A worker inspects a newly-cast copper anode sheet as it cools in its mold at the MMC Norilsk Nickel PJSC copper refinery in Norilsk, Russia (Photographer: Andrey Rudakov/Bloomberg)  

Commodities Markets 2018: Invisible Enemies, Solid Friends

(Bloomberg Gadfly) -- If you're looking for what kept a lid on commodities this year, just keep in mind that it's invisible.

Having notched a gain in 2016 for the first time in six years, it looks like the Bloomberg Commodity Index will end 2017 back in the red again:

Commodities Markets 2018: Invisible Enemies, Solid Friends

Breaking down the 22 underlying commodities' weighted returns for the year so far, only nine show a gain. The chart below shows the top and bottom five performers. One stands out -- and not in good way:

Commodities Markets 2018: Invisible Enemies, Solid Friends

With the index down about 4.3 percent this year, that 3.4 percentage point drag from U.S. natural gas futures plays an outsize and unhelpful role. Looking at the top and bottom five, it's clear grains also had a bad year, while metals helped to limit the loss overall.

To get a clearer picture on what shaped the index's performance this year, the chart below breaks it down into its main sub-groups -- energy, industrial metals and so forth -- showing relative size, returns for the year as a whole, and recent performance this quarter:

Commodities Markets 2018: Invisible Enemies, Solid Friends

Stuff you burn and stuff you grow -- constituting about 61 percent of the index -- were the big losers this year.

In energy, besides natural gas, West Texas Intermediate crude oil suffered from a trifecta of weakness through the first half; dislocation from oil's eventual rally due to logistical problems; and, until very recently, an upward-sloping futures curve inflicting losses as positions got rolled from month to month. Brent crude has benefited more from OPEC's supply cuts, but its index-weighted return was a mere 0.4 percentage points.

As for crops, U.S. harvests have continued to exceed expectations, and there's no OPEC for corn, wheat and soybeans.

What's striking about that chart is the upper-right quadrant: There's nothing in it. That's where you would see sub-groups that not only made gains in 2017 as a whole but were also maintaining momentum into year-end. Industrial metals, which so far this year have delivered the biggest gains to the index, on a weighted basis, have slipped 5 percent since the end of September. 

Commodities Markets 2018: Invisible Enemies, Solid Friends

Peering into 2018, the index likely needs industrial metals to get their mojo back after this quarter's breather. There is good reason to think they will, with global economic growth on a synchronized upswing and manufacturing indicators reading bullish:

Commodities Markets 2018: Invisible Enemies, Solid Friends

Copper and aluminum, the two biggest weightings in the industrial metals sub-index, should continue to benefit from relatively tight supply, with aluminum potentially getting a helping hand from China's efforts to rationalize capacity and curb pollution.

Prospects elsewhere look more mixed. Precious metals -- another large sub-sector that is also in the black this year -- face headwinds in the form of further increases in U.S. interest rates next year, which would tend to hold back gold prices.

The recent hiatus in the weakening of the dollar -- a trend through most of 2017 -- helps explain the recent weakness in commodities in general, but is especially pertinent for gold. Against these hurdles, geopolitical risk is making something of a comeback, centered on places like North Korea, Iran and Saudi Arabia. That should offer some support for gold next year (provided there isn't a mass defection into cryptocurrencies instead).

Energy is also a mixed bag. Natural gas has taken a beating already. But absent some favorable weather -- favorable for gas, not us, that is -- rising production (particularly of gas associated with oil wells) and new pipelines enabling more natural gas to flow out from the eastern U.S. could deliver more pain 2018.

Oil looks more hopeful, especially as futures curves for both Brent and WTI now present less of a drag on returns. Yet much rests on the interplay of OPEC's discipline, shale's exuberance, and geopolitical hotspots like the Middle East and Venezuela. Faith in OPEC's powers have fueled a speculative rally in crude oil, but that has also paved the way for America's exploration and production companies to hedge next year's output and potentially undercut the market again.

Down on the farm, meanwhile, there is little reason to expect the abundance in grain supply that has kept that sub-index in a bear market for years to abate (absent a weather or geopolitical event).

Commodities Markets 2018: Invisible Enemies, Solid Friends

Livestock has been more lively of late, and soft commodities such as sugar and coffee always have the potential for surprise gains. With a combined weighting of just 14 percent, though, hogs, cattle, cotton, coffee and sugar would need sharp rallies indeed to lift the index as a whole.

Taken altogether, there's a reasonable chance the index ekes out a gain in 2018 after this forgettable year. As for most of this decade, though, supply encouraged by the supercyclical boom of the previous decade -- particularly in energy and agriculture -- presents a formidable hurdle. 

-- "Low Energy" chart by Dave Merrill

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

To contact the author of this story: Liam Denning in New York at ldenning1@bloomberg.net.

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