The problem with commodities

Gold masks

Experts see further strength in most commodities - including gold. But interest rate rises in developed countries could see gains melt away, writes Ceri Jones.

Despite the highly unusual economic conditions, the central arguments for a commodities super-cycle remain intact. Demand for commodities from major new industrial powers such as China continues to soar, while global supply is running down.


More than 90 million new middle-class consumers are joining the 21st century every year, at a time when many precious metals are disappearing fast.

Terbium, for example, which is used in fluorescent light bulbs, could be gone in two years, while indium, used in flat-screen televisions, and even silver could be exhausted in 10 years.


"We expect the bull market to continue due to increasingly constrained and limited supply, and greater demand from developing economies," says Christopher Wykes, commodities product manager at Schroder Investment Management.

"That is not to say there won’t be volatility. But, historically, bull markets in commodities run for 20 years, and as demand recovers we expect this one to be longer than average."


However, super-cycle drivers alone don’t account for the meteoric rise in many commodity prices in 2009. Quantitative easing and low interest rates, designed to avert recession, have debased the value of western cash and encouraged investors to borrow those currencies to purchase higher-yielding commodities.


Jamie Horvat, senior manager at Sprott Gold and Precious Minerals fund, who predicted gold’s stellar rise in 2009, says commodities have risen because central banks in the US, the UK, Japan and the EU are destroying the wealth of savers by forcing money into the system.

"If they continue to print money and expand money supply, hard assets should double in value," he says. "Commodities and other assets in south-east Asia are acting as an inflation hedge and carry trade. This carry trade is creating an asset bubble that will burst as soon as the central banks show even a sign of reversing interest rates."

Horvat adds: "Once rate hikes begin they will come quickly, knocking the value out of commodities such as oil and gold that have been driven far beyond fundamentals." However, he believes this scenario is some way off and that gold will first hit $2,000 (£1,227).

Inventory issue

On the demand side, there is uncertainty about inventory levels. China appears to have staged a remarkable recovery on the back of its stimulus programme, but just how much of its rising commodity inventories are being consumed and how much merely stockpiled is unclear.

This year, China has imported twice the 1.46 million tons of copper it imported last year, and molybdenum, which is used to strengthen stainless steel, is being stockpiled so massively that oversupply could dominate the market for years.

Jane Foley, research director at, says: "Some of the price rise in oil is warranted, but a year ago it was difficult to see where growth could come from in 2009, and while we’ve had more growth than expected, prices can’t continue to rally, given that supplies are as high as they are.

While gold and oil could both go higher, at some stage they will fall back and long-term gold investors could get their fingers burned."

Foley believes that, although gold will rise in the near term, as soon as investors see that the much-hyped inflation threat will not materialise, it will "drop back to $1,000 very quickly".

She adds: "One year on from quantitative easing there are no signs of inflation. Weak sterling has not imported inflation  - because manufacturers do not have enough pricing power. I worry that the significant price increases in oil, metals and other commodities will be short-lived."

Golden years?

Making money out of gold in the past year has been easy. The precious metal rose 60% in the first 11 months of 2009, from $750 per ounce to nearly $1,200. But the near-linear progression in gold can mask the volatility of some commodities and how difficult they are to call correctly.

Crude oil, for example, has been on a roller coaster ride, rising to $150 in July 2008 and plummeting to $30 in December 2008 before doubling in 2009.

While gold divides opinion, there is more confidence about industrial metals on the back of the putative recovery. "Base metals and energy could be more interesting in 2010, as they will profit from an increase in economic activities," says Peter Koenigbauer, senior commodities portfolio manager at Pioneer Investments.

"The demand for base metals will increase as a significant proportion of stimulus funds are placed in infrastructure projects. If a sustained recovery continues, we will also see an increase in the demand for energy for the transportation sector."

Some investors will respond to the diversity in this asset class by investing in a product that tracks a broad commodities index.

The S&P GSC (Goldman Sachs Commodity) and Dow Jones-UBS Commodity indices account for 85% of all commodity investment. However, these indices are 70% weighted to energy, which investors might choose to avoid.

Instant access

Exchange traded funds (ETFs) continue to proliferate, providing investors with instant access to everything from lean hogs to lead. Exchange traded commodities are different because they hold large stockpiles of the underlying commodity.

These tend to be limited to gold and silver, and other expensive metals such as palladium and platinum.

Nik Bienkowski, chief operating officer at ETF Securities, where assets under management increased threefold in 2009, says the top three ETFs recently have been gold, natural gas and broad agricultural indices, with silver and platinum close behind..

Spreadbetting offers immediate and leveraged access, and is well suited to this volatile asset class. David Jones, chief market strategist at IG Index, thinks oil offers some good short-term trading opportunities because whenever it falls to $76 it bounces back over the next few days.

He would not be surprised to see oil back above $100 in the longer term.


Among funds, JPMorgan’s Natural Resources fund is recovering after a catastrophic 2008, when it was too heavily weighted to smaller companies which were hit when many hedge funds were forced to sell.

Nearly half the portfolio is now made up of companies with a market capitalisation of more than $2 billion.

Resources shares

Among quoted resources shares, the key is to concentrate on the fundamental attractions of the business rather than the commodity price.

David Field, manager of Carmignac Commodities fund, favours the copper industry "given its more favourable higher demand versus more limited supply and lower inventory build-up compared with other metals". He likes Xstrata, Freeport and Equinox.

"With the right stockpicking, companies will be more profitable from the rise in prices. They will also prosper from good quality management and potentially more capital expenditure for development," says Field.

"Moreover,  companies can trade at levels that, compared with gold, offer an interesting leverage. We like Randgold, GoldCorp and Yamana Gold."

This article was originally published in Money Observer - Moneywise’s sister publication - in January 2010

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