Broad commodity ETFs have enjoyed a decent start to 2018. From the low point in mid-December, the ETFS All Commodities (AIGC LN) has gained 5.6% with rallies in oil, industrial metals, precious metals, and agriculture.

James Butterfill, head of research & investment strategy at ETF Securities.

Despite the recent gains, James Butterfill, head of research & investment strategy at ETF Securities, is wary of interpreting this as a positive sign for broad commodities this year: “Commodities as an asset class are a very heterogeneous group and we expect varied performance from each.”

Gold

Butterfill believes there will be little change in gold prices in the coming year despite the expectation that the Federal Reserve will continue to tighten monetary policy. “We think the downside risks to gold prices are limited because real interest rates will remain depressed as inflation gains pace in the US”, he notes.

Butterfill also surmises that gold prices may be pushed higher if a shock event, such as an equity market correction or an escalation of geopolitical tensions, occurs. Gold is increasingly being seen as an insurance policy and safe-haven asset of choice, leading investors to continue to be optimistic about gold despite the rising interest rate environment.

Risks he highlights include: continued sabre-rattling between US/Japan/South Korea and North Korea; an escalation of the proxy war between Saudi Arabia and Iran; a disorderly unwind of credit in China; Italian policy paralysed by the inability to form a government after the election; Catalonian independence causing ongoing uncertainty in Spain; a potential second general election in Germany; and market volatility measures such as the VIX or bond equivalent MOVE index (Merrill Lynch Option Volatility Estimate index) spiking as yield-trades unwind.

In ETF Securities’ bull-case scenario for gold, where the Federal Reserve becomes increasingly dovish, gold could rise to as much as $1,420/oz. In its bear case, it is assumed the Fed delivers four rates hikes in 2018 as it tries to anchor inflation expectations, 10-year nominal Treasury yields rise to 3.3% by the end of the year, the US dollar appreciates, and by year-end inflation falls back to 1.6%.

In this scenario, assuming the absence of any geopolitical risk or adverse financial market shock, Butterfill sees gold falling to $1110/oz by the end of 2018.

Source: ETF Securities.

ETF Securities’ blockbuster gold product is the ETFS Physical Gold (PHAU LN) which has $6.3 billion in assets under management (AUM). Investors looking for short exposure may wish to consider the ETFS 1x Daily Short Gold (SBUL LN).

Crude Oil

As crude oil enters the New Year above $60/bbl, having gained a third during 2017, this represents the highest prices traded in oil since early 2015; however, Butterfill believes the trend may be peaking. With demand growth expected to taper due to higher prices, and supply to accelerate, he sees the oil price remaining in a range from $45 to $60/bbl for 2018, although notes that a significant geopolitical upset in the Middle East could cause temporary price spikes.

On the supply side, he thinks US production will likely hit an all-time high, surpassing the cycle peak reached before the price war in 2014 and above the 10 million barrel mark last hit in 1970. He notes, “there is little indication that the backwardation in futures curves is going to stop US production from expanding. US shale oil production can break-even at close to US$40/bbl. With WTI oil currently trading at US$60/bbl, there is plenty of headroom for profitability and we expect a strong expansion in supply.”

The real shifts in supply though will due to the policies (and levels of compliance) of OPEC and its ten non-OPEC partners. While at the end of 2017, the cartel posted their best level of compliance with the production curb deal to date, Butterfill reckons that compliance in the extended deal announced end-November will fall short of expectations in 2018. In particular, he points to Russia’s insistence on discussing an exit strategy and a review in June 2018 as an indication that the patience of non-OPEC partners in the deal is wearing thin.

ETF Securities’ two major oil-tracking products are the ETFS Brent Crude (BRNT LN) and the ETFS WTI Crude Oil (CRUD LN) which have AUM of $109 million and $714m respectively.

Industrial Metals

Butterfill expects the star performer for 2018 to be industrial metals, which are likely to benefit the most from improving emerging markets growth. He says, “Emerging market demand is crucial for commodity markets as they represent 70% of industrial metals demand. In this respect, we expect any weakness in commodity prices to be largely offset by solid demand growth, again led by China. Although concerns remain over the build-up of debt, Chinese policymakers have continued to show a willingness to support the financial system with stimulus to ease financial conditions.”

At the same time as a surge in demand, Butterfill expects supply to remain in deficit in 2018 as the lack of investment in mining infrastructure continues to bite. Industrial metal prices began to fall in 2011, which led to a collapse in capital expenditure by miners. He points to capital expenditure by the largest 100 mines being 60% lower in mid-2017 than in mid-2013.

It is likely that as commodity prices continue to rise in 2018, capital expenditure growth will turn positive. However, the long lag times behind investment and completion of mines, as well as the damage of four years of a lack of investment into mining infrastructure, is why ETF Securities sees industrial metals remaining in a supply deficit. “We don’t expect the tightness of mine supply to reverse any time soon,” says Butterfill.

Historically, Butterfill notes that metal markets begin to move towards a balance two years after miner profit margins hit rock-bottom. Miner margins fell to a low of 2% at the beginning of 2016 and since have recovered to just over 7%, indicating that supply should begin to improve in late 2018. He believes this process could take years to move back into balance, however.

Source: ETF Securities.

ETF Securities’ ETFS Industrial Metals (AIGI LN) offers a play on this theme. It has $168m in AUM and provides exposure to a basket of industrial metals including copper (43.1%), aluminium (26.6%), zinc (15.8%), and nickel (14.5%).