Before the emergence of Covid-19, commodities were already at the start of a bull cycle. But once the virus-spread became a full-fledged pandemic by early 2020, supply-chain disruptions occurred, demand tensions mounted—and then it was all further exacerbated by the harsh accelerant of the Ukraine/Russia war. The cycle was further amplified by the emergence of environmental, social, and governance (ESG) concerns as a supply-restraint factor, which sent commodities prices soaring. Are we now in for a period of prolonged higher prices?
“I don’t want to call this a supercycle—that’s a bit of a cliché—but the magnitude and duration of this cycle is like nothing I’ve seen,” says Albert Chu, co-manager of the NRF.
The current cycle is supply driven—not demand driven, Chu says. The last supercycle was in the early 2000s, when China really began to make a rise and demand for commodities increased exponentially.
“Now we’ve normalized post-pandemic… but the correct price signals aren’t being sent… That’s a dangerous situation. When policy makers don’t let the markets decide, that’s when we get policy failures, which compounds the cycle.”
Meanwhile, geopolitics is never far from the world of commodities, and the conditions for friction are widespread. In the land rush for green metals, for example—those which are necessary for the clean-energy transition—many are mined in unstable countries, which could make for tricky investing in specific commodities, such as cobalt and lithium (essential for EV batteries). Committing capital in companies that derive their resources or assets from less than reliable nations can become a misplaced investment.
How does Chu evade such potential pitfalls for the fund? “We avoid emerging markets and frontier markets because they are too geopolitically risky. With commodities I can always replicate it somewhere else. For example, we have no Russia exposure. I can find pure plays in natural gas and oil outside Russia.”
Chu uses an à la carte tactic for investing. “We were looking, for instance, at a large metals/mining concern, which had a little bit of iron ore, a bit of copper, a bit of this and that. But I don’t need a buffet. We take a basket approach and fill it with pure plays in copper or uranium and so on. That way I can commit less capital, adjust for it on a beta basis, and lets us take an alpha approach, more concentrated, because we don’t need to be in everything—I don’t need to play the benchmark names.”
Commodities are macro-beta—which allows advantage to be found in a lot of ways. “This is a very actively managed fund, very alpha-focused, not benchmark-focused. We identify an inflecting commodity, going up or down—then find the best equity story for extra juice.”
One of the key entry points in the search for alpha are dispersion rates. Chu looks at companies in the top 50 percentile and the bottom 50 percentile of the equities in the S&P Global Natural Resources Index and analyzes the difference between returns. “That’s the dispersion rate in commodities,” Chu says—“usually 40–50%—which is a huge difference between the best and worst performers. Because the dispersion is so wide, it is implied that there are a lot of opportunities for stock/commodity picking.”
Meanwhile the increasing momentum to decarbonize economies is affecting the calculus of investing in commodities. Achieving net-zero carbon emission by 2050 (as the UN’s 2015 Paris Agreement aims for), though, won’t be a smooth linear path.
“Mathematically the replacement cycle doesn’t add up,” says Chu. “We don’t have the grid capacity, we don’t have the recharging stations, we don’t have enough lithium or copper to make this penetration. Where is the substitution effect coming from? We’ll need decades for transition—and it’s going to be massively inflationary and massively problematic.”
While it’s true that there have been significant technological advances toward the clean-energy transition, especially the headway with electric vehicles—“but what about everything else?” Chu asks. “About 60% of energy goes toward mobility2… But what about petrochemicals, what about resin—like this table I’m sitting at—what about all the by-products? We don’t seem to realize just how pervasive hydrocarbons are in our world.”
Chu adds: “Renewables will take a big chunk of energy, but there’s a problem with that. While, say, a nuclear plant runs at 100% utilization—it’s always generating. Wind/solar runs at 20–30%.3 That’s not sufficient in my view.”
Nuclear energy, however much a clean viable option it may be, requires around 10 years to complete a power plant,4 so small modular reactors might be an acceptable recourse to the “not in my backyard” public sentiment toward nuclear energy. But that’s a long way off. That puzzles Chu. “I call it the Homer Simpson effect—we think nuclear energy glows and is lethal. In reality, nuclear energy has a good safety record. Coal and wood burning are associated with more deaths.”
Chu believes that as part of the ongoing energy transition, we are shifting away from the primary energy sources of oil/gas and coal without asking ourselves about the unintended consequences.
“Like in physics—in thermodynamics—there is no action without an opposite and equal reaction. There will be disruption. There’s a duration mismatch—we are not going to get to the transition like a snap—there will be friction.”
And in that friction, and because the commodities market isn’t monolithic and static, there are other potential sources of alpha for the fund, he says.
Chu believes the opportunity outside energy is agriculture. “I call it the ‘commodity iceberg’—because all we’re seeing is the tip—no one’s seen the bulk of it under the surface—there’s a mass of disaster—food inflation and supply instability—waiting to happen. The problem is food production.”
Agriculture obviously needs water—but it’s becoming scarcer. For example, under the US Great Plains (which provides a quarter of production) lies the Ogallala Aquifer, but the depletion rate is faster than what snow and rain can refill. Some of this may be due to drought, but studies reveal that state and federal policies pay farmers to over-withdraw water supplies.5 This affects production. The water table is shallowing, and that caps planting intentions.
Chu likens farming to outdoor manufacturing. “It’s a factory without walls or a ceiling. Climate is the single biggest variable. What happens during climate change? Erratic weather,” such as a severe frost—the first in 40–50 years—which affected the coffee crops in Brazil in 2021.6
“Water is the most un-substitutable commodity,” says Chu, “and it’s also the most mispriced, because every government in the world subsidizes water—because we think of it like air, like a right, not a commodity. Utilities artificially keep down the price of water. So we play water scarcity by playing agriculture—because that’s what agriculture is in a way—the export of water.”
Chu believes that we’re now seeing phenomena colliding, that over the next several years, “this is going to be as much a food/agriculture story as much as an oil story.” To position the fund, Chu buys agricultural names: “We buy seeds, fertilizers, crop chemicals, Latin American farmlands, grain processors. You don’t want to be in staples, natural food companies—they’ll get hit by inflation.”
Chu’s approach to investing is what he calls old-school. Fundamentals and experience drive his conviction. “We’re not quant-based—we’re good ol’ fashioned stock pickers. We go out there and kick tires, we look at supply and demand. It’s all I look at: demand and supply—when the gap is widening, buy it, when narrowing, sell it. Try to find things where the gap is widening.”
Chu’s style also is agnostic (neither singularly growth nor value, e.g.), and he looks for inflection points, for pure play (which he thinks is the best use of the fund’s capital), for companies with good assets, and for company shifts—a change in cash flow, management, improved returns, and the like. He then asks, can we accomplish the desired exposure for a commodity in one company or basket?
“When adding a zero-correlating asset like commodities over a long period of time, it diversifies the portfolio, maintains standard deviation, increases expected returns—so you should always have real assets in your portfolio.” Chu says the fund is an allocation not a technical trade.
He adds further comment on his method: “Disaggregate what the market’s telling you. Identify what’s driving the market, take it apart, and find the pure play. It’s all about real-factor investing” which is accompanied by nonlinear correlation measures (such as the relationship between dependent and independent variables).
As for what comes next, “When you look out, say, 40 years into the future, I can give you any answer you want. But I traffic in reality. In commodities, there’s a coming-to-reality moment. When you run out of oil, when you run out of arable land, then what?”
1 Natural Resources Fund fact sheet, as of March 31, 2022.
2 Bloomberg NEF; accessed May 2022.
3 Statista.com; accessed May 2022.
4 “Process of building a nuclear power plant,” Stanford University, January 2018.
5 “Farmers are depleting the Ogallala Aquifer because the government pays them to do it,” The Conversation, November 9, 2020.
6 “The big Brazil frost,” Global Coffee Report, March 2021.
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