What’s in store for commodities?

By Robert J. Gorman, CFA, Chief Portfolio Strategist, TD Waterhouse

Two men discuss investment options in the commodities sector.

If you wish to focus on one commodity in particular, you can purchase ETFs tied to the prices of individual commodities.

Until mid-2008, most commodity prices — oil and gas, the metals, and the agricultural complex — had been on a steep upward trajectory for several years. The underlying support was strong, synchronized, global economic growth that stimulated demand at a time when supplies were generally low.

The commodity story

Tight supplies were the result of low commodity prices in the late 1990s, especially for metals and energy, which limited exploration and development. In other words, most of the advance in commodities this decade was a function of supply and demand.

From the fall of 2007 through mid-2008, another reason for the spike in commodity prices was “non-physical demand,” or, more simply stated, demand from investors, as opposed to users of the commodities. Hedge funds and commodity funds ploughed a rising tide of money into commodities to capitalize on the boom, pushing many prices sharply higher.

By the summer of 2008, the global credit crisis was causing economic growth to slow, reducing the demand for commodities. Hedge funds and commodity funds began to exit their positions, first to take profits and later to meet investor redemptions and reduced lines of credit. The net result was that commodity indices fell about 40% from their cyclical peak in little more than half a year.

The supply response

As demand for commodities has slackened, inventories have been growing. At the time of writing, London Metal Exchange (LME) copper inventories had been rising for 35 consecutive days, while aluminum stockpiles had been growing for 61 days. Similarly, U.S. crude oil inventories had been rising nearly every week over the past four months and natural gas in storage within the U.S. is roughly equal to last year’s level, despite cold weather that should have drawn down inventories.

There is a saying in the commodities business that “the best cure for low prices is low prices,” meaning that if prices are too low, producers will stop producing, the reduced supply will bring supply and demand back into balance, and prices will rise. We are now part-way through this process (see “On the rebound?” below).

Line graph, “On the rebound,” showing the rise and fall of the TD Commodity Price Index from 2001 to 2008, indicates that prices are expected to bounce back in 2009.

For example, the number of rigs exploring for natural gas in the U.S. has fallen 26% from its September 2008 peak in response to a steep drop in the price of natural gas. Meanwhile, Chile, the world’s largest copper producer, reduced the production of the red metal to 7.9% in December 2008 from its year-ago level, as copper prices have retreated from their cyclical peak of around US$4 to about US$1.50 at the time of writing. Similarly, OPEC has been cutting crude oil production to help reduce supply and firm up prices.

When commodities rebound

After a sharp drop from their cyclical peaks, most of the damage to commodity prices has taken place. However, soft global demand means we are likely to see some further weakness in the near term until supplies are reduced and demand firms up.

So while the turnaround will not be immediate, there are several ways you can participate when the rebound comes.

If you wish to focus on one commodity in particular, you can purchase Exchange-Traded Funds (ETFs) tied to the prices of individual commodities. To diversify a little further, you can buy an ETF linked to an index of commodities, such as the agricultural complex. In each of these cases, there is risk associated with the specialized nature of the ETF and volatility of the underlying commodity. Alternatively, you can buy a mutual fund that focuses on a particular sector, such as energy, though here too there is inescapable volatility. To diversify more and reduce volatility further, you can simply buy a broad-based Canadian equity fund or ETF, major components of which will be energy and materials, the two principal commodity groups. As always, this entails market risk, and you should conduct your own research.