Why the commodities bust is about to turn into a boom

• Commodities have taken a beating this year with oversupply as one of the main culprits.
• That doesn't mean investors should abandon ship.
• Here's why broad based commodities indices will get a boost in the next three to six months.

Brittany Sowacke | Bloomberg | Getty Images

Oil workers in the Permian Basin outside Midland, Texas

Diversified commodity indices are down about 5 percent year-to-date. Equity markets are up significantly and the Japanese yen has weakened, which suggests that broader economic concerns do not seem to be driving prices. This puts the focus on supply as the main culprit. However, blaming the commodities slump on supply alone would be inaccurate. Global purchasing managers' indices disappointed expectations in April. Softness in car sales and questions over U.S. economic stimulus also weighed, while China's outlook still calls for a slowdown.

So should the market be worried? We don't think so for two reasons. First, we expect favorable developments for prices on the supply and demand side in the coming months. And second, elevated speculative positions in the futures market have made it easy for supply and demand concerns and technical factors to pressure prices lower. With the most aggressive net long positions in the futures market having moderated, the negative impact of these short-term flows on prices should diminish.

We believe that the investment cycle will broaden and strengthen in the coming months, particularly in Asia. Even in the U.S., where activity indicators in the first quarter of this year were disappointing, the investment side of gross domestic product showed a strong year-on-year acceleration. This and good European economic numbers give us confidence that global GDP growth can still gain traction and support commodity demand in the second half of this year. Demand for commodities has been strong this year with oil offtake—a form of upfront trading—running at a healthy pace, supported by Asia and Europe.

Considering our outlook for firmer economic activity amid disciplined supply, we believe the odds are in favor of higher commodity prices. Historically, the strongest return periods for commodities are during the later stages of an economic upswing. We therefore feel comfortable in our outlook for a 10 percent-plus appreciation in broadly diversified commodity indices over the next three to six months.

Average commodity returns are particularly strong during the later stages of an economic upswing, when our preferred metric, the OECD composite leading indicator, is improving but at a decelerating pace. This happens when economic growth reaches trend growth or rises above it. On the flip side, most return weakness for commodities occurs during stages when change in the indicator is negative and at a decelerating pace. This occurs when economic growth tends to be markedly below trend growth or contracting, and actual demand for commodities is weak.

Can this old pattern, which has weakened since 2012, re-emerge? We think it can, because conditions today are more favorable for greater supply discipline than in recent years. We make this call based on three main observations.

First, capital expenditure has dropped in the past three to four years. In the mining industry, it is down 40 percent from its 2013 peak, whereas in the energy sector, it has fallen more than 40 percent from its 2014 highs. These adjustments suggest that supply growth will be slow in the coming years. We see supply growth easing across base metals and bulk commodities.

The second factor to consider is China's greater focus on supply capacity in areas like steel, coal and aluminum. Additional pricing power is shifting toward the supply side in certain commodities thanks to China's enforcement of capacity adjustments and China-induced supply disruptions becoming an issue.

And lastly, OPEC is again managing crude oil supply. While allegations of cheating are an ongoing topic, key oil-producing countries indicated the need to work together to reduce elevated oil inventories in order to bring near-term stability to the market.

On the other hand, new projects are urgently needed to secure long-term supply and prevent global spare production capacity from plunging below 2 million barrels per day in 2022, according to the International Energy Agency. The limiting factor for OPEC remains U.S. shale supply, which we believe will cap prices in the $60-65 per barrel range for now.

Considering our constructive economic and constrained supply stance, energy and industrial metals should again fare best at the later stage of an economic upswing. In this context, precious metals should lag. Agriculture and livestock also show a traditionally positive profile in later stages. Nevertheless, in addition to oil prices, we caution that supply shifts remain the key driver of prices.

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

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