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Volatile but fundamentally floored?

Published in Automated Trader Magazine Issue 10 Q3 2008

We continue our coverage of commodities with one man’s analysis of the long-term case for investment. David Nahmanovici delivered his analysis at IDX in London, back in June. We were in the audience.

David NahmanoviciCommodities, with their unique properties and reputation for high volatility, were once eschewed by many investors as too risky for serious consideration." So began David Nahmanovi's solo presentation in the Queen's Vault at The Brewery on the second day of IDX. Nahmanovici, manager for commodity investment solutions at Barclays Capital, had earlier asked his not-quite-capacity audience whether they were, or were intending to become, investors in commodities. The answer - a near-unanimous no to both questions - gave him perhaps more of an opportunity than he had expected.

Current enthusiasm for commodities, Nahmanovici explained, was prompted by their strong price performance, the lack of correlation between this and other mainstream asset classes such as stocks and bonds, and commodities' potential as a hedge against inflation. But the boom was having the counter-intuitive effect of obscuring the more compelling long-term case for commodity investment based on fundamentals. This, said Nahmanovici, was being "pushed aside" by increasingly strident claims that price performance was the product of speculation in commodity futures, with commodity index investment as "the main culprit".

Nahmanovici said: "We at Barclays Capital continue to believe that this is a fundamental-driven market, driven by suppliers, producers and consumers." Making the point that the negative correlation of commodities with other asset classes tends to be "very negative when you most need it," Nahmanovici added: "Even though commodities are one of the most volatile asset classes, having commodities in your portfolio reduces the overall volatility of that portfolio."

But what of those fundamentals? And first,as a way of getting to that question, is this a time to be getting into commodities, out of commodities, or sitting on your algorithms until they stop trying to trade at all?

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"The most interesting thing is, if you look at investment flows and price performance, they have not coincided." A lot of money has flowed into agriculturals, which have underperformed, but not much has gone into base metals, which have done well. "The second thing is, you can't just look at commodities as an asset class," said Nahmanovici. The priority now is to drill down, not just into sectors, but into individual commodities within those sectors.

If this suggested a progressive downturn in the degree of correlation even between individual commodities within a given sector, the big picture also seemed to suggest a significant decoupling. Nahmanovici said: "One thing we'll agree on is that it is unusual for commodities to be so strong at this stage of the cycle. Usually, commodities are highly correlated with global growth. You can see the breakdown of that relationship in 2004 and 2005, where the GSCI continues to skyrocket while the world's GDP stabilises." The same breakdown was visible at sector level: base metals could once be correlated to the US housing market; not any more. The big-picture change, argued Nahmanovici, was popularly but wrongly attributed to the dollar; to hedge funds; to index investing.

Demand was holding up, even gasoline demand in the US. "If you look at base metals, yes, 2007 wasn't a good year. Now the signs are that the worst is over. We can see demand picking up again." As to China, the key point was that any fall-off in demand in commodities, and energy in particular, had been more than offset by demand from China; Nahmanovici cited the specific examples of Chinese demand for copper and soya beans. "Chinese commodity import demand has stayed very, very strong." On the supply side, however, the IEA has consistently over-estimated oil production, said Nahmanovici, and the same applied to copper. What this meant, in practice, was that both copper and oil would in future have to be sourced from more remote locations not necessarily characterised by (for example) political stability. This led Nahmanovici to an example that he would be pressed to repeat in the Q&A at the end. Stressing that his presentation should not be construed as containing any investment advice or recommendation, Nahmanovici pointed to the Chilean copper-extraction industry, which uses very, very big trucks that roll out on very, very big tyres. Those tyres, he observed, impose a necessary lag on copper production because there is a two-year lag between a tyre order being placed and a tyre being delivered. However much worldwide demand for copper might increase, supply from Chile can't be increased until the tyres arrive for the extra trucks. "If you think that high prices are an incentive for everybody to start a copper mine, that's not sufficient."

In the Q&A, the suggestion was made from the floor that a viable strategy would be to invest in copper via a tyre manufacturer; Namanovici didn't comment. Citing a number of other production constraints (aluminium smelters are expensive, for example, while even the cost of agricultural fertiliser is rising), he said: "This market is not crazy. It continues to be dominated by fundamentals."

Finally, Nahmanovici offered two conclusions that might be drawn from his presentation. "First, there is the increasing interaction between different parts of the commodities markets. Asian living standards, climate change, carbon cost, resource scarcity, all these driving higher prices, which in turn drive other prices in a virtuous circle." Nahmanovici cited ethanol as a link between agricultural and energy markets. The second conclusion arose from Barclays Capital's own survey data. "People want more commodities exposure, and they want more active strategies."