Falling commodity prices: a buying opportunity?
Commodities are currently one of the most unpopular asset class among mainstream investors, and have been for some time.
Prices have fallen at unprecedented rates, with oil dropping 55 per cent this year alone. Two weeks ago, commodities indices hit their lowest point in 13 years. The aggregate Bloomberg Commodities Index is down over 60 per cent from its 2008 peak. Since March 2009, commodities have returned -15 per cent overall. In contrast, equities have returned 215 per cent and high yield bonds 150 per cent.
“There has been no place to hide – gold, energy, industrial metals, and even soft commodities have all been weak,” says Guy Stephens, managing director of wealth management firm, Rowan Dartington.
The reasons behind this are interconnected. Growth has slowed and demand weakened in many emerging markets, most of which are major commodities consumers. An existing excess in the oil supply is projected to increase further, as Iran has begun to produce again, leaving a glut of approximately 1.5 million barrels per day.
An anticipated Federal Reserve interest rate hike will make the US dollar more expensive. As the vast majority of commodities are denominated in dollars, they will become more expensive to purchase as a result. The devaluation of the yuan earlier this month also means China is exporting deflation abroad to commodity producers and exporters.
A contrarian prospect
Given this backdrop, a number of professional investors have suggested that commodities could be a buying opportunity.
Roland Morris, strategist at asset manager Van Eck Global, made headlines recently when he announced “commodities represent great value versus the rest of the market”.
Morris’ view is shared, or at least understood, by other analysts.
Rory McPherson, co-manager of the Russell Multi Asset Income fund, says recent price action in the asset class has piqued his interest in commodities.
“Commodities have massively underperformed and are massively unloved – their paltry returns make them attractive for the contrarian investor,” he says.
Some may be interested in commodities as ‘a falling knife’. In investment parlance, ‘a falling knife’ is a security or industry that has dropped significantly in price or value, which could either rebound or continue falling. ‘Falling knives’ can be lucrative buying opportunities – but also represent a significant risk, as they may lose all their value.
Stephens believes “the value opportunity is tempting”. However, he adds a note of caution.
“Exposure should be carefully sought in high quality companies that can ride out the tough times.”
David Keir, head of research at Saracen Fund Managers, favours a stock-specific approach.
“Due to the current move away from commodities, share prices of major oil and gas, metals and mining companies can represent very good value,” he says.
“Not only are businesses like Rio Tinto and BHP Billiton still cash generative, they still pay dividends. This could represent a great buying opportunity – at some point, the market will turn, and a fortune can be made. Investors will be paid to stick around until the situation improves.”
Keir believes the combined effect of developed markets returning to growth, and assorted stimulus measures in emerging markets, will do much to counteract the current depressing influences on commodities. He expects marked increases in share prices in three to five years’ time.
Further to fall?
However, many remain sceptical of commodities, believing it is only the beginning of a major downswing. For David Jane, co-manager of Miton’s Cautious and Defensive Multi Asset funds, the worst could be yet to come.
“The current environment is not a buying opportunity, but an occasion for those holding commodities to sell,” he says.
“I’m yet to come across compelling evidence the market has reached its lowest point, beyond fluff about it ‘probably’ already having hit it; the reality is markets can always fall further – a lot further.
“Likewise, I’m waiting to hear why it is commodities will rise any time soon – and how and when, for that matter. Given the current state of the market, it could be decades before we see positive movement again.”
While appreciating the contrarian case, McPherson prefers to remain on the sidelines – at least for the time being.
“To invest in commodities we have to be comfortable with the business cycle and valuations – and we aren’t,” he says.
“Given the current environment, it’ll be very difficult for commodity prices to increase. This will be the case for the foreseeable future.”
Stephens says gold in particular faces a uncertain future, with investors questioning its established role as a hedge against inflation.
Quantitative easing programmes, put into place in the UK, US and eurozone in response to the global financial crisis, were expected to produce rampant inflation. As a result, investors piled into gold, pushing its price to a record high of £1233.84 per ounce in September 2011. However, inflation failed to materialise and the gold price has fallen 40 per cent since.
“The market nowadays seems confused over the rationale for holding gold,” says Stephens.
Investors who continue to hold commodities may draw some solace from the fact that while an equity can lose all of its worth, physical assets will always retain a certain value. Some may be attracted to investing in commodities via futures as a result.
However, McPherson warns against such a strategy.
“Investing with futures is expensive and costs about 10 per cent a year – prices have to rise by more than that just for a holder to turn a profit, and if the price stays still they keep paying 10 per cent just for holding it,” he cautions.
Jane also says developments could put the long-term prospects of traditional commodities in jeopardy.
“The rise of renewable energy is, for oil and gas investments, a disaster waiting to happen,” he says.
“We also have surfeits of copper and other key metals and a vast number of mines to extract more, but alternatives are on the way there too.”