Photo: Bloomberg TV
Goldman Sachs Head of Commodity Research Jeffrey Currie just published his investment outlook for 2013. His big call: commodity prices may be done going up, but that doesn’t mean investors can’t still make money.In fact, Currie thinks that commodity investing is entering a new era, which he calls “The Old Economy Renaissance,” and he is targeting 13 per cent returns on commodities investments in the short term, with a 7.5 per cent return by the end of 2013.
This new term – The Old Economy Renaissance – is derived from another one coined by Goldman 10 years ago: “The Old Economy Revenge.”
Currie says that at the time, in 2002, the commodity complex was coming off a long period of spare capacity that characterised much the previous decade. Oil companies had invested a lot of money in production, dramatically increasing supply and thus keeping commodity prices stable at low levels.
Because returns in commodity investments were low in the 1990s, money was channeled into other areas of the economy.
However, by 2002, all of that spare capacity in the commodity complex had been used up, and commodity prices began to rise as supply tightened. This initiated the “Old Economy Revenge,” in which money began to flow back into investment in commodity production, and prices rose sharply.
The chart below shows illustrates this story:
Photo: Goldman Sachs
The problem for commodity investors in the past decade, where prices rose sharply, was that they weren’t getting in on the gains, says Currie. The reason for that was the slope of the commodities curve: futures contracts were in “contango,” which meant that markets were already pricing in higher commodity prices in the long term than in the short term.
This kind of dynamic makes it hard for investors to benefit from rising prices, as it creates a “negative carry” environment.
A quick aside for those who may need a refresher on the concept of negative carry:
Say you’ve invested in oil via a December futures contract, and you want to continue holding your investment into January. That means at the end of December, you will have to “roll” the contract forward by selling your December contract and buying a January contract.
If the market is in contango, the January contract is going to be more expensive than the December contract because the market expects higher prices in the longer term than in the short term.
So, you sell your December contract, and then you have to turn around and buy the January contract at a higher price.
That is clearly not a great recipe for making money, and it’s been frustrating for those looking to cash in on rising commodity prices.
The chart below, says Currie, shows that “in fact, the returns from commodity investments were larger during the 1980s and 1990s than during the past decade owing to the negative carry that characterised the bull market of the 2000s.”
Photo: Goldman Sachs
That brings us to the “Old Economy Renaissance.” It can best be summed up as a return to a positive carry environment – wherein futures markets are in “backwardation,” the opposite of “contango” – and Curry thinks it should promise to be much more friendly to commodity investors.
Thus, Goldman’s call:
It is no longer about price appreciation…
In a near-term tight but long-term stable market, returns tend to be generated more by the backwardation in the term structure and less by price appreciation. For example, over the recent period front month Brent crude oil futures have been trading at a $0.70-$1.00/bbl premium to second-month futures. Consequently, even if front-month Brent crude oil prices remain stable, the price of the second-month contract will tend to rise by $0.70- $1.00/bbl over the course of each month as it becomes the new front-month contract.
This implies that by rolling the long futures position each month (i.e. selling the futures contract that has become prompt and buying a futures contract a month further forward), one could potentially earn a 7.5%-11.0% return over the course of a year if front-month Brent crude oil prices hold at current levels and the recent backwardation remains.
This leads us to the next question: Why does Goldman think we are entering into an “Old Economy Renaissance?”
Currie’s explanation is this: sustained high prices over the past decade have caused producers to invest in new technologies that help them to harvest more commodities, because they can sell them in the current market for high prices.
However, those new technologies have the effect of relieving long-term supply constraints, because the world will be able to use them to access previously unaccessable energy resources, shale oil being just one example.
This effect is a big part of what’s driving all of the chatter about the U.S. rising as a dominant world energy producer in the coming years. Indeed, a look at the Brent crude oil futures curve confirms that investors are already pricing in lower oil prices in the future.
However, in the short term, Currie expects demand to keep prices elevated, mainly due to the increased demand that a U.S. recovery in 2013 – in line with Goldman economists’ house view – should create for commodities.
Hence, the commodity supercycle isn’t over, and neither are the investment opportunities, says Goldman.
It’s just entering a “renaissance” phase.