Extracting the Best from Natural Resources

The commodities complex provided both real returns, as well as a high hit rate, in various historical inflationary environments.

In times of inflation volatility, investors often flock to real estate, infrastructure or private investments. These asset classes may offer some degree of protection but historical data shows that natural resources rank among the most effective. Table 1 shows that the commodities complex provided both real returns, as well as a high hit rate, as defined below, in various historical inflationary environments. While the sharp inflationary spikes of recent years are likely anomalies, the low inflation environment of the past several decades is unlikely to be the norm going forward. In an environment where market and inflation volatility persists, we believe that natural resource equities can offer potential protection and real returns in various market environments.

Historical precedent shows that commodity demand destruction from economic slowdowns is more limited than generally perceived, as well as isolated to certain commodities rather than broad based.

A common argument is that a bearish economic cycle will derail commodity prices. Separating myth from reality is important here. Firstly, historical precedent shows that commodity demand destruction from economic slowdowns is more limited than generally perceived, as well as isolated to certain commodities rather than broad based. Secondly, demand tends to return to growth trends within a relatively short period of time. In many cases, the severity of commodity downturns depends as much on supply response. Furthermore, occurrences of “stagflation” – a low growth, inflationary environment – are quite rare, with the main recorded instance in the 1970s when global markets were hit by a combination of supply shock (oil embargo) and ineffective central bank policies. If the 1970s cycle serves as a precedent, commodities offered one of best offensive and defensive investments. It is also interesting to note that commodities’ outperformance in the 1970s was not isolated to the energy complex, but was rather experienced across agriculture and precious metals.

Economic cycles will rise and fall but consumption will remain a constant trend.

How can commodities outperform if economic growth is low or negative? Contrary to popular belief, natural resources demand is not as price sensitive as commonly perceived. Indeed, it is generally supply response that ends commodity cycles. When viewed through a long term, multi-decade lens, we can see that consumption of commodities (showing grains and steel as an example in Figure 1 and 2 below) trends steadily higher, with economic shocks like the Global Financial Crisis (GFC) being fairly small blips in the overall bigger picture. As an example, during the depths of the GFC, peak quarterly crude oil demand saw only a 3% decline to the trough and by 2009-2010, global oil demand had rebounded to new highs. Economic cycles will rise and fall but consumption will remain a constant trend.

One of the most important characteristics of the natural resource asset class is its low correlation to other major asset classes.

One of the most important characteristics of the natural resource asset class is its low correlation to other major asset classes. Using the Bloomberg Commodity Index as a proxy, we analysed the correlation of natural resources to both equities and bonds across various timeframes, as well as during significant market events. The low correlations are particularly remarkable from a long term perspective (when economic and/or commodity cycles are smoothed out). During extraordinary market events such as the GFC or Covid-19 pandemic, correlations with other assets can temporarily ‘go to one’ but will revert to the historic low correlation shortly thereafter.

Each commodity is exposed to a unique supply and demand dynamic that drives distinct price performance, regardless of broader systematic trends.

Dispersion is a vital feature of investing in natural resources. Each commodity is exposed to a unique supply and demand dynamic that drives distinct price performance, regardless of broader systematic trends. For example, in the broader metals and mining universe, iron ore demand will be primarily driven by Chinese property and infrastructure consumption while another metal like copper will have a more diverse set of consumption drivers such as energy transition uses. For natural resource equities, the average dispersion (measured by the average performance in the top 50% versus the bottom 50%) is close to 50% (see Figure 3). This is among the widest across asset classes and can create meaningful opportunities for active investors.

Given the size of the physical market, the daily financial market is consequently highly liquid, providing a daily and constant mark-to-market on price.

Commodities are one of the basic building blocks of the global economy and the market is long-established and developed. As of June 2023, the annual market size of oil surpassed $2 trillion (market size measured as 2022 production multiplied by June 2023 prices). The largest metals markets as illustrated by iron ore, gold and copper were $283 billion, $196 billion and $183 billion, respectively. Given the size of the physical market, the daily financial market is consequently highly liquid, providing a daily and constant mark-to-market on price. Within listed public equities, the three-month average daily traded volume for the S&P Global Natural Resources Index is estimated to be in the range of $7.5-8 billion at the time of writing.

As geopolitical tensions continue to shift and grow in the future, commodities will be increasingly ‘weaponised’ and we believe the natural resource equity complex will be one of the most effective means of hedging the resulting price volatility.

In recent years, we have seen an emergence of a multi-polar world and a slow breakdown of historical social and economic conventions. From the rise of China as an economic superpower to the increased military activism seen in Russia/Ukraine and the Middle East, there is an underlying power paradigm change. For investors, geopolitical shifts and spikes are difficult to hedge against. One overarching factor that links many geopolitical events is commodities. The natural resource world is bifurcated between the ‘have’ and ‘have nots’, with production often concentrated in the hands of a few producers. Using wheat as an example, the top 10 wheat exporters in the world account for more than 80% of total global export volumes (see Figure 5). Even more alarming, the Russia/Ukraine region accounts for between 30-40% of global total exports. Even non-traditional areas like renewables are often dominated by one or two countries. China, for example, controls most of the solar supply chain (see Figure 6), as well as other critical areas like rare earth. As geopolitical tensions continue to shift and grow in the future, commodities will be increasingly ‘weaponised’ and we believe the natural resource equity complex will be one of the most effective means of hedging the resulting price volatility.