Oil could jump 30% or more in 2016

The risk of lower commodity prices in the first half of this year continues to loom as most commodity markets are still in a supply surplus, suggesting things will get worse before they get better. The latter part of 2016, however, offers more positive prospects for returns, led by better economic activity, higher oil prices and retreating U.S. dollar strength. Crude oil, the most challenging commodity to invest in, should also deliver the most upside in 2016.

There is an intuitively logical rationale for commodity prices to bounce back after five years of negative returns and a terrible 2016 start. Most commodity prices are trading so low that many mid- to high-cost producers of energy, precious metals and industrial commodities are loss-making on a cash-cost basis or are not in a position to cover their capital costs.

Workers steady a section of drill pipe during drilling operations for Chesapeake Energy.
Daniel Acker | Bloomberg | Getty Images
Workers steady a section of drill pipe during drilling operations for Chesapeake Energy.

The only caveat for this year is that accelerating economic growth has been a precondition for stronger commodity prices in the past. What some of the best commodity years like 1983, 1999, 2003 and 2010 all have in common is a material acceleration in global GDP growth following periods of economic malaise. Growth often picked up in the latter part of the year preceding the mentioned years like in 2002 (U.S. and Asian growth picked up in the second half of 2002) or in 2009 (China's economy bounced firmly in the second half of 2009). Global GDP growth accelerated 1.1 percentage points to 5.4 percent during these years, with 2010 setting the top and 1999 the bottom of this range.

We expect global GDP growth to accelerate by only 0.2 percentage points in 2016, somewhat less than the latest estimates from the International Monetary Fund. Since stronger economic growth should mainly be concentrated in the developed world, a convincing case for commodities is difficult to make with respect to demand. Moreover, global GDP growth has had the tendency to disappoint market expectations in recent years.

On the supply side, investors should not expect that adjustments are in a position to significantly drive prices higher for metals or bulk commodities. The nature of mine supply is still simply too sticky to give prices a material push and any price increase would likely come with a quick supply response. So until mine capacity is finally shut in, the pain on the producer side will stay high for another year. That said, production cuts should help stabilize prices in 2016. Without weather extremes, agricultural markets should stay range-bound.

The story in crude oil is somewhat different, although prices need to remain low or go even lower in the short run to clear the market and cut non-OPEC output. The aggressive production profile in U.S. shale basins, which should decline rapidly over a 12 to 24-month horizon, is setting oil apart from mined commodities. We believe this gives oil prices the most upside in 2016 with the opportunity to go long towards the middle of the year.

Overall, for 2016, we recommend investors avoid commodities on a broad basis for the third consecutive year. In our view, there is likely to be more downside potential in the first half of the year followed by a recovery in the second half. Sector wise, the most upside on a spot basis in 2016 is energy (crude oil) followed by base metals and agriculture, in our view. Precious metals should trade largely flat while livestock prices are expected to drop again. In terms of magnitude, energy clearly sticks out with an expected return of around 32-42 percent over 12 months, while other sector increases are likely to range from 0-10 percent only.

Commentary by Dominic Schnider, head of commodities at UBS Wealth Management, which oversees $1 trillion in invested assets. Follow UBS on Twitter @UBS.