Commodities are flat but commodity producers are cash machines
Commodities have been at the centre of the investing discourse for the past year and yet 12 months on, the index is only marginally positive. The real opportunity for investors has been in the equity of the commodity producers rather than in the commodity themselves.
#commodities have been at the centre of the investing discourse for the past year and yet 12 months on, the index is only marginally positive. Such a view would miss the forest for the tree as the real opportunity for investors has been in the equity of the commodity producers rather than in the commodity themselves.
If we consider the total return performance for the commodity index vs. two major ETFs for materials & energy producers, while the former is “only” up 3.5%, commodity producers are up 33% and 31% for materials and energy respectively. A whopping ~40% outperformance vs the S&P500 (see chart). The reason for the discrepancy is easily explained. Commodity producers are businesses that provide exposure to multiple aspects of the industry, such as exploration, production, and marketing. This can provide greater diversification and potentially reduce risk & volatility compared to investing in just the commodity itself. Moreover the operational performance of the companies in the space, e.g. cost control and the ability to develop new sources of supply, can provide additional avenues for growth and return on investment.
More importantly perhaps is that these companies have been generating enormous amounts of cash. As ESG policies have made investment in the space ever more difficult and uncertain, companies prefer distributing cash flow to shareholders in the form of dividends and buybacks. The structural underinvestment in the space also set up the stage for higher prices ahead and more profits for the producers.
The combined impact of underinvestment, higher inflation, decarbonization and deglobalization are likely to support the profitability of energy and material companies for years to come more than offsetting the vagaries of the economic cycle. As the exposure to these sectors is still extremely low, less than 8% of the S&P 500, outsized returns for investors should continue.
Disclosure: Not investment advice. Do your own research. Hold all assets mentioned. Twitter @pietroventani for more timely comments and updates
