Long-only commodity investing has been probably one of the most misunderstood asset allocation decisions in the past decade. With the end of what has been called a “super-cycle,” investors have largely fled this class—and did so after previously making it a core strategic allocation. They were bloodied by negative returns, changing risk premiums (futures contango, not backwardation), and diversification that accomplished little except diverting capital from higher-returning assets.
Commodities provide diversification because they behave differently from stocks and bonds; consequently, investing in commodities requires a different framework for analysis. The major decline in commodity prices since the financial crisis was not the result of a bubble bursting, a shift in the business cycle, or a sign that commodity financialization had ended. Rather, it reflected a shift in the fundamentals that drive commodity cycles, such as global demand, excessive capital investment, and the economic interactions of commodity-producing countries.
This book focuses on some key issues associated with market dislocations that make commodities different from other asset classes. These market dynamics often center on the tensions between large competing players and the logistics that control pricing and distribution. This focus differs from the general commodity research read by most CFA charterholders concerning the price behavior in liquid futures markets.
In this quick read, commodity expert Blake C. Clayton provides a good overview of key supply and demand issues in the varied global markets. He writes about the dynamics of commodity markets through the four major forces that influence the commodity landscape:
- the conflict between importers and exporters,
- the tension between sovereign states and private companies over market power,
- the interplay between international cooperation and nationalism in solving problems of shortage, and
- the interaction between the physical and financial aspects of modern trade.
Clayton discusses these forces or themes indirectly through a set of examples and cases. Through writing about specific commodity sectors, he shows that price swings like the super-cycle of the early 21st century are not unusual. Nevertheless, historical commodity price data show enough variation that stories of either exhaustion or ongoing innovation cannot be used to explain long-term commodity behavior.
The first case involves the long-term dynamics of metals and oil—nonrenewable commodities—around the recent super-cycle. The discussion looks at two competing long-run stories. The classic Malthusian view is that these resources will eventually run out; hence, real prices should generally increase with global growth. In contrast to the expected long-term uptrend view is the alternative—namely, that “being long commodities means being short technology.” Shortages are ultimately solved through innovation and capital expenditures.
In reality, real prices for nonrenewables have trended low but have been interrupted by periodic upward price shocks. Such price shocks are associated with short-term supply inelasticity, but markets respond over time by finding new supply, which creates the down cycle. As the old commodity saying goes, “The solution to high prices is high prices.”
The author’s second case focuses on the volatility of the prices for food, renewable commodities in the “above-ground” commodity markets. Again, there is a tendency for nominal and real prices to diverge and for a downward real price trend to be established over the long term. Nevertheless, the economic stakes of an upward price shock are higher than for metals and oils because developing countries are often dependent on food imports and are marginalized because food consumes such a high percentage of people’s income. Food is a strategic good even more than oil is. Here, the core themes of import–export conflict, sovereign state interests, international cooperation, and capital flows directly affect the dynamics of supply and demand. Where food is concerned, strategic behavior and the threat of geopolitical unrest can reverberate across global markets.
A third issue running through commodity markets is the traditional fear of speculation. Even before the development of commodity futures trading, a vigorous debate raged on the question of whether speculators distort prices. Clayton reviews this history with specific focus on oil markets, but he presents limited evidence that speculators have a negative influence on markets. The increased correlation between commodities and financial assets during the super-cycle, together with the huge expansion of speculative futures trading, suggests that there is significant spillover from financial to commodity markets that is unrelated to hedging, but whether this trading distorts prices is unclear. The impact of speculation is an issue that requires more careful research; indeed, the interaction between speculative behavior and commodities could be a book unto itself.
To focus on the theme of international cooperation and nationalism, Clayton reviews the government’s release of oil from the US Strategic Petroleum Reserve (SPR) as a response to the Libyan oil crisis. At price extremes, governments can manipulate commodity prices through cooperation or self-interest, which adds to market uncertainty. The actions of governments affect the behavior of commodity players.
The SPR oil case is an interesting example that the author could have generalized to stress the key points associated with his initial themes.
The final chapter focuses on the gold standard. Clayton provides a simple historical review and addresses the issues surrounding implementation of this frequently discussed monetary alternative. However, gold, even though it and other precious metals still seem to be viewed as potential stores of value, is unlikely to come back as a monetary standard. Therefore, this chapter, despite offering a useful summary of the topic, is misplaced in a short book.
A more interesting area for discussion would have been the interplay between commodity prices and currencies, particularly the impact of the dollar on commodities. This interplay is critical to understanding market direction, trade flows, and capital movements. The current declines in emerging market currencies and growth are closely associated with the commodity price decline and the spillover to other financial markets.
Clayton gives detailed examples, but he could have expanded on how markets can be classified, compared, and contrasted. Commodity markets are not all the same, yet certain common problems affect long-term pricing trends and pricing. The impact of competition and actions of importers and exporters, the competitive interaction of government and private users, the trade-off between cooperation and national self-interest, the impact of technology versus Malthusian doomsayers of “peak commodities,” and the role of futures—all could have been explored more fully to enhance the author’s key ideas and demonstrate the uniqueness of these markets.
Clayton, now a Citibank commodity analyst actively engaged in short-term market analysis, wrote this book while he was a fellow at the Council on Foreign Relations. His somewhat academic thesis grapples with long-term issues and extends the commodity discussion beyond a focus on financial pricing models and emphasizes the larger competitive forces of supply and demand. This emphasis on economic forces is important for any meaningful discussion of strategic asset allocation to commodities in the current financial environment.
—M.S.R.