Commodity prices soared during the first decade of this
century. But now the party is over. New sources of supply are
coming online just as demand from China is slowing, leading to
expectations of price declines.
Should investors shun commodity-related investments? We
dont think so. Still, the new environment will require
that investors take a more focused approach to extract
From 2001 through 2010, commodities posted double-digit
price increases year after year, with only a brief pause during
the global financial crisis. Those days are over. Decades of
underinvestment, along with Chinas unexpectedly strong
emergence, drove the so-called supercycle, which has now given
way to new dynamics.
Today significant investment combined with Chinas
growth slowdown has fueled expectations of supply surpluses and
spot price declines. While each commodity faces a unique supply-demand situation, the cases
of iron ore and crude oil highlight how investors can
effectively navigate a more challenging pricing
Chart 1: Commodity Prices Poised for Further
Iron ore is the poster child for commodity oversupply
concerns. Iron is the fourth most common element in the
earths crust, and so it is only a matter of time before
investment allows lower-cost supply of the ore to catch up with
demand likely around 2017, according to Macquarie Group.
In the meantime, higher-cost supply from Chinas coast and
smaller non-Chinese producers must plug the gap between
lower-cost supply and demand. These higher-cost mines require
prices of around $120 per metric ton (MT) to break even on a
cash basis. If prices fall too far below that level for too
long, these mines will shut down.
Spot iron ore prices are averaging more than $130/MT so far
in 2013, but we expect them to fall toward this $120/MT
marginal cost over the next couple of years. Yet despite the
likelihood of falling prices, iron ore is still an attractive
investment in our view.
Heres why. Direct exposure to iron ore prices occurs
through futures contracts. Today futures contracts for the
average spot price of iron ore in 2016 are trading at around
$100/MT. This pricing structure means that if spot prices fall
to the $120/MT marginal cost and stay there for all of 2016, an
investment in the 2016 futures contract at current levels will
produce a 20 percent gain. The investment would only lose money
if spot prices average less than $100/MT in 2016, which the
consensus believes but which our analysis suggests is highly
Crude oil also faces oversupply concerns. The application of
hydraulic fracturing and horizontal drilling to shale
formations, commonly known as fracking, is revolutionizing the
crude oil supply picture. In the U.S. alone, crude production
from shale is expected to reach 5 million barrels per day (bpd)
by 2020; thats more than the current total production of
any other country except Russia, the U.S. and Saudi Arabia (see
chart 2). Whats more, this and other marginal sources of
supply are profitable at an oil price of $85 per barrel (bbl).
Modest cost inflation brings the break-even cost to around
$95/bbl by 2016.
With spot Brent crude oil prices currently averaging about
$110/bbl, we expect prices to fall toward the $95/bbl marginal
cost over the next few years. This $95/bbl level also happens
to be the 2016 futures price for Brent crude. We think this
creates an interesting opportunity to benefit from potential
price shocks with relatively little downside.
Chart 2: Shale Production Changes Oil Supply
The downside is limited because we believe the $95/bbl
cost is more a floor than a target price. Shale well
producers are able to quickly curtail production if
oversupply pushes prices to uneconomic levels. In the event
oil is abundant, the 2016 futures are unlikely to appreciate
but they are also unlikely to fall in value.
In fact, the 2016 futures stand to benefit significantly
in the event that oil prices rise above $95/bbl because of
supply disruptions, geopolitical risk or general cost
inflation. Furthermore, such inflationary shocks would likely
hurt most equities and fixed-income investments. In our view,
this makes 2016 oil futures quite attractive from an overall
These examples show how investors can seek to generate
returns from commodities with ample medium-term supply and
likely declines in spot prices. Meanwhile, other commodities
such as copper and natural gas, with different supply and
demand dynamics, should see spot price increases, though
perhaps not on the scale of those of the past decade.