Oranges to Aliens: Divining the Future of the Commodities Complex

Commodities markets are where raw material producers (farmers, miners, etc.) and consumers (grocery stores, bakers, manufacturing facilities, etc.) come together to trade their respective resources amongst one another. Here, the market reflects a relatively pure example of supply and demand dynamics, where changes in the agreed-upon price of transactions is largely driven by alterations in the supply of – or demand for – materials. Speculators who enter the commodities market (such as financial firms and traders) provide additional liquidity by buying and selling commodities, while often hoping to profit on their investment by effectively betting on future states of the supply/demand relationship in a given market. For instance, orange juice concentrate is a popular commodity to trade for some market speculators and ultimately reflects a bet on the severity of coming weather patterns in Florida. [1][i] Put simply, bad weather can wipe out crops of oranges, reducing supply, and therefore driving up the price of orange juice concentrate.

While a relatively short-term bet on an orange harvest is a clear-enough call on the future patterns of weather – and a simple example of how events unfolding in the world can have a direct impact on commodity prices – the picture can become much more convoluted in other scenarios. Often, the future trend in price for a given commodity market can become inextricably tangled up with all of the complexities of geopolitics, evolving industrial and consumer needs, as well as material availability.

Consider, for instance, the effect of geopolitics. In the wake of the Russian invasion of Ukraine, economists warned of the impacts on global grain production, as Ukraine – a storehouse of fertile soil and relatively cheap farmland – has historically been a major producer: around 8% of global wheat production, 13% of corn flows, and 40% of the sunflower oil market. As a result, in the immediate wake of the initial invasion, prices for sunflower oil rose a whopping 71% over the course of a month. [ii] Alternatively, the Russian-led tempering of liquified natural gas (LNG) exports to European countries led to a spike in energy prices across Europe, which were felt harshly in Germany as household electricity spot prices increased from around 100 Euros/Megawatt at the start of the Russian invasion in February 2022, to a peak of over 700 Euros/Megawatt in August 2022. [iii]

So, unlike the task of forecasting weather patterns in the Gulf of Mexico, a successful investment in the sunflower oil or European electricity markets in the recent past would have required effectively predicting – or rapidly responding to – the military action of a foreign dictator and his subsequent tactical sanctions. While the connection may be clear in hindsight, in the future, it’s hard to say which markets will be most impacted by which events in the uncountable set of future possible worlds.

Furthermore, changes in consumer and industry needs can also shift the commodity supply and demand dynamics. One consistent and sustained arc of coherence within this space is the transition (however long it takes) of the global energy industry towards more renewable sources. Central to this effort (arguably) is the increased prevalence of electric cars and battery-powered infrastructure that require… well… batteries. So, how do supply and demand dynamics of raw materials change during this transition?

While this may be another geopolitical standoff in the making – as China controls the lion’s share of current mining operations that produce key materials for battery production – it seems that the script on this story isn’t quite written yet. In a relatively surprising article recently published in the journal Science, I was made aware of just how little we really know about the prevalence and location of these key commodities, particularly in the U.S. [iv] For instance, just in the past two years, the U.S. Geological Survey (USGS) found several billion dollars worth of deposits in Appalachia of critical electronics materials (zirconium, niobium, among others) for manufacturing batteries. As it turns out, little has been done in the way of mineral exploration in the U.S. since the last broad geographical survey in the 1980s (looking primarily for Uranium), as corporations have migrated mining operations abroad due to the relatively strict environmental regulations they faced in the U.S.  In the time since this discovery, the USGS has embarked on a more extensive mapping of American mineral reserves, already discovering before-unknown seismic zones, as well as entirely new frontiers to search for rare earth materials like lithium. It seems the story may have just begun on the mineral wealth of the Americas in the new era of batteries.

Herein lies a dilemma for the aspiring commodities investor: is the future state of the world one in which the U.S. harnesses its not-yet-fully-discovered domestic mineral reserves to bootstrap a renewable energy revolution from within, or do foreign governments monopolize this commodity market in such a way that the western world is forced to abandon the battery-fueled future and double-down on fossil fuels? As with most things, reality likely lies somewhere in between, but a smart investment decision looks different in either case.  How then, can you make a sound investment in the world of commodities? Supply and demand shocks are bound to happen in the future, as is drift in the supply and demand needs of consumers and industry.

For a long-term investor, a portfolio allocation to commodities bears a somewhat different goal than in the shorter-term ‘betting’ described above. Here, investors seek exposure to the broad increases in material prices often associated with inflation. However, exactly where those inflationary forces manifest is, arguably, as much of a dart throw as betting on whether feeder cattle or soybeans will be more impacted by the next major global military act. Put simply, it’s a difficult problem. As we’ve written in the past, a relatively robust solution to this lies in the diversification of commodity exposure across sectors, so that a portfolio allocation to the entire commodities complex is sure to capture the ebbs and flows of inflation regardless of where they appear. So, whether it’s a catastrophic meteor strike in 2024 that spikes global lean hog prices, or alien contact in 2025 that tanks the demand for oil, divining the future is hard. But, a diversified commodities investor can sleep soundly knowing that regardless of what the future holds, they are well positioned financially to ebb and flow with it.

References

• [1] H. Shefrin, “Commodity Futures: Orange Juice and Sentiment” Ch.9 in “Beyond Greed and Fear: Understanding Behavioural Finance and the Psychology of Investing”. Oxford University Press, 2022.

Footnotes

• [i] As well as, apparently, the supply of oranges from Brazil.
• [ii] See here for the data.
• [iii] See here for the data.
• [iv] Not to mention the already discovered (but ethically and environmentally contentious) deep sea polymetallic nodules that are estimated to contain more cobalt (among other metals) than the entirety of land-based resources.