Commodities: The Building Blocks of the Global Economy

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1 January 11, 2013 Topic Paper December 29, 2014 PERSPECTIVE FROM PELAGOS CAPITAL MANAGEMENT Why Commodities: Commodities have the potential to provide a degree of protection from the erosive effects of inflation, offer an alternative source of alpha and add an important element of diversification. The Potential Advantage: Commodity markets and prices move primarily to their own internal dynamics of supply and demand. Essentials: What matter most are the growth rates of supply and demand, as well as the imbalances they create. Pricing Dynamics: Commodity prices reflect the here and now of today. Tomorrow, they will reflect the here and now of tomorrow. Risks: Supply is prone to disruption in a way that demand is not. The China Factor: China s influence on commodity markets differs by commodity. Structural and cyclical factors are arising that run deeper than the country s economic growth rates. Not FDIC Insured May Lose Value No Bank Guarantee

2 A Strategic Alternative Complement to Traditional Asset Classes Exposure to commodities has become an increasingly important component of many multi-asset portfolios. We believe commodities offer three important benefits: inflation protection, diversification including potentially lower correlation to traditional asset classes and potential for higher returns. The supply-demand balance is a primary driver of commodity prices. Imbalances can arise from the differing pace of these two forces as well as changes in key local markets. World commodity consumption growth has been driven largely by China, where demand remains intact despite slowing GDP growth. China s influence on commodity markets varies by commodity and includes structural and cyclical factors that run deeper than the country s economic growth rates. The longer-term secular increase in emerging and developing market demand for commodities, set against a backdrop of long lead times to achieving production growth, makes for a strong structural case for commodities. And a Multi-Asset Portfolio Building Block With interest in alternative investments rapidly growing, exposure to commodities has become an increasingly important consideration in many multi-asset portfolios, including those of investors such as pension funds that have historically focused on traditional asset classes. Considering their generally cyclical nature and price sensitivity, investors may be surprised to learn that commodities can be used as a potentially stabilizing force in a portfolio as well as a potential return enhancer. To fully appreciate their strategic and tactical value, it is important to first understand the nature of commodities. This paper is an introduction to commodities as an asset class: the role they play in the business cycle and economy; the dynamics of supply, demand and price; and the influence of the commodity consumption behemoth, China. Commodities are the basic building blocks of the global economy the raw resources and agricultural products that, through some form of processing, are transformed into consumable goods. For investment purposes, they are generally grouped into three major categories: energy, metals, and agriculture and livestock. Aside from some metals, physical commodities are not typically held as a store of value today. Instead, transactions are conducted in both physical and secondary marketplaces. Potential Investment Benefits of Commodities Exposure As a complement to traditional asset classes such as stocks and bonds, commodities offer a number of distinctive contributions to a multi-asset portfolio: Potential Inflation Protection: Relative to stocks and bonds, commodities have demonstrated a positive relationship with periods of rising inflation, which may protect against inflation s erosive effects. Commodities can be effectively used in a multiasset inflation protection strategy or as an inflation protection component of a balanced portfolio. As shown in Figure 1, changes in the Consumer Price Index (CPI) have demonstrated a positive relationship with changes in commodity prices. Figure 1: A Positive Relationship between Commodities and Inflation August 31, 2004 October 31, /04 12/05 3/07 6/08 9/09 1/11 4/12 7/13 10/14 CPI Year-over-Year Index (Left-Hand Scale) Bloomberg Commodity Index (Right-Hand Scale) Source: Bloomberg, US Bureau of Labor Statistics. Diversification: Commodities provide an opportunity to diversify a traditional portfolio of stocks and bonds across a longer-term horizon of changing economic environments. Their macroeconomic, demographic, seasonal and logistical fundamentals may manifest and interact on differing timescales. Physical balance is also influenced by behavioral elements, such as buyer fears of supply disruption. Correlation to stocks and bonds varies over time. Figure 2 illustrates three phases of commodity correlation to the S&P 500 Index and MSCI World Index: 1) range-bound, 2) driven higher by the financial crisis, and 3) signs of recalibration to lower absolute levels

3 Figure 2: Correlation under Varying Conditions As of November 30, /31/99 6/27/01 12/23/02 6/19/04 12/15/05 6/12/07 12/7/08 6/4/10 11/30/11 5/27/13 11/30/14 11/22/14 S&P 500 Index vs. Commodities MSCI World Index vs. Commodities Source: Bloomberg. Higher Return Potential: Commodity total returns are driven by three key factors: Changes in the spot, or cash, prices in the physical market Roll yield 1 resulting from changes in the shape of the forward curve 2 Collateral returns from securities held against exposure Active management of commodity exposure can potentially add value (alpha) if the manager combines skill with a solid understanding of the nature and drivers of commodity markets, as well as the context of commodities in a diversified portfolio. When combined with effective rebalancing, portfolio efficiency may also be increased. Please see Risks on page 8. The Commodity Life Cycle Though diverse in nature, most commodities share a common three-phase lifecycle; they are purchased from a producer, processed or refined by a commercial buyer and eventually sold for consumption. Despite these common pathways, however, each commodity possesses its own set of considerations and value chain. Figure 3 illustrates this three-phase process for some of the commodities commonly found in multi-asset portfolios. Figure 3: From Raw to Refined: How Commodities become Consumables Producer Commercial Buyer Consumer Energy: Natural Gas, Crude Oil Utilities, Refineries Electricity, Heat, Gasoline, Diesel, Jet Fuel Base and Precious Metals: Aluminum, Silver Manufacturers, Refineries Automobile Parts, Construction, Electrical Solar Energy, Medical Agriculture and Livestock: Soybeans Millers, Processors and Packers Vegetable Oil, Animal Feed 3

4 Figure 4: When Commodities Shine Brightest in the Business Cycle Stocks Recovery Bonds Commodities LATE EXPANSION/EARLY CONTRACTION: Typically positive for energy and industrial metals. Early contraction does not necessarily mean lack of support for commodity prices, as late expansionary usage often drains stockpiles. Business Cycle Bonds Stocks Recession EARLY RECESSIONARY PHASE: Commodities may outperform when other asset classes face headwinds based on forward-looking expectations. Commodities Source: Franklin Templeton Investments. For illustrative purposes only. Commodities are driven more by absolute levels of consumption and production than by changes in economic growth rates. The physical supply-demand balance is prone to oversupply during late recessionary periods, when stocks and bonds are typically pricing future economic recovery and the prospect for lower interest rates. Figure 4 shows performance of commodities against stocks and bonds during various phases of the business cycle. Supply and Demand Drive Commodity Markets Throughout the multiple stages between purchase of the raw material and final consumable good, supply and demand forces are constantly at play, influenced by economic conditions, seasonal trends and changes in key local markets. It is the margin made through these transformations that underpins commodity demand. Demand, however, is only one side of the commodity equation. What matter most are the growth rates of supply and demand, as well as the imbalances they create. Commodity sectors may have common drivers, but the influence of any one driver will vary, not only between sectors, but also within a given sector. Typically, economic drivers of demand have a stronger relationship with each other than with drivers of supply. Figure 5 outlines some of the more pronounced factors affecting commodity supply and demand. What matter most are the growth rates of supply and demand, as well as the imbalances they create. Figure 5: Headwinds and Tailwinds Factors Affecting Commodity Supply and Demand Commodities in General Growth of production and consumption Consumption is often more continuous than production, which results in a disproportionately larger influence on the supply side of the equation Capacity additions and closures (production and processing) Demographics and concentration of supply base Efficiency gains and substitution effects Transportation and trade policy Supply disruptions and stockpiling Grade and quality Energy Metals Agriculture and Livestock Growth rate of North American production OPEC Global refinery and processing capacity additions/closures Refining margins Weather conditions and events Source: Franklin Templeton Investments. Upstream ore and concentrate availability Production costs, especially labor and energy Downstream demand for finished goods Planted and harvested area Yield Weather events Feed cost Disease 4

5 Understanding the Risks: Supply Disruptions Supply is prone to disruption in a way that demand is not. Trade sanctions, labor and civil unrest, and geopolitical events can siphon global supply, tighten physical markets, and boost price levels. These types of events may not be supportive for other asset classes, especially if they are persistent. The effects of such disruption can be exacerbated in an environment of pre-existing physical market tightness, low stockpiles and production cost increases. When supply growth is unable to keep up with consumption growth, production must ramp up to restore balance. From the producer s perspective, success is tied to spare production capacity. When spare capacity is lacking, physical market prices may receive more support. For example, Figure 6 illustrates the rise in crude oil prices set against a backdrop of low OPEC spare production capacity. More recently, declining crude oil prices have been accompanied by an increase in OPEC spare production capacity. Supply is prone to disruption in a way that demand is not. Figure 6: Potential Influence of Spare Capacity on Price January 2000 November /00 7/01 1/03 7/04 1/06 6/07 12/08 6/10 12/11 5/13 11/14 Source: Bloomberg. OPEC Spare Capacity Thousand Barrels/Day (Left-Hand Scale) Crude Oil Price (Right-Hand Scale) During periods of ample spare production capacity, producers are able to increase production to meet demand. When spare capacity is constrained, however, producers can do little in the short- to medium-term to meet unexpected demand growth. Generally, volatility will be higher under such conditions; however, a supply-driven risk event can occur at any point in the cycle between ample spare capacity and low spare capacity Price: A Function of a Commodity s Market Commodity prices reflect the here and now of today. Tomorrow, they will price to the here and now of tomorrow. Factors affecting commodity price levels vary, from one-time events that quickly resolve, to more persistent structural and cyclical drivers. Commodities are primarily driven by fundamentals macroeconomic, demographic, seasonal, and logistical and may interact on differing timescales. Prices are more closely tied to existing economic conditions than stocks or bonds, which tend to have a longer-term outlook and discounting mechanism. Price action over the long term is best thought of as a sum of smaller, shorter-term price moves. Commodity prices reflect the here and now of today; tomorrow, they will price to the here and now of tomorrow. In contrast, stock and bond prices are more influenced by future expectations. Expectations also influence commodity prices, but in a different way. For example, procurement fears may cause commercial buyers of commodities to increase their purchases and stockpile. In such a scenario, trading of the physical commodities would continue to have an impact on price. Compared to stock and bond markets, commodity markets have limited capacity for pricing in changes of forward expectations. Seasonal fluctuations in the supply-demand balance are typically priced in the forward curve. Figure 7 illustrates forward pricing of US natural gas futures, with higher prices for peak-demand months. Figure 7: Pricing in Seasonal Demand Variation: Natural Gas Futures Curve October 2014 December 2026E USD/MMBtu /14 11/15 12/16 1/18 3/19 4/20 5/21 6/22 8/23 9/24 10/25 12/26 Source: Bloomberg. 5

6 Figure 8: Forward Curve an Imperfect Predictor of Crude Oil Prices February 2005 March 2020E Brent Forward Curve By Year, Priced on First Trading Day of Year Contract Date Source: Bloomberg. Beyond seasonal effects, the probability of other events or risks is not typically priced into the curve in a meaningful way. Moreover, commodity future prices may reveal little about the actual market price at expiry (Figure 8). The composition of buyers and sellers differs by contract expiry. Producers are more likely to hedge with longer-dated contracts, which can put pressure on the back end of the forward curve. As commodity futures move through time toward expiry, the front-month future price converges to the current supply-demand balance. Stocks simply do not possess such a pricing dynamic. Although real-time core demand is procurement for throughput needs, it is naturally influenced by near-term expectations. If an announcement is made that a production stream currently offline will soon be back online, commercial buyers may defer their purchases because of expected increased availability in the near future. Prices will be determined by the buyers and sellers on the day the production stream comes back in force, with a new set of determining factors that may make them more or less aggressive. The influence on price is derived from near-term expectations, usually measured in days and weeks, rather than years. For example, we expect the prospect for US natural gas exports in 2018 and beyond is expected to have little to no influence on prices in Understanding the Risks: Price Disruptions Although disruptive events are difficult to predict, they typically take time to reach their full effect on price levels. Low probability events can have a high impact on pricing, largely because of the practical limits of an immediate supply response. Disruptive events are difficult to predict, and typically take time to reach their full effect on price levels. Often, the risks to commodity production can affect procurement decisions and manifest in both supply and demand forces. A solid understanding of the nuances of local and global markets is essential to gauging the impact and duration of supply uncertainty. Effective research and analysis of commodity markets can uncover scenarios in which an event may have a disproportionate effect on price levels and the potential scope and duration of impact. The initial catalyst may, however, remain elusive. Supply uncertainty can bring volatility and upward price pressure to bear on commodity markets. For example, planting delays may result in grain prices being buffeted by the possibility of lower realized plantings than intended. In the energy markets, 6

7 geopolitical headlines can similarly amplify the risk premium. Risk premiums of this nature tend to subside over time as clarity is gained and the adverse impact is avoided. Price shocks can have implications that reverberate through the consumer base, and inventory rebuilding takes time. Commodities have relatively long lead times to production, and incremental supply to meet consumption growth is not always readily available. By the time production growth is able to keep pace with consumption growth, the market dynamics may have shifted. Unexpected price spikes can affect purchasing power and potentially economic growth. The China Factor China is a key economy in dictating commodity trade flows. The country has demonstrated stockpiling activities as well as forging relationships with important commodity-producing nations. We believe the rise of China will play out meaningfully across the commodity spectrum. The Compelling Case for Commodities Commodity markets and prices move primarily to their own internal dynamics of supply and demand. For many portfolio managers, that characteristic alone merits the inclusion of a commodities allocation in multi-asset portfolios. China s influence on commodity markets differs by commodity. Structural and cyclical factors are arising that run deeper than the country s economic growth rates. World commodity consumption growth has in large part been driven by China. While Chinese GDP growth may be slowing, the nation s demand for commodities remains intact, driven by urbanization and a rising middle class. China s influence on commodity markets differs by commodity. Structural and cyclical factors are arising that run deeper than the country s economic growth rates. Policies related to investment and urbanization policies will continue to be influential to consumption growth in the coming years. China s demand for commodities has been largely influenced by infrastructure spending, property markets and demographics. Urbanization and rising middle-class incomes form the backbone to consumption growth. While the pace of urbanization has accelerated, proportionately it still lags that of Brazil, Russia, and OECD members, as shown in Figure 9. Figure 9: Drawn to the City Lights: China s Rapid Urbanization Percent of Population in Urban Centers 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Brazil China India OECD Members Russian Federation Source: The World Bank: World Development Indicators. Although influenced by many of the macroeconomic and geopolitical events that affect stocks and bonds, commodity markets and prices move primarily to their own internal dynamics of supply and demand. For many portfolio managers, that characteristic alone merits the inclusion of a commodities allocation in multi-asset portfolios. That said, a deep understanding of the nature of the physical commodities, as well as the nuances of their markets, is critical to investing successfully in this asset class. In the hands of a skilled manager, commodities can potentially help protect portfolios from the erosive effects of inflation, offer an alternative source of alpha and add an important element of diversification, including potential for low correlation to traditional asset classes. With careful attention to due diligence and adherence to a disciplined investment process, the risks inherent in commodity investing can potentially be effectively managed and used to advantage. The longer-term case for investing in commodities is based on a secular increase in emerging and developing market demand, set against the backdrop of long lead times required for production growth. This structural case, combined with the nature of the asset class, suggests fertile ground going forward. ABOUT PELAGOS AND FRANKLIN TEMPLETON ALTERNATIVE STRATEGIES Pelagos is an investment management team that focuses on multialternative investment solutions using commodities. Franklin Templeton s alternative capabilities include over 90 dedicated investment professionals managing a suite of global specialized and alternative investment products, including hedge funds, real assets, private equity, debt, and multi-asset strategies and customized portfolios. Franklin Templeton uses a multi-boutique structure that allows each investment team to stay true to its style while our global platform provides a unique perspective on investing. 7

8 WHAT ARE THE RISKS? All investments involve risks, including possible loss of principal. Investing in physical commodities, either directly or through complex instruments such as commodity-linked total return swaps, commodity futures, commodity index futures and options on commodities and commodities index futures, presents unique risks, is speculative and can be extremely volatile. Market prices of commodities may fluctuate rapidly based on numerous factors, including: changes in supply and demand relationships; weather; agriculture; trade; domestic and foreign political and economic events and policies; diseases; pestilence; technological developments; and monetary and other governmental policies, action and inaction. Derivatives involve costs and can create leverage in a portfolio, which may result in significant volatility and cause the portfolio to participate in losses (as well as gains) in an amount that exceeds the portfolio s initial investment. A strategy may not achieve the anticipated benefits; and may realize losses when a counterparty fails to perform as promised. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Foreign investing carries additional risks such as currency and market volatility and political or social instability, risks which are heightened in developing countries. IMPORTANT LEGAL INFORMATION This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. All investments involve risks, including possible loss of principal. Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments ( FTI ) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FTI affiliates and/or their distributors as local laws and regulation permits. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction. Issued in the U.S. by Franklin Templeton Distributors, Inc., One Franklin Parkway, San Mateo, California , (800) DIAL BEN/ , franklintempleton.com - Franklin Templeton Distributors, Inc. is the principal distributor of Franklin Templeton Investments U.S. registered products, which are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation. 8

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