Commodities & Natural Resources: the scramble is on!

This week The Armchair Trader analyses the Association of Investment Companies’ Commodities & Natural Resources sector.

Resources are a zero-sum game. The country, or group, that controls the world’s resources, holds all the political and economic power. In the nineteenth century, the so-called Scramble for Africa (and for Asia) was a game of Risk that the major European colonial powers engaged in.  It saw imperial powers invade the continent to control its resources, such as gold, diamonds, tin, rubber, copper and, shamefully, human beings to support the transatlantic slave trade.

Not much has changed since. World powers are still fighting for control of resources. The war in Ukraine can simply be boiled down to a desire to control of the country’s vast agricultural and mineral resources, but also to control the land mass in order to regulate (and tax) the shipment of resources through its territory. The newfound interest in Greenland from the President of America – a land mass that previously was irrelevant to the US – may have something to do with the ice retreating and uncovering vast quantities of strategic minerals. DRC, Syria, the Sahel conflicts can all trace their origins to control of resources, or routes that tranship goods.

Control of oil and gas, despite the energy transition, is still critical, especially to the US. But as hydrocarbons are phased out the next scramble is for battery minerals and metals used in electronics. Control of ‘man-made resources’ such as microchips is causing tensions between America and China in Asia. When I was born there were just shy of four billion people on earth. Now it is more than eight billion. This is putting huge pressure on agricultural and water resources, and as population continues to grow, control of agricultural and water resources will become the flashpoints for conflicts of the future.

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The sector is a great diversification play

The AIC: Commodities & Natural Resources sector consists of investment trusts and closed-ended funds that focus on companies involved in natural resources, energy, mining, and agriculture. These funds provide investors with exposure to commodities, which can act as an inflation hedge and a way to diversify from traditional equity markets.

The sector has seven funds, ranging from the £1.2bn BlackRock World Mining [LON:BRWM] investment trust to the £60.5m Golden Prospect Precious Metals [LON:GPM] investment trust. The average size of fund in the sector is £284m, but half of the assets in the sector are accounted for by the BlackRock fund, with most investment trusts being in the £100m to £150m range.

Although all the funds are focussed on natural resources, the investment approach between managers and funds is varied. Some funds have a greater bias towards oil & gas, while others look at critical minerals in the transition story. Most will buy the shares of explorers and miners, farmers, oil companies, but many also have direct commodity exposure, holding physical commodities like gold, silver, lithium, copper, or soft commodities like wheat, timber and cotton. These can be held directly or through derivative exposure.

Cyclical trends in commodities

It will come as no surprise to learn that investment trusts in this sector are very sensitive to the commodity cycle, a natural boom-and-bust pattern linked to the global economy. When there is strong economic growth, the demand for resources grows and supply struggles to keep up with demand. Eventually supply catches up and the cycle reaches its peak – it’s often at this point everyone is scrambling to get in on the game and the risk of overinvestment is at a premium, and it’s when overproduction occurs.

Then along comes economic slowdown, as central governments try to put the break on inflation by contracting money supply and raising interest rates. This causes commodity prices to fall, and producers at the margins, who were making money at the peak become inefficient and often collapse. The contraction causes greater price falls, putting less-marginal producers under pressure, often forcing them out of business too. Then supply falls and commodities become scare, and the cycle reboots itself.

A good manager will understand this cyclicity, and seek quality in their investments, and have the nerve to stand fast when everything around them is crumbling and panic sets in. It’s not an easy part of the market to make one’s living from, as you have to have a cast-iron constitution, impeccable sense of timing, and a belief in your convictions.

We can see this in some of the performance number in the sector, which models the boom-to-bust-to-boom nature of the commodities market

AIC Commodities & Natural Resources: some constituents

As we can see in the table above, there is vast disparity between the performance of the different funds. Each trust selected in the table was top of sector in one time period, with Golden Prospect being top over the last year, beating the average fund in sector by 56 percentage points.

Over three years Riverstone Energy was head and shoulders above its peers – tripling your money had you invested in 2021, but then again not too clever over the last decade. Over ten years BlackRock was the fund where you would have wanted your money to be.

I find this sector the most-fascinating of all 48 AIC sectors, as, to be fair, many sectors are much-of-a-muchness in that portfolios in the larger, more-vanilla sectors are forced into similar positions by their benchmarks, and the determining factor is often the fund management team.

By refreshing contrast, investment companies in the Commodities and Natural Resources sectors have a very different playbook and the strategies and investment philosophies of the managers who earn their bacon (or pork belly) in this sector are disparate and varied.

Next week we’ll conduct a deeper-dive into some of the strategies that managers have and hope to deploy on managing their clients’ money in the global commodities market.