Quest for profit breaks commodities link with stocks

Investors smelling profits in commodities are using the sector as an early cycle play, alongside equities, because a lack of production capacity means higher prices sooner rather than later.

Historically, prices of natural resources lag equities, which typically front run the economic cycle by between 18 to 24 months.

The change is also partly due to the tumbling dollar, a major driver in recent weeks.

The natural resources sector is also one of the last to price in economic expansion. But not this time.

“During the recent recession a lot of spare capacity was created in many sectors, but not in petroleum and mining,” said Ashok Shah, chief investment officer at London & Capital.

Very high

“The little capacity that was created in petroleum and mining will be used up much faster when we eventually have growth ... The squeeze on prices will come more quickly and that is why commodities have become early cycle plays.”

Global capacity utilisation rates in petroleum products and mining between 2002 and 2007 averaged more than 90 per cent.

Analysts estimate those levels fell to 80 per cent — still very high — in July 2009.

In contrast, utilisation rates among manufacturing companies was estimated at around 65 per cent last July from about 80 per cent between 2002 and 2007.

Equivalent numbers for the auto sector were 45 per cent and 80 per cent respectively.

The large output gap in manufacturing and the auto sector means production can ramp up easily without any bottlenecks when the global economy sees stronger growth, albeit from low levels.

Not so in commodities, where firms are running a tight ship.

Fund managers expect central bank and government stimulus to help the global economy return to stronger growth, albeit from very low levels, probably in the second half next year.

“At this time, both equity prices and commodity prices are equally benefiting from reflationary public policies,” said Hilary Till, principal at Premia Capital Management.