iShares S&P GSCI Commodity-Indexed Trust ETF: Pure Commodity Upside

Commodities are a unique asset class. They don’t discount the future like equities and bonds - prices are just set through whatever price is needed to clear the market given prevailing supply and demand conditions in the present. So, we can predict future commodity prices if we have a view on future supply and demand, and this view won’t be priced in today, as today’s price simply reflects today’s supply and demand balance.

The global economy is set to recover from the current recession, and this is going to drive commodity demand. But commodity supply, in almost all commodities, has seen several years of underinvestment, as prices were low and capital markets shunned various extractive industries in favor of greener sectors.

Now, with China’s economy ramping up to support a glorious economy just in time for the Chinese Communist Party’s 100^th anniversary, non-energy commodities are suddenly in demand already. Oil has rebounded as gasoline demand rises as people shun public transport in favor of driving themselves while the coronavirus is still around, and this seems to be a trend worldwide. High oil inventories are being worked off, and this should help drive up oil prices. Gold prices are set to stay strong as real interest rates stay low.

One way to play this trend is to buy the diversified large-cap commodity producer BHP Group (BHP), which supplies copper, iron ore, nickel, metallurgical coal, oil & gas and potash, which The Global Investor recently backed.

A purer way to play this bull market across the commodities complex is to own the iShares S&P GSCI Commodity-Indexed Trust ETF (GSG), which tracks the S&P GSCI Total Return Index, a world production weighted index. Production weighted simply means the dollar value of commodity production, so while the S&P GSCI index includes many constituents (see Appendix below), it is heavily weighted towards energy. The 2020 Reference Percentage Dollar Weights for the S&P GSCI were as follows: Energy 61.7%, Agriculture 15.9%, Livestock 7.3%, Industrial Metals 10.7% and Precious Metals 4.5%.

Structural bull market

The 2021 commodity outlook, it is probably fair to say, will be driven by V-shaped demand recovery based on the success of the COVID-19 vaccine. However, The Global Investor thinks this commodity price recovery will be the start of a much longer structural bull market driven by three important factors which Goldman Sachs neatly summarized in a recent report.

Revenge of the old economy. Structural under-investment in the old economy due to a decade of poor returns, particularly in energy where ESG issues have further reduced investment, was accelerated during 2020 in response to Covid, leaving inadequate production capacity to meet a V-shaped vaccine-driven demand recovery. Investment decisions are at a historical trough, taking 7.9 mn bld of oil out of 2025 expected supply. In our view, this will spell the end of non-OPEC growth in 2021.

REV’ing demand through social need. Covid is already ushering in a new era of policies aimed at social need instead of financial stability. This will likely create cyclically stronger, more commodity-intensive economic growth that should create the elusive cyclical upswing in demand. Three global initiatives have the potential to REV the global demand for commodities: Redistributional policies, Environmental policies and Versatile supply chain initiatives. From China’s new 5YP to Europe’s Green Deal or Biden’s stimulus plan, policymakers are looking to REV demand after a decade of policies aimed at financial stability.

Revaluation and reflation. Covid has led to a massive rise in government spending, particularly in the US where the dollar was already facing headwinds. Although the dollar got a boost from a flight to safety at the beginning of the crisis, this support is likely to fade in 2021 and beyond, creating a positive feedback loop similar to what it did during the 1970s and 2000s when oil and gold reached historical highs. In addition, inflation tail risks are greater than at any other time since the 1970s due to the REV policies above.

(Source: Goldman Sachs)

A couple of good articles on China’s new 5-Year Plan can be found here and here.

The social need Goldman talks about can only be met with fiscal policy, as monetary policy seems to be mostly out of bullets. Fiscal policy to support society is going to mean that, when all else fails, building infrastructure is suddenly going to become very important. To rebuild the global economy from the economic devastation of the pandemic is going to mean that building bridges and actually making real stuff will suddenly become noble and honorable again. All this requires commodities, and this trend is already underway in China. It won’t be long before the US and Europe realizes it needs to do the same.

With Janet Yellen at the Treasury, the Fed and the Treasury are going to be on the same page, and in talking about the Fed’s new framework, the central bankers there have acknowledged a cyclically strong economy is going to help solve many of the social issues. Fiscal policy will take on a renewed importance.

All of this is setting up for a repeat of the early 2000s, when the structural bull market was driven by the massive capex cycle from China and other large emerging markets. Also similar to 2000s, there has been a structural underinvestment in the production of many commodities, thanks to the combination of low commodity prices and the role of ESG in moving capital markets away from funding the extractive industries.

Let's take a look at each commodity group in turn.

Energy

The OPEC+ group is cutting production by 7.2 million barrels per day, or 7% of global demand, in its bid to re-balance global oil markets. In the downturn of 2020, oil refineries have been surprisingly quick to shut capacity, and this means that when the economic recovery kicks in and transportation-led demand roars back as the vaccine is rolled out, petroleum products could find themselves in a bullish deficit, pushing up gasoline, heating oil, gasoil and, ultimately, WTI and Brent crudes too.

In natural gas, the continuing coal-to-gas substitution is going to be accelerated by the environmental agenda we are likely to see under the Biden administration, and this is bullish for natural gas prices.

Precious Metals

While monetary policy is largely out of bullets, at least central bankers can keep interest rates very low. As the economy rebounds, supply-demand imbalances in goods and services may put some upward pressure on inflation. With nominal interest rates locked in at low levels by central bankers and slightly rising inflation, real interest rates get driven down, which supports precious metals prices. Additionally, as industrial production comes back as the economy reopens, silver demand will increase quickly, boosted further by accelerating global solar investment.

Base Metals

The Global Investor believes the base metals group of commodities has the most bullish technical and fundamental setup to support ongoing price rises. COVID-19 supply disruptions in South America and Africa have come at a time when China is ramping up demand. A recovery in global manufacturing is likely as pent-up demand hits economies as the vaccine kicks in. Further demand will come as US and Europe introduce infrastructure spending from more powerful fiscal policies. Copper, nickel, zinc and aluminum are supported by the secular growth story in renewable energy, electric vehicles and green construction. Higher base metal prices will be needed to throughout the complex to prevent scarcity conditions developing.

Agriculture

Although weather patterns tend to drive agriculture prices in the short term, and these are difficult to predict, there are some longer-term macro factors at play too.

La Nina threatens South American crop production over the next two to three years. The US-China trade tensions caused a large destocking of Chinese corn and soybean inventories, which now require a multi-year restocking cycle. Finally, increased government biofuels mandates should create a demand pull in the coming years, led by renewable diesel, boosting demand for corn and soybeans.

Risks to the thesis

The main risk of this idea is that the economy doesn't recover as expected if the COVID-19 vaccine fails and the global economic recession continues. However, this situation would just postpone, not cancel, the forthcoming bull market in commodities. Another risk is that this ETF has around 60% exposure to Energy, and this commodity group is exposed somewhat to the whims of the OPEC+ group.

Conclusion

The iShares S&P GSCI Commodity-Indexed Trust ETF gives investors a diversified exposure to global commodities without the idiosyncratic risks associated with commodity-producing companies, and global supply-demand conditions are setting commodities up for a long-lasting bull market.

Appendix

The S&P GSCI Methodology can be found here.

The commodity future contracts included in the S&P GSCI index are the following: Chicago wheat, Kansas wheat, corn, soybeans, coffee, sugar, cocoa, cotton, lean hogs, live cattle, feeder cattle, WTI crude oil, heating oil, gasoline RBOB, Brent crude oil, gasoil, natural gas, aluminum, copper, nickel, lead, zinc, gold and silver.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in GSG over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.