Understanding the Commodity Cycle
When trading commodities, understanding the commodity cycle is arguably the most important element in determining their future direction. This article provides an overview of the process and outlook on various commodities over the next 18-24 months.
The Best Brokers For Commodity Cycle Trading
Commodity Cycle – Key Points
- Commodities are a fast-moving asset class, with about 35% more volatility than US equities, 2.3x the volatility of the US dollar, and 3x the volatility of 10-year US Treasuries
- Commodities are more of a pure trading asset class than stocks and bonds, given they are not cash-producing or yield-generating assets, but can rather be thought of as alternative currencies subject to their own supply-and-demand forces
- All commodities go through cycles that are largely driven by the investment behavior of producers
- Identifying where each commodity is in its cycle, and ideally getting in at the start, is the key to trading them successfully
- I give my opinion as to what direction each of the main commodities is likely to trade in over the next 18-24 months (starting from January 2018)
Trading commodities is different from other asset classes in that they are predominantly pure alpha type bets. When you invest in stocks, bonds, or in carry-related forex trading, you expect to capture a spread-related compensation with regard to duration or interest rate differentials.
Namely, stocks, having no expiration (unlike most bonds) and being the most junior stakeholders in a company’s capital structure (therefore paid after bondholders in a hypothetical bankruptcy scenario), typically provide the highest return over the long-run. This is expected given investors want to be compensated for taking on more risk.
Bonds provide returns commensurate with their duration (i.e., the further the bond is from expiry, the more investors expect to be compensated), interest rate risk, and credit risk.
Carry-related forex trading involves being long a higher-yielding currency against a lower-yielding currency and trying to profit off the spread between the two.
Commodities, on the other hand, don’t have yields to speak of. Understanding where commodities should trade relies primarily on supply-and-demand analysis, rather than analysis of expected future cash flow performance as in the case of stocks and bonds.
One can also think of commodities as alternative currencies; that is, something tangible that is commonly considered of value. A common example is gold, which historically has been a common backing for a nation’s currency. Therefore, commodities can also be considered a store hold for wealth.
But given commodities are not cash-producing assets, trading them is thus largely driven by analysis of where price alone will move.
How is this done?
Well, it’s important to understand that all commodities go through an investment cycle. It roughly follows a five-step process.
The 5 Phases of the Commodity Cycle
- In phase one, a surge in demand for the commodity-related input causes it to exceed its supply. When demand outstrips supply, prices rise. This surge in demand can relate to economic growth, a surge in innovation or new industrial usage (e.g., cobalt in electric vehicles), or basic economics wherein low prices beget higher demand – and hence the old adage “low prices cure low prices.”
- As prices start rising, more producers see their margins expand or at least have the capacity for them to expand. This incentivizes larger amounts of capital spending to increase production. During this time, prices are keen to increase further. This helps to stimulate growth and inflation in the broader economy.
- As capital expenditure ramps up, capacity is increased. This brings more supply onto the market. At the same time, higher prices begin to erode market demand. For a highly in-demand commodity, high prices will encourage substitution (e.g., cobalt in lieu of lithium in electric cars; natural gas instead of coal for heating) and undermine demand through alternative channels. Demand and supply begin to equilibrate and prices start to stabilize.
- The next phase begins once supply from new production overwhelms demand and prices begin to fall.
- Once the reality of lower prices hit the market, capital expenditures must be curtailed (or discontinued entirely) to avoid producing unprofitably. This helps to drain supply from the market, creating a new equilibrium that becomes a cyclical bottom. Once this production capacity evaporates, this provides the basis for the supply constraints witnessed once the cycle turns back to stage one and repeats itself.
How This Template Applies to the Current Commodities Picture
Some commodities have longer cycles and some have smaller cycles, and some have cycles that barely move to any appreciable extent (e.g., uranium).
In oil, as of January 2018, we are in phase III of the commodity cycle, where capital expenditure in the oil sector is accelerating, rig count is increasing, and this provides the capacity for more supply to come online. Most upstream oil companies are profitable at USD$65 WTI and $70 Brent oil prices and will be encouraged to bring supply to market to take advantage of prices near three-year highs. But this forthcoming supply-side increase and demand-side erosion that occurs as price rises puts oil much closer to its cyclical top than a cyclical bottom.
For those in oil trades currently, whether that means being long oil equities, oil bonds, or the commodity itself, now would be the time to begin reducing exposure. Generally speaking, the shift from phase III to phase IV of the commodity cycle is when one might look to reduce exposure.
Trades that have been going well tend to bring the sentiment that whatever we’re trading is a good investment. However, it often means that it’s getting more expensive.
Price Outlook for Various Commodities
If I were to give a summarized rundown, here are my current thoughts (January 2018) on where various commodities are likely to go over the next 18-24 months based on the commodity cycle template used above:
- Gold (slightly)
- Silver (slightly)
Up, then Down (expected inverted U-shape price trajectory over next 18-24 months)
- Coal (both met and thermal)
- Iron ore
Down, then Up (expected U-shape price trajectory over next 18-24 months)
- Liquefied natural gas
- US natural gas
All commodities trade in cycles. Any given commodity cycle never flows perfectly as new information becomes available regarding innovations in production, evolving industrial uses, substitution effects, and price speculation from investors.
Most commodities are currently mid-cycle, which means there’s not a ton of upside (or downside) when taking into account the asset class as a whole. We can still nonetheless find pockets of the market that may be worth trading if one has the conviction that the prospective returns are high enough.
If we plot US stocks (as represented by the Wilshire 5000) versus commodity prices, stocks appear very expensive against commodities historically.
But this, naturally, is more of a consequence of stocks being historically expensive – due to years of low interest rates and central banks purchasing assets to boost their prices – rather than commodities being cheap on their own.
Disclosure: As of the time of writing, I am net long gold, and stocks and bonds involved in the business activities of oil production, exploration, and refining.