Q: Paul, how do you approach investing in commodities?
A: There is roughly $400 billion invested globally in commodities futures markets. Strategies may include:
- Passive, long-only exposure to indices such as the Goldman Sachs Commodity Index
- Exchange Traded Funds (ETFs) that track an underlying commodity such as GLD (gold) or USO (oil)
- Mutual fund products that track a basket of commodities
- Risk premia strategies that utilize volatility and curve structure to add alpha
- Limited partnerships that are typically actively managed strategies
When I consider the current environment, which is best characterized by divergent returns, I think the latter offers the most potential.
Q: How do you see commodities fitting into an investor’s portfolio?
A: Commodities are an uncorrelated asset class, so I view an allocation to the sector as a way for an investor to diversify a portfolio, generate returns and protect against inflation in the longer-term. An allocation to commodities or a commodity strategy should be viewed as part of an individual’s overall alternative investment allocation bucket. A pure commodity strategy that is using underlying futures and options, that goes both long and short, will track more closely to other alternative strategies, such as equity hedge fund vehicles, than it will a real assets allocation, which is typically overweight real estate and more long-only oriented.
Q: How has the U.S.-China trade war impacted the commodity markets?
A: The biggest impact has been a disruption to supply chains, which has produced market inefficiencies. For example, due to the trade war, U.S. soybean exports to China have fallen 70% year-over-year. China is currently purchasing the vast majority of its soybean import needs from South America at a huge premium. However, this exchange sends the wrong signals. Its telling South America to expand production despite the U.S. holding record inventories. If markets could operate freely, the lowest cost supplier, in this case the U.S., would see an increase in exports allowing its balance sheet to improve while pressuring South American premiums and signaling that current production is adequate and expansion isn’t necessary.
This same type of scenario is playing out in several industries, not just agriculture. The concern going forward is whether supply chains have been altered forever and if domestic producers should cease, or at the very least reduce, capital investments. Decisions being made now, with the currently available information, could have major ramifications for years to come. Unfortunately, nobody wins as markets become paralyzed and decisions are made under irrational circumstances, which can create opportunities for long-short oriented strategies.
Q: What effect will a lower interest rate environment have on commodities?
A: The biggest effect thus far has been to encourage a massive inflow of capital into precious metals. Gold, silver and, to a lesser extent, platinum are all top performers over the past 12 months. According to the most recent quarterly report from the World Gold Council, Central Bank demand for gold increased to a three-year high and was up 8% year-over-year. With nearly $15 trillion of government bonds trading at negative yields around the world, the reallocation of capital into precious metals will likely continue.
Q: Where do you see the biggest opportunities in commodities?
A: I think we will continue to see a divergent return profile within commodities. The reality is that some markets are oversupplied due to the trade war, while others are seeing renewed demand outstripping supply. I think precious metals will continue to outperform and that livestock markets will experience upward pricing pressure stemming from China’s protein shortage. I view energies as mostly range-bound. OPEC is making necessary cuts, which should provide a floor, but with the U.S. producing record amounts, the upside is capped as well. Overall, stable energy prices are a positive for the U.S. economy. Soybeans and soybean meal are dealing with excess inventories while soybean oil is tight due to biofuel mandates. These are just some opportunities, but the point is that a balanced portfolio of long and short exposures allows investors to take advantage of the widest opportunity set in the current market.
Q: What are some overarching themes in commodities?
A: The trade war will continue to be an overriding theme. Another major theme is African Swine Fever, which has decimated China’s hog herd, contributing to a protein shortage there. To put this in perspective, China’s hog herd is more than 10-times larger than the U.S.’s. Their meat shortage could result in a multi-year bull move for livestock markets (if the trade war ends). As previously mentioned, the low interest rate environment will likely continue to be a big theme in commodities as well, with precious metals benefitting the most. Lastly, weak currencies from commodity producing countries such as Brazil, Argentina, Russia and Australia, should continue to push (distorted) expansion outside of the U.S. within agricultural markets.
Q: You have been involved in the commodity markets for 17 years, what excites you about them and why have you made a career of this?
A: My internships while attending college were with commodity related companies. I should mention, I didn’t seek commodity related roles, but rather they were the only roles that I found opportunities in, so in a way the industry chose me. However, I am very fortunate to have discovered this field because I find it to be very conducive to my mindset and global macro interests. As a result, I quickly realized that I wanted to make a career in commodities. The markets are very dynamic, constantly evolving and there are so many nuances to them. Commodities can be impacted by market specific fundamentals, macro events, politics, currencies, capital flows, weather, etc. Some inputs are more predictable than others, but the constant change challenges and excites me. I have enjoyed making a career of analyzing the markets and determining where there is a dislocation or inefficiency that, over time, supply and demand factors and economic theory will correct.