How the Commodities Market Turned in 2016

Bull and bear balancing on seesaw
Oliver Burston/Getty Images

Many commodity prices rose to highs during the great bull raw material market that peaked during the period from 2008-2012. The price of crude oil peaked at over $147 per barrel in 2008. Gold rose to all-time highs of $1920.70 per ounce in 2011 and copper climbed to over $4.65 per pound the same year. In 2012, the price of corn skyrocketed to over $8.40 per bushel and soybeans reached all-time highs just under $18 per bushel.

During those years, most all commodities posted record highs as the U.S. dollar was weak and global interest rates moved lower.

A bull market in commodities

The global financial crisis in 2008 caused lots of volatility to hit markets across all asset classes and commodities were no exception. However, the accommodative central bank policies of quantitative easing and low short-term interest rates that followed the 2008 financial debacle were highly supportive for raw material prices. Quantitative easing is a central bank tool that allows a monetary authority to purchase sovereign (and sometimes corporate) debt issues. QE allows central banks to influence medium and longer term interest rates as they print money to buy bonds. Additionally, when these monetary authorities decrease short-term interest rates, it stimulates inflationary pressures by encouraging borrowing and spending and inhibiting saving.

Commodity prices tend to response to inflationary pressures, and that is why they appreciated dramatically from 2008-2011 as central banks embarked on a stimulative warpath to fight deflationary and recessionary pressures in domestic as well as the global economy.

The bull market comes to an end

The U.S. economy is the world’s largest and when it started to become clear that risks following the 2008 crisis were on the decline, the central bank began to send signals that QE would end and short-term interest rates would not remain at zero forever.

As the economy in the U.S. improved after 2011 commodity prices began to fall. In the grain sector, the drought of 2012 allowed the bull to stick around for another year by from 2013-2015 commodity prices, as an asset class made lower highs and lower lows. In late 2015 and early 2016, many raw materials fell to multiyear lows. Crude oil traded all the way down to $26.05 per barrel in Mid-February 2016, over 82 percent below the 2008 peak. Gold fell to $1046 in late 2015, over 45 percent off its 2011 highs. Copper traded to just under $1.94 in early 2016, 58 percent below the 2011 highs. There are many more examples. Agricultural commodities, metals, energy prices, and minerals all fell to the lowest levels in years by the beginning of 2016.

Commodities are valuable assets in the world that are highly sensitive to moves in currency and fixed income markets. The dollar is the reserve currency of the world, and it is the benchmark pricing mechanism for raw materials. When the dollar strengthens commodities tend to move lower and when it weakens against other currencies, raw material prices tend to appreciate. When it comes to interest rates, higher rates increases the cost of carrying raw material inventories while lower interest rate does just the opposite.

When it became apparent that the U.S. central bank would end QE in 2014 and begin to increase interest rates in 2015, the dollar appreciated against other currencies, and commodity prices moved lower. When the Fed hiked rates for the first time in nine years in December 2015 and promised 3-4 more such increases in 2016, many commodity prices moved to multiyear lows in late 2015 and early 2016.

Commodities bottom at the beginning of 2016

2016 began in ugly fashion; the Chinese domestic stock market plunged, and many other equity indices around the world followed in a case of Asian contagion. China is the demand side of the fundamental equation for commodities as the nation has the world’s largest population and growth over recent decades had caused the Chinese to increase raw material purchases.

As the Chinese stock market cascaded lower, it gave the U.S. central bank reason to pause when it came to their policy of increasing interest rates. The dollar retreated from highs of 100 on the dollar index futures contract and raw material prices dropped. On February 11, when the S&P500 index posted an 11.5 percent loss on the year, the Baltic Dry index fell to all-time lows of 290. The Baltic Dry Index measures shipping activity of dry bulk cargos around the world. The activity in commodity markets ground to a halt. However, February 11 marked the lows for many assets, and the markets began to improve in the weeks and months that followed.

Meanwhile, the U.S. Fed remained on the sidelines and did not increase rates. At first, it was the potential of Asian contagion that stopped the Fed from another interest rate hike. As June approached, a referendum in the United Kingdom to exit the European Union threatened to increase volatility in world markets. While the conventional wisdom was that the U.K. would remain within Europe, the June 24 vote shocked markets when they voted to leave. Brexit gave the Fed another reason to stay on the sidelines. All the while, commodity prices rose with gold leading the way. The yellow metal traded up to over $1384 in the wake of the Brexit vote and silver ascended above $21. Both precious metals pulled back in the months following the early July highs but other commodities performed in spectacular fashion.

Crude oil rose from just above $26 per barrel in February to over $50 at the beginning of October. The price of sugar increased from 10.13 cents per pound in August 2015 to over 24 cents on September 29, 2016. The prices of iron ore, zinc, tin, nickel, and lead all posted double-digit gains in 2016. In perhaps the most telling signal for raw material markets, the Baltic Dry Index rose from 290 in February to 915 in early October, a gain of over 215 percent.

All the while, the U.S. central bank did not increase interest rates providing support for many raw material prices.

A new bull emerges from commodity prospects

It appears that raw material prices reached a significant bottom based on price action that followed those lows. Markets rarely move in a straight line, and while commodities are perhaps the most volatile of all assets, they are no exceptions. However, the raw material asset class has posted impressive gains in 2016, rising by over 10% in the first three-quarters of the year.

While the U.S. Federal Reserve is likely to increase the Fed Funds rate at the December meeting or the beginning of 2017, that rate will only rise to 50-75 basis points which is still a historically low level. Meanwhile, interest rates in Europe and Japan remain in negative territory. Low interest rates continue to provide support for commodities as the market heads into 2017. Additionally, the bear market from 2012-early 2016 caused many high-cost producers to exit the market, and that means production is in the hands of stronger and well-capitalized entities. At the same time, there is evidence that massive inventories of raw materials have been declining at a time when output has slowed, and demand is picking up. Moreover, demographic trends continue to support the rationale that more people in the world will require more commodities in the years ahead. Classic economic theory and common sense dictates, as demand rises, inventories fall, and prices rise.

Each commodity has individual supply and demand characteristics. There are so many factors that come into play when it comes to the path of least resistance for raw material prices including weather, global economic and political trends, and other endogenous and exogenous pressures. However, as an asset class commodities appear to have made a significant bottom in late 2015 and early 2016 and now the path of least resistance will be higher in the months and years to come.

Raw material prices are some of the most volatile assets that trade. Routinely, commodity volatility exceeds variance in stock, bond, currency and other asset classes, therefore; the road higher will be anything but a smooth ride. 2016 is likely to be remembered as a year where the commodities market, as an asset class, turned higher and that should bring more investors and traders back to markets they abandoned in recent years.

Some advice on approaching commodity markets

Everyone loves a bull market because psychologically, it is far easier to go long than to take a short position. Increasing participation by speculators and investors will serve to increase liquidity and at times, volatility in the world of commodities. One of the golden rules for investing in commodities is that buying on price dips during bull market cycles tends to yield optimal results. In a volatile asset class, it is always better to approach markets with caution. Buying when prices are correcting lower on a short-term basis increases the chances of profiting as the primary trend will eventually take the assets higher. When it comes to ETF and ETN products, the unleveraged vehicles are appropriate for medium term trading. However, one most approach the leveraged vehicles appropriately. While it is tempting to buy leveraged ETFs or ETNs and hold them, these products are most effective when employed on a very short-term basis. Trading or investing in leveraged products are appropriate for intra-day positions and should not remain in portfolios for longer than a handful of days. One of the most important virtues of a successful commodities trader or investor is the ability to exercise discipline and to stick to a trading plan. When considering an investment position, establish a plan including how much risk you are willing to take and make sure the reward you seek is equal or higher than that risk. Once you take a position, stick to your plan. Always remember, do not worry about missing an opportunity, taking a profit too soon, or taking a loss. In the volatile world of commodities investing, there is always another chance right around the corner.