If you think the movements in stock and currency markets can sometimes be significant, have a look at commodities and the share prices of companies that produce them. Recent years have given this analyst many more grey hairs that can’t be completely blamed on his two young children.

Commodities do tend to have greater short-term volatility than other asset classes. This is partly due to trading by financial entities that often exceed the trading between producers and consumers. The daily turnover of oil futures for example, dwarfs the turnover of actual physical oil barrels. This can see data points like weekly US oil inventory levels move oil prices by several percentage points. Whilst this creates noise, it is important to look at the bigger picture. Over time, fundamentals take over with prices reflecting actual supply and demand.

Looking past short-term volatility, the longer-term picture has been interesting

For over a decade, China has increasingly come to dominate global demand for many commodities as it aggressively directed investment into key areas of their economy. This saw elevated prices for oil, iron ore and copper amongst others as demand outstripped supply. There was a brief but nasty pullback during the GFC but the China led stimulus saw it all back on again.

Source: Wood-Mackenzie-Brook Hunt, WBMS, CRU, McCloskey’s, Tex Report, AME, Platts, Bloomberg, UBS Research

But as the old saying goes “what goes up must come down” and in 2014 Chinese growth started to slow. However, more importantly, supply finally increased responding to the soaring prices. By late 2015/early 2016, oil dropped from US$110 a barrel to under US$30, iron ore fell from US$130 to US$40 and the share price of the world’s biggest miner BHP fell from AUD$35 to AUD$15.

Source: Bloomberg

2016 broke the despair with a strong recovery that was supercharged after Trump’s election, seeing many commodities overshoot their fundamentals. Iron ore moved from a comfortable US$50-60 to US$90 and is now back in the comfortable mid US$50’s. Even oil has lost around US$9 over the last two months on higher than expected US shale production and concerns over whether OPEC cuts are honoured by members.

Members of the Milford Investment team have been in both China and the US in recent weeks. In our view, concerns over China weakness are overplayed giving some comfort that the pullback in iron ore looks largely done. US shale oil production continues to exceed everyone’s predictions on its resilience, but remember that it produces only about 5-6 per cent of the world’s oil production whilst new developments in many oil regions around the world remain lacklustre. Hence, we should see prices range bound for oil and most other major commodities over the next year or two.

What does this mean for resource stocks?

Whilst share prices of these companies usually move in tandem with the underlying commodities, it is not always the case – so opportunities do arise. An investor should also look at what the current share price is implying in terms of earnings. In this case, what level of commodity prices are being factored in to get that share price? The recent pullback has driven some distortions, creating opportunities to invest in good quality resource companies at reasonable valuations.

Hopefully the only new grey hairs for me over the next few years are from my children, and not from commodities.