The commodity crunch point

Businesses may diversify in response to major shifts in commodity markets. For example, there may be growing incentives to diversify operations geographically. Countries undergoing commodity transitions may look to attract foreign investors by allowing joint ventures as a way of gaining business and technological know-how in industries that offer the potential for economic diversification.

Business owners facing disruption from commodity transitions can also adapt by diversifying into the emerging sectors that are disrupting their business models. For example, many established oil and gas players are looking to expand their resource base by incorporating renewable energy assets. They are adopting a 'cleaner' barrels approach in conventional fields’ development by distinguishing between prospective exploration projects based on their carbon intensity.

Entrepreneurs should consider ESG factors as part of their response to major commodity market shifts. ESG performance in their company, the countries in which they operate, and across their supply chains increasingly affects business reputation and brand value.

Governments worldwide are placing greater emphasis on ESG topics, and we are seeing more and more countries adjusting their policies to attain the UN’s SDG targets. This could lead to tighter regulations. We think companies that follow best practices in these areas will enjoy a relative advantage.

When entering a new market or shifting supply chains in response to commodity disruptions, we favor countries with a strong track record on ESG issues and sustainability. Failure to do so could be costly, with repercussions ranging from regulatory fines and consumer boycotts to avoidance of their company’s financial instruments by ESG-driven investors.

Create nimble but resilient operating models by considering the strength and diversity of your supply chains and deciding on early versus late adoption when investing in a new technology.

In fast-moving markets, seizing new opportunities and mitigating risks requires a robust, flexible operating model. Having an adequate contingency plan and being prepared to react to changes in the legal, regulatory, and market environment is crucial not only to ensuring the success of a foreign venture, but also in protecting the incumbent business.

Entrepreneurs should also consider assessing the strength and diversity of their supply chains. In a world of increasing trade frictions, access to resources is of paramount importance, since commodity markets are extraordinarily concentrated. Over 70% of the world’s iron ore, corn, and lithium, for instance, are produced in just five countries.

Equally, policy actions contemplated by commodity producers can have major implications for supply chains and business models alike, depending on whether such policies are permanent or temporary. This issue is likely to increase in importance for business owners, as we expect regulatory changes to become even more prevalent.

Investors need to consider how existing and new positions would be affected by the commodity transitions. For a start, many investors invest directly in commodities. Gold, for example, enjoys a long-standing reputation as a safe-haven asset. We think commodities can provide interesting opportunities for tactical investors. An alternative way to build exposure to the asset class is through the equity and bonds of commodity-producing companies. The bonds of gold miners, for example, not only benefit from rising gold prices, they often offer appealing coupon payments. Investment selectivity is essential. For single bond investors, a careful issuer selection is key. Company fundamentals tend to be at least as important as the price change of the underlying commodity.

As an investor, you should also consider that countries better positioned to cope with commodity transitions should generally offer more attractive risk-adjusted returns over a long-term investment horizon. But increasing efforts to deal with the changing commodity landscape can boost asset prices, too, especially if these improvements occur from a weaker base.

Population growth, aging, and urbanization, coupled with the increased drive to tackle climate change and a broad range of technological advances, are disrupting commodity markets and requiring commodity-producing countries to adjust their policies. For investors, these trends can provide appealing long-term investment opportunities due to above-average growth rates. Investors may wish to consider longer-term investment themes which should benefit from the policy responses of commodity-producing countries to handle commodity transitions. Some of the CIO Longer Term Investment (LTI) themes include: renewable energy, energy efficiency, clean air and carbon reduction, agricultural yield, water scarcity, and smart mobility.

Diversification within each theme and across themes minimizes risks related to specific technologies and companies. We advise investors with existing single security holdings in these sectors to revisit their investments in light of the expected changes. For example, the move to a cleaner energy mix would benefit companies operating along the renewables value chain, but would be more problematic for companies that are part of the coal value chain.

As many commodity markets change due to environmental, social, and governance trends, we recommend investors shift to suitable investment strategies. Such strategies seek to optimize the risk-reward of an investment portfolio by adding exposure to industry leaders, i.e., to sovereigns and companies that are most advanced in meeting the shifting requirements, and avoiding exposure to the laggards.

There is also a growing number of fixed income instruments – green bonds, for instance – that link their proceeds to climate-change solutions. As such, investing in them not only enables investors to contribute to solving some of the world’s most pressing challenges, they can do so without the risk of forfeiting investment performance via lower returns or higher volatility, in our view.