This Commodity Supercycle Feels Different...Because It Is

In 2003 I fell into commodities and related equities by sheer dumb luck. It felt like a curse at the time, but today I tell anyone in their 20s to embrace the research coverage that nobody on the team wants, especially if that sector or region has gone nowhere for ten years. Inside three years, they will very likely have the expertise everyone desperately needs.

At the time, Chinese commodity demand was just stretching its wings. I will never forget one night in 2004 watching hedge fund managers get up during a buyside dinner with CEO Andrew “Twiggy” Forrest to call in buy orders to their night traders for a penny stock nobody had heard of called Fortescue (Asia offices were not yet a thing).

Cloudbear: “Didn’t he destroy Anaconda Nickel?”

Jefferies Broker hosting dinner: “Nah mate, that asset is Minerva’s screwup - he had the right idea. Acid leaching nickel laterite is just ahead of its time.”

The title of the presentation on the screen read ‘The New Force in Iron Ore,’ and the pitch was to build a vast iron ore system in Western Australia from scratch. I checked the stock quote on my corporate Blackberry (everybody had one by now).

Cloudbear: “The stock ripped 10% last night and is up another 20% tonight. What the heck is going on?”

Jefferies Broker: “We were in Boston yesterday.”

Of course you were. I could feel the FOMO coursing through my veins.

The stock, like many others, proceeded to rally over 50x in the next few years. This was just the beginning of a bull run in commodities the likes of which we have not seen since.

I believe we are in a structural long-term commodity bull market again now, but the most dangerous four words in finance apply: it’s different this time. And the difference, while subtle, may prove critical to unlocking outsized returns. What follows is a simple framework for how I think about navigating this key difference today.

It comes down to this: in the 2000s, China’s emergence pushed the demand curves for all commodities out to the right. This rising tide lifted all boats as China needed more of everything. Curves backwardated to call inventory out of storage, which enabled passive speculators in futures to collect a positive yield as they rolled from front to second month futures. In June 2004, Gary Gorton and K. Geert Rouwenhorst of the National Bureau of Economic Research (NBER, the same entity that officially dates US recessions) released their working paper Facts & Fantasies About Commodity Futures (link here). Per the abstract, the study looked at [emphasis mine]:

“…an equally-weighted index of commodity futures monthly returns over the period between July of 1959 and March of 2004 in order to study simple properties of commodity futures as an asset class. Fully-collateralized commodity futures have historically offered the same return and Sharpe ratio as equities. While the risk premium on commodity futures is essentially the same as equities, commodity futures returns are negatively correlated with equity returns and bond returns. The negative correlation between commodity futures and the other asset classes is due, in significant part, to different behavior over the business cycle. In addition, commodity futures are positively correlated with inflation, unexpected inflation, and changes in expected inflation.”

At the time of publication, the Federal Reserve had been holding rates at 1% for a year — a level last seen briefly in 1958. This condition had set off a scramble for yield and absolute returns, the US housing bubble was well underway, and Gorton & Rouwenhorst’s paper rang the dinner bell for pensions and other long-term allocators. Just imagine: a 45-year passive allocation to commodity futures could provide equity-like, inversely correlated returns. But negatively correlated equity-like returns, with inflation protection, AND a positive roll yield? With the Fed at 1%? It wasn’t a question of whether to allocate, but how much.

The Goldman Sachs Commodity Index (GSCI) had already been around for over a decade, but the audience arrived in droves. With S&P’s early 2007 acquisition of GSCI, the asset class’s reputation was secured. Over $300 billion was allocated during the boom — inflows which further inflated commodity curves and lifted the tide until the party ended in 2011.

Today the situation is different. The Chinese demand story is challenged (over?), but perhaps offset by the demand from 3.5 billion people who live along the axis from Istanbul to Jakarta, as my friend Louis-Vincent Gave of GaveKal aptly puts it. While this baton changes hands — a process that could take years — focus has shifted to supply constraints and the decade of severe underinvestment prior to the pandemic. Underinvestment has gradually pushed supply curves up and to the left over time, and this in turn has changed the character of today’s commodity price moves. While the 2000s rising tide shifted curves into backwardation all at once, the phenomenon today is characterized by a series of Rolling Crackups precipitated by lack of inventory and investment.

An aside here: some credit is due to Kevin Muir at The Macro Tourist for a bit of inspiration. A few years ago he coined The Era of Rolling Bubbles to describe how different speculative enterprises like ARKK, BTC, ETH, and Dogecoin were ripping at different points in time going into the peak of the mania. The phenomenon of Rolling Crackups manifests similarly.

With supply curves pushed up and left, cyclical changes in demand move prices more sharply in shorter periods of time, but at different points and with lags that relate to substitution, demand destruction, cost push, and other outcomes. Just think: prior to Autumn 2021, most had never heard of TTF natural gas in Europe. Suddenly it rallied hard, taking seaborne thermal coal prices with it. Henry Hub rallied to $6, but quickly fell back below $4 with the warmest December in 60 years and the impossibility of the US “stocking out” that winter. Russia’s invasion of Ukraine sent Brent to nearly $140 in early March, and the LME nickel contract exploded on the Chinese billionaire short squeeze around the same time. Corn rallied to a peak above $8 in late April, and Henry Hub began a huge move to nearly $10 in June.

Many like to compare the current environment to the 1960s-70s, and they are more right than they realize, as back then commodities also ripped at different times (sourced from charts in Stanley Kroll’s The Professional Commodity Trader):

• The wheat Mar’73 contract rallied from $1.50 to $2.70 from July to December 1972 (during which time copper actually declined).

• The copper May’73 contract then rallied from 50c in December 1972 to 72c in April 1973. Silver then took over as the Mar’74 contract rallied from $2.20 in April 1973 to $3.45 in January 1974. As this move was finishing, gold ran from $90 in November 1973 to $195 in December 1974.

• The soybean July’73 contract ran from $5.10 in March 1973 to $12.80 in June. A month later, the wheat May’74 contract began rallying from a $2.50 low in July to $5.15 by September 1973.

To be sure, the entire commodities complex does have “common ground,” and there are clearly times when it seems like everything is out of favor (like right now, except for maybe uranium and cocoa). But if we really are right back in the 1960s-70s, I believe the key to success is positioning in those commodities that nobody has cared about for a while and are seemingly invisible, and being prepared to surf from one Rolling Crackup into the next invisible commodity, particularly when there is a loose underlying connection.

As a parting example, Henry Hub has traded in the $2’s for nearly a year, and until recently was given up for dead on seemingly endless 100+ Bcfpd supply, with no tightness expected before 2025 LNG capacity comes on, a 5yr+ high inventory, and seemingly zero stock-out risk even with a cold and extended winter (which itself is a non-consensus outlook). Even many bulls don’t see a scenario of end-of-season inventory approaching 5yr lows — impossible. But this commodity lives in the tails, and is showing early signs of a possible crackup. Were something to happen here, there is a loose line-of-sight from a rallying gas price to rising ammonia and nitrogen-intensive fertilizer pricing which could affect US spring planting decisions. Add in a potentially late Brazilian second corn harvest, and the enormous speculative net short position in corn futures (with a near-historic commercial net long) holds interesting unwind potential as we approach 2H24. One thing rolls into the next, but things move at different times. Perhaps a surprise 1H24 gas rally sets off a 2Q-3Q thermal coal rally as well?

As always, none of the above is meant as financial advice (please note my disclaimer link at the bottom), but rather as an illustration of my Rolling Crackups framework. This has helped me think about positioning opportunities since Covid…who knows if it continues to hold, but maybe it helps your thinking as well.

Kindly yours,

-Paulo aka Cloudbear