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How to profit from a fall in commodities

We identify the countries and sectors that could benefit from the recent falls in the prices of iron ore, oil and gold - and how to access them via funds.
November 21, 2014

The second half of 2014 has so far seen a dramatic decline in the price of many major commodities, with the prices of iron ore, oil and gold all taking a tumble. The price of Brent Crude, an international standard for oil, has dropped to $77 (£49.19) per barrel, having been more than $100 at the start of September. The price of iron ore has dropped from around $135 per tonne to now closer to $80 in the past year. And the price of gold has sharply dipped below $1,200 per ounce.

While each of the commodities has its own supply and demand dynamic, the linking factor between all of the declines has been a slowdown in global growth expectations. In spite of hopes earlier this year that the world had moved onto a trajectory towards sustainable growth, recent weeks have shown there is still a lot of work to be done, as Japan fell into an unexpected recession and Europe registered negligible GDP expansion.

Slower growth has led to lower demand and, with supply of most commodities staying the same or rising, a drop in prices was the result. While gold is not supposed to be tied to global growth it tends to be affected by general commodity movements, while the strength of the dollar, gold's main safe haven rival, has also contributed to its fall.

But while a drop in the price of oil can be seen to have a positive impact in most peoples' lives as it is translated to lower fuel costs, lower commodity prices can also be a boon to investors who know where to look.

Erik Knutzen, chief investment officer for multi-asset at Neuberger Berman, says a lower oil price has several beneficial knock-on effects, such as lower fuel prices that "drive consumer confidence and expenditures due to increased spending power". He also points out that lower fuel input costs "reduces the cost of manufacturing and helps the exports of manufacturing-driven economies". The countries that look set to benefit from low commodity prices are therefore those which import those commodities.

Russ Koesterich, BlackRock's global chief investment strategist, gives the example of India, which he says imports 85 per cent of its oil needs. India has already begun to benefit from the lower oil price, according to Mr Koesterich, in that it has helped to lower its chronically high inflation and pushed the stock market to all new highs.

He says countries such as Japan and China should also benefit from lower commodity prices and says investors looking to take advantage of this macro economic trend should try to exploit it by buying into Asian equities.

In terms of specific sectors that investors can focus on to derive benefits from the low commodity prices, as well as the manufacturing sector, another sector that will get a boost is the airline sector, according to JPMorgan Asset Management's global market strategist Alex Dryden. He says the uncertainty overhanging the sector from the possible spread of ebola - meaning that investors would refuse to travel - has now dissipated and airline stocks now look particularly attractive, given that low oil prices significantly lower their costs.

But the main winners may simply be retailers and stocks exposed to consumer spending in developed markets such as the US, where people will suddenly find a little extra cash in their pockets in the build-up to Christmas because of low fuel prices, which will likely lead to higher retail spending.

However, pointing out areas that will rally from low commodity prices is difficult because these benefits quickly get priced in. As mentioned, India's stock market has already moved to an all-time high. China and Japan have also rallied recently, while airline stocks have shot up significantly in recent weeks.

On the other hand, commodity and resources stocks and funds have sold off heavily as collapsing prices feed through into difficult profit outlooks for these companies. Many investors in mining funds or funds invested in a number of oil stocks will have already felt the pinch and could be sitting on losses.

But it may be that the real way to benefit from this sell-off is to buy the beaten-up commodity stocks now. The managers of resources and commodities funds all insist that the price of commodities such as oil and iron ore cannot stay at such depressed levels for any sustainable period of time due to supply and demand dynamics.

Joanne Warner, head of global resources at First State Investments, says the "mining sector can be classified as being close to the bottom of the cycle" because at the current price some mining firms will start losing money and be forced to shut down projects. She says: "As investment in new supply is curtailed and global growth slowly continues, we expect the [supply and demand] mismatch to reduce."

Benoit Gervais, manager of the CF Canlife Global Resource fund, thinks the same is true with the oil price because he believes that below $85 per barrel "there is no growth in supply". US shale oil companies are in particular danger, with many of them needing oil at more than $90 a barrel just to stay afloat. Though he expects the sector to remain volatile, Mr Gervais sees the current environment as "definitely a good buying opportunity now".

However, investors should be wary of diving in too soon. The Organisation of the Petroleum Exporting Countries (Opec) has signalled that it is unlikely to step in to halt the decline in the oil price until it reaches $70. And Citigroup predicted the price of iron ore could fall to $60 per tonne in 2015, which would decimate mining firms.

James Sutton, a manager on JPM Natural Resources fund warns that price recovery "always takes longer than you expect".

But any further drops in commodity prices would mean that they will start to become priced for a global depression so, unless that is your expected economic outcome, on a medium-term time horizon now might be an attractive entry point into commodities.

 

Best funds to profit from commodity falls

Those investors looking to profit from the fall in commodities by investing in regions that could benefit from low prices should take a look at the First State Asia Pacific Leaders (GB0033874214) fund.

Managed by Angus Tulloch and Richard Jones, the fund boasts an enviable track record; it is the second best performing fund in the IMA Asia ex Japan sector in the past 10 years. In fact, it is only outperformed by another First State fund, which is unfortunately closed to new investment.

Another attraction of Mr Tulloch's fund is that it has a significantly overweight position in India. The country, which makes up less than 10 per cent of most Asian benchmarks, makes up 23.7 per cent of the fund's assets, according to its latest factsheet.

For investors looking to get passive exposure to the Asian stock market, there are several tracker funds available, with the best generally available at an ongoing charges figure of between 0.2 per cent and 0.25 per cent.

The Fidelity Index Pacific ex Japan fund (GB00BHZK8G51) is the cheapest of the bunch, at 0.13 per cent, but the tracker was only launched this year. So for investors who prefer to see more of a track record when it comes to issues such as tracking error the BlackRock Pacific ex Japan Equity Tracker (GB00B849FB47) is available for 0.15 per cent. Be wary when choosing an Asian tracker fund, though, many of the options available track subtly different indices so investors should be aware of exactly what they are tracking.

But for those investors not keen on the volatile world of Asian equity markets, another way to benefit from low oil prices is with a bet on the US consumer, who is likely to spend more with oil prices so low. Given the difficulty in finding active managers in the US, and given that consumer spending, in various guises, affects a huge number of companies in the country, a simple S&P 500 index tracker may be the best option. The Vanguard US Equity Index fund (GB00B5B71Q71) is available for an exceptionally low ongoing charge of 0.1 per cent and it has a strong record in terms of tracking error since its launch in 2009.

Within commodities funds, it has been a perfect storm recently for the BlackRock World Mining Trust (BRWM). Historically seen as one of the best resources funds around, the trust has been mired in controversy after having to write down its London Mining Marampa royalty contract and convertible bond, causing a shock 8.8 per cent fall in its net asset value (NAV).

Managers Evy Hambro and Catherine Raw have since revealed the portfolio has about 4 per cent exposure to other royalty payments but they have assured the risks in the contracts are very small. The board of the trust has insisted this year's dividend is completely secure, but analysts at Winterflood Securities have suggested the 2015 dividend may be under threat.

But much of that is already baked into the price of the trust, which moved from trading roughly around its NAV to a nearly 10 per cent discount following the London Mining write-down. The long-term track record of Mr Hambro and Ms Raw indicates the issue is likely to be a blip rather than a symptom of poor management.

Although the dividend remains a worry, investors looking for a contrarian buying opportunity in the mining sector right now could do a lot worse. The board may also be tempted to appease investors by lowering the management fee on the trust which, at 1.3 per cent of gross assets, is higher than the 1 per cent fee on BlackRock's equivalent open-ended fund.

On the other side of the resources spectrum is the City Natural Resources High Yield Trust (CYN), which is currently highly exposed to the oil and gas sector, as opposed to the diversified mining exposure of the BlackRock trust. The City trust also benefits from more diversified exposure to areas such as palm oil and agriculture, as well as its fixed income exposure.

The discount of the trust is nearly at 20 per cent but, while this is at the lower end of its historical range it is not exceptionally low so investors should not expect a significant narrowing of the discount. With its gearing currently at a punchy 26 per cent, compared with BlackRock's 13 per cent, the City trust is a risky play at the moment.

Both the BlackRock and City trusts have disappointed investors in recent years, losing a huge amount of value. Anyone investing now should be prepared for more short-term volatility. But if you want to catch a falling knife, the choice is whether you think the mining or the oil and gas sector look set to outperform over the long-term.

 

Performance of recommended funds

Fund1-yr %3-yr %5-yr %10-yr %OCF/TER*
First State Asia Pacific Leaders 17.340.575.1326.40.89%
BlackRock Pacific ex Japan Equity Tracker3.827.847.7n/a0.24%
Vanguard US Equity Index17.277.3116.7n/a0.10%
BlackRock World Mining IT -22.6-37.8-25.7961.50%
City Natural Resources High Yield Trust -19.2-50.9-26.494.81.42%

Source: FE Analytics as at 18 November 2014. *Ongoing charges figure or total expense ratio.