ukrainian harbors began to move after Russia, Ukraine, Turkey and the United Nations reached an agreement to open shipping lanes on the Black Sea, even as the war continues.
Metals prices dropped recently but experienced some variation in pricing trends compared to energy and agricultural commodities. “China is a major source of demand for metals, and its frequent shutdowns of major cities in pursuit of its ‘zero-COVID-19’ policy slowed demand in recent months,” says Haworth. By early summer, metals prices eased. Haworth attributes this to factors like slower car sales (as supply chain constraints, particularly for semiconductor chips, limited automobile production) and a recent decline in housing market activity. Both automobile production and home construction drive much of the demand for copper.
The short-term decline for commodity prices may hold for some time. “Investors are as negative about commodities right now as they have been in the last three years,” says Haworth. Economic trends going forward may dictate how long the negative sentiment persists.
Longer-term supply concerns
Energy demands are likely to hold up over the long term, even with the increased focus on reducing carbon emissions to combat climate change. At the same time, supplies may not change dramatically from where they stand today. “OPEC and others did not put much new investment into infrastructure that could boost production,” says Haworth. Instead, he says that increased earnings were returned to investors through dividends or stock buybacks. “In the current environment, the oil industry does not have the labor force or materials to massively restart exploration,” says Haworth.
Hainlin agrees that the current environment differs from what has been a usual trend in the energy industry. “Normally, when prices go up like we saw in recent months, producers expand capacity. Then they reach a point of overcapacity and prices drop,” says Hainlin. “This typically leads to a boom-and-bust cycle. But this time, oil producers have demonstrated significant capital discipline.” The result is that production levels are unlikely to increase significantly, which could keep oil prices elevated above average levels of recent years.
Metals may be in a less favorable position if industrial demand is driven lower due to an economic slowdown. However, Hainlin notes that if China can resume normal business activity, “that would be a tailwind to industrial metals, such as copper.”
Investor considerations around commodities
Investors often consider the inclusion of commodities in a portfolio to hedge the impact of higher inflation. Both Hainlin and Haworth say there are limited benefits with commodities investments. “It’s difficult to earn a durable return with direct investments in commodities or commodity futures,” warns Hainlin.
“The primary challenge in doing so is that historically, it’s a very volatile asset class,” says Haworth. “Investing in commodities often requires that you make two good decisions – to buy at the right time and to sell at the right time.”
Yet there are other approaches that can provide portfolio benefits in certain environments. One effective way to capitalize on today’s commodities market is through investments in infrastructure. This includes companies involved in oil pipelines, airports, cell towers, toll roads and other forms of infrastructure. “There is strong demand in many of these areas today,” says Hainlin, “but benefitting from owning these investments doesn’t always require that prices move higher. These investments also generate regular income for investors.” Hainlin says companies in infrastructure-related businesses tend to have fixed costs but realize bigger profits in times when inflation drives prices higher.
Investors should be prepared for frequent changes, both higher and lower, in commodity prices. Talk to your financial professional about the opportunities to position your portfolio more effectively to prepare for price movements in the commodities markets.
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