The Fundamentals Driving Commodity Prices in 2024

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• Commodities can be volatile, subject to political decisions, weather patterns and cost of production. KLI Asset Management, commodities-focused hedge fund, uses a fundamental analysis framework to generate absolute returns regardless of pricing swings.
• Mismatched commodity fundamentals often take several months to realign. By maintaining a wide portfolio diversification, KLI avoids overleveraging on positions while waiting to realize a gain.
• Despite recent bearish signals, copper, crude oil and European carbon allowances (EUAs) are among the commodities with long-term upside based on current global supply and demand.

Investing in commodities has been a roller coaster for the last few years. As many analysts predicted a rapid acceleration in raw material consumption in the post-pandemic economic recovery, commodity prices have taken wild pendulum swings that feel impossible to time. So how does a commodities-focused hedge fund navigate these choppy waters?

For KLI Asset Management, the answer is a strong reliance on fundamental analysis and broad diversification. The UK-based fund manages about $400 million — a large portion of which is internal capital — and has a proven track record of absolute returns in a volatile space.

“We’re not short-term traders,” says KLI Chief Investment Officer and founding partner Ricardo Leiman. “We are really focused on the fundamentals and where we can get it right.”

Lately, the short-term commodities market has been full of slow growth and bad news. The Bloomberg Commodity Index is down 25% from its June 2022 high with energy, agricultural products and base metals headlining the disappointment. Yet the KLI team expects a correction based on fundamental supply and demand, a prediction informed by extensive internal analysis and their close contacts with merchants in the physical trading space.

Ricardo and his KLI co-founder Pedro Marion spoke with host Moritz Seibert on an Open Interest episode of Top Traders Unplugged to explain their approach to commodities trading and where they see opportunities in the next 12 to 18 months. Here’s what to look for.

Elements of a strong commodities position

“The interesting thing about commodities,” says Ricardo, “is that nothing happens in the medium term.” Typically, commodity traders are looking months out on futures contracts, but prices can move suddenly due to fluctuations in the physical market — more so than with financial assets, including stocks and bonds. To manage this volatility, KLI balances three factors in its commodities positions.

1. Supply and demand

Most importantly, KLI focuses on fundamental analysis — how do supply and demand impact price? Through a combination of internal research and consultations with merchants and buyers in the physical markets, KLI identifies the best pricing opportunities. “[Networking] gives us an edge in understanding all the price points and elasticity of supply and demand,” Ricardo notes.

Patience is the trick. If a commodity price is misaligned based on actual demand, it will rarely correct overnight. Pedro estimates that KLI holds long positions for six to 12 months on average, waiting for market realignment.

“It usually takes quite a bit of time for the market to come back to reality,” Pedro says. “But because it’s commodities — tangible assets — the fundamentals will always win.” If manufacturers or consumers need a particular commodity and global supplies dip too low, eventually the price will go up until storehouses can restock.

2. Portfolio diversification

In this sense, waiting becomes a matter of position sizing. “If you have too much level leverage [in a single commodity], you can’t hold the position long enough,” Pedro explains. “If you have too little leverage, then you don’t have the right-sized position to make the money that you should have made.”

For this reason, KLI’s portfolio includes a wide range of energies, metals and agricultural products, never exceeding a 35% concentration in a single commodity. Approximately 20% to 25% of the portfolio consists of commodity equities, offering some hedge against sudden price drops and a positive carry through dividends.

“[Diversification] gives us the ability to hold positions when the market goes against us,” Ricardo says. If the fundamental analysis supports a long-term hold of a particular commodity, the firm can ride out a few tough months without impacting the absolute return.

3. Liquidity

Of course, when they’re ready to exit a position, the fund managers need enough liquidity in the market to do so. How liquid? Ricardo’s goal is to be in or out of a position within 24 hours.

“That’s the nature of commodities. Suddenly, everything happens, and the market is really not prepared or paying attention,” Ricardo says. These parabolic moves can go down as quickly as they skyrocket, emphasizing the importance of a short-term trade window, even if KLI has held the position for a year or longer. 

Ricardo gives examples of crude oil, natural gas and base metals such as copper and aluminum as high-volume markets with constant open interest. Conversely, bulk freight fluids such as industrial chemicals or cooking oil are among the items that don’t meet the trading liquidity criteria.

Spotting the trends

Trading high volatility without overleveraging capital — why not use options? Moritz asks, “Do you think about buying a long-dated call on copper or a call spread? Or does selling a put play a role in your book?”

Despite the occasional advantage of buying a call when he views a price that might move quickly, Ricardo generally prefers to stay away from options. “Because of the drawdown of the supply chain, [the timing of commodities] is more unpredictable,” he says.

Instead, KLI focuses on directional movements based on commodity trading advisor (CTA) trends. These CTA models can help forecast commodity flows and highlight buying opportunities.

“We look at the short-term CTAs, which are basically trading moving averages. They’re simple to track, very fast and very active,” Ricardo explains. He compares this analysis with longer-term CTAs — those tracking momentum or the shape of the commodity’s futures curve — to inform the timing of when to get in or out of a position.

Yet Ricardo offers a word of caution. A KLI analysis was inconclusive as to whether or not solely following CTA trend models resulted in higher profits. “In the end, the fundamentals are what really drives local [metal] miners,” Ricardo says.

Fundamentals always win

From a consumer perspective, supply and demand is simple. As more people travel in the summer, gasoline prices go up. When it’s a mild winter with less demand for natural gas heating, energy prices go down.

But because commodities traders are usually looking at futures contracts rather than the actual price of the commodity in today’s market — often called the spot price — the fundamental impact isn’t always apparent in long-dated trades.

Take coal, for instance. Coal prices fell in 2023, despite global demand reaching record levels. As Europe and the United States shut down coal plants and push toward renewable energy sources, there’s a perception among investors that the green energy transition will result in a plunging demand for coal. The reality, however, is a different story.

“Asia is burning coal like there’s no tomorrow,” Ricardo says. “You have increasing demand in China, increasing demand in India and the continuous building of coal-burning plants across Asia. So despite the West declining in terms of coal demand, we continue to see that Asia is picking up.“ Fundamentally, a higher demand suggests a correction is coming to the downward price trend.

Commodities to watch in 2024

Pedro’s one concern with coal is that the market doesn’t have the liquidity KLI normally looks for. “With all the negative publicity [around burning coal], all the banks have had to pull out of it,” he says. At least for now, Ricardo and Pedro see stronger buy opportunities in other commodities.

Copper

Opposite coal on the clean energy spectrum is copper, a primary component in solar panels, wind turbines and other electrical systems. China, quickly becoming the world’s leader in electric vehicle production, has skyrocketing demand for copper and other so-called green metals, and global stockpiles are shrinking.

“​​The price of copper has gone down [alongside] a massive drawdown in global inventories, which is pretty difficult to put together,” Ricardo says. Once again, prices have the potential to go higher, only this time in a commodity market with more global liquidity.

Oil

Speaking of clean energy, Ricardo forecasts that we’ll still live in a both/and world for quite some time — fossil fuel consumption and electrification. That puts all eyes on oil.

“I think that the green transition will take a lot longer than the politicians have estimated,” he says. As long as consumers drive gas-engine cars, diesel powers farm equipment and jet fuel fills the tanks on planes, crude oil demand will stick around for the foreseeable future.

EUAs

In our energy-conscious geopolitical climate, emissions are an intriguing commodity play. European Union Allowance (EUA) futures have trended downward since summer 2023, largely attributed to less energy usage in a mild winter and falling gas prices. Supply is harder to calculate as emissions caps are based on political decisions, but upticks in industrial production or power consumption will likely increase demand.

“Right now, we think that emissions could easily double in price from today's numbers,” Pedro says. “It depends on what your horizon is. In two to three months, I can’t tell you where emissions will be. Maybe nine or 15 months ahead, it is getting quite compelling to be long on emissions.”

What to avoid

On the flip side, Ricard and Pedro find other commodities less interesting for a long-term investment. The first on the list is one making headlines in 2024.

Cocoa

Cocoa prices have gone stratospheric, up over 130% year to date at the time of this writing. Poor harvests in West Africa have dwindled global supply, creating a parabolic rally as importers scramble to fill their stores. Although Ricardo acknowledges this kind of situation would normally be a good market opportunity, he isn’t interested in cocoa as a long-term play.

“Cocoa is dependent on two countries that manage 70% of the global supply. We [at KLI] think that doesn't really fit our category of risk diversification because it has a lot of political risks associated with it,” he says.

Grains

Conversely, favorable weather conditions in the U.S. could lead to a bumper crop. When combined with falling global demand for U.S. grain exports, there may not be enough demand for the supply, pushing the price down.

“Our view has been we’ve been negative on corn and soybeans for a few months,” Pedro says. Ricardo further predicts that an overabundance of grain could drive prices below the cost of production for U.S. farmers — not an ideal situation for investors.

Closing thoughts

In any case, KLI’s approach is that that reward is worth the wait. “We’re more like investors on the commodity spectrum, waiting for fundamentals to take place, than the short-term traders trying to make a quick buck in and out of positions,” Ricardo says.

Perhaps the most valuable commodity in the market is patience.

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.