Author: Miscellaneous Talks on Seeing the Big Picture from Small Details

Table of contents

I. The Dual Anchor Mechanism of Price Formation

II. The term structure does not lie.

III. Inventory Constraints: Stratification Across Commodity Volatility

IV. Functional Division of Market Participants

V. Quantitative Logic of Extension Benefits

VI. The Three-Part Framework for Inflation Hedging

VII. Considerations for Commodity Portfolio Allocation

VIII. Summary of Core Methodologies

9. *A Beginner's Guide to Commodities for Portfolio Managers*

I. The Dual Anchor Mechanism of Price Formation

Commodity prices serve two time dimensions simultaneously, which is the starting point for understanding the entire system.

The long-term anchor is determined by the marginal cost of production, which is the lowest price at which the highest-cost producer is willing to invest in the last product required by the market. This anchor moves slowly but has far-reaching effects.

Taking crude oil as an example, in the early 2000s, as idle capacity was exhausted, marginal costs rose sharply, and the market shifted from the "exploitation stage" (using existing assets to improve utilization) to the "investment stage" (requiring the development of new capacity), which drove a systematic rise in the central oil price.

In practice, long-term futures prices (usually 5-7 year distant-month contracts) are the best tool for proxying marginal costs because producers' pricing decisions are concentrated within this period.

Short-term anchors are adjusted in real time by inventory levels. The price spread between spot and forward contracts (time spread) is a direct reading of inventory tightness, rather than a prediction of future price trends.

Methodology: When analyzing any commodity, first separate "how much the forward anchor has moved" from "how much the spot price has deviated from the anchor"—the former reflects structural changes on the supply side, while the latter reflects the current physical market tightness.

II. The term structure does not lie.

The signal value of term spreads is extremely high, and they have a self-enforcing nature under arbitrage mechanisms:

Backwardation = Near-month price is higher than far-month price → There is genuine scarcity in the market.

The buyer is willing to pay an "immediate delivery premium" to take delivery immediately.

Contango = Near-month price is lower than far-month price → Ample inventory

Holders prefer to sell the spot and buy the forward, thereby collecting storage costs.

The reliability of this signal lies in its arbitrage constraint: if the discount is artificially maintained when inventory is plentiful, the holder will immediately sell spot goods and buy forward contracts, thus smoothing out the price difference.

Therefore, a sustained large discount must correspond to real physical scarcity.

The extreme case during the COVID-19 pandemic (WTI futures prices falling into negative territory) is a mirror image of the extreme premium – when inventories are filled to the point of having nowhere to store, spot prices become negative after discounting storage costs.

OPEC's role deserves separate understanding: the oil-producing alliance can control inventory levels by managing supply, thereby affecting the shape of the curve (maintaining a discount structure), but it cannot move the long-term anchor—high-cost producers (US and Canadian shale oil) are the determinants of marginal cost.

III. Inventory Constraints: Stratification Across Commodity Volatility

Storage costs are the underlying explanatory variable for all behavioral differences in commodities, forming predictable cross-commodity stratification:

Methodological significance:

Copper is known as "Dr. Copper" and is used as a barometer of the global economy because its low storage costs allow prices to reflect future demand (i.e., expectations of economic growth).

Natural gas and agricultural products, on the other hand, are highly anchored to current physical realities and cannot be explained by "future gaps"—the market for these products will use inventory accumulation and price declines to absorb any premature pricing expectations.

IV. Functional Division of Market Participants

Each of the three types of participants has its own economic function, and none can be dispensed with:

1) Commercials: are the reason for the existence of the market.

Producers lock in prices in advance to transfer price risk by selling in the futures market, forming a structured short position. They are willing to accept a locked-in price lower than the expected spot price; this discount is the risk premium.

2) Index Investors: These are passive liquidity providers.

By buying long-term futures contracts on the opposite side of commercial hedgers, collecting a risk premium, and without making directional judgments or participating in price discovery, historical data shows that there is no significant correlation between index fund inflows and commodity price movements—they do not drive prices.

3) Speculators: are the core mechanism of price discovery.

Taking the corn market as an example, the USDA's ending inventory forecast is a public benchmark. When the forecast is low, speculators buy to raise prices and slow down consumption; when the forecast is loose, speculators exit and let prices fall to accelerate consumption.

This real-time adjustment allows the market to smoothly complete inventory reduction or replenishment in advance, rather than violently correcting itself when physical shortages have already occurred. The fact that price volatility actually increased significantly after onion futures were banned is a counter-evidence of the price-stabilizing effect of speculators.

V. Quantitative Logic of Extension Benefits

The excess returns of commodity futures consist of two parts:

Excess return in futures trading = Price gain + Roll yield

Price gains come from changes in spot prices, which are concentrated at the front end of the curve (demand shocks cause a sharp rise in near-month prices, while far-month prices change only slightly due to their anchored marginal costs).

Rollover gains come from the change in the value of the contract as the delivery date approaches:

• Discount Market:

The passage of time increases the value of the contract (as each day brings it closer to the higher price for immediate delivery), generating positive rollover income.

• Premium Market:

As time passes, contracts incur more storage costs, resulting in negative rollover revenue (rollover loss).

Brent crude oil in 2024 is an extreme case: spot prices remained almost unchanged throughout the year, but investors earned double-digit returns solely from rollover gains.

Enhanced Roll strategy : Hold near-month contracts below the discount curve to maximize roll-over gains; roll over to more distant month contracts below the premium curve to reduce roll-over costs. This is a core active management tool for improving long-term returns on commodity futures holdings.

VI. The Three-Part Framework for Inflation Hedging

Treating "inflation" as a homogeneous whole is a common mistake—the three inflation mechanisms correspond to three completely different hedging tools:

Scenario 1: Late-cycle inflation → Allocate to cyclical commodities

When the economy overheats, the output gap is positive, demand consistently exceeds supply capacity, and inventories continue to decline. In the later stages of the cycle, inventories are nearly depleted, oil prices and industrial metals rise sharply, bonds have weakened, and stock returns begin to dull—commodities provide just the right opportunity for diversification.

The key signal is that inventory remains below historical seasonal levels and the rate of depletion is accelerating.

Scenario 2: Supply disruption and inflation → Broad basket of commodities (excluding precious metals)

Supply shocks (geopolitical events, extreme weather, policy disruptions) cause inflation to rise while growth declines, putting pressure on both bonds and stocks. Commodities, as "disrupted inputs," are often the only assets with positive real returns. Because the timing and source of disruptions are unpredictable, it is necessary to hold a broad basket rather than betting on a single commodity.

The reason for excluding precious metals is that, in this scenario, precious metals may fall in the opposite direction due to expectations of interest rate hikes (increased opportunity costs) and liquidity needs for margin calls.

The Commodity Control Cycle is a structural analytical framework for supply disruption risk, describing a self-reinforcing geoeconomic logic chain:

Countries focus on domestic needs → subsidize domestic supply → overcapacity depresses global prices → high-cost producers exit → supply becomes more concentrated → major players have the ability and motivation to weaponize supply → countries focus on domestic needs again.

Currently, about 90% of rare earth refining is concentrated in China, which is a signal that the cycle has entered the third/fourth stage, meaning that the risk of supply disruption has substantially increased.

Scenario 3: Risk to Institutional Credibility → Gold

When rising inflation expectations are driven by questions about fiscal discipline or central bank independence, or by doubts about the neutrality of reserve currencies, gold is the only neutral asset that does not rely on the credit of any government.

The classic case from the 1970s (US fiscal expansion + political pressure to intervene in monetary policy + Iranian asset freeze undermining the neutrality of the dollar) clearly demonstrates the boundaries of gold's role in this scenario.

Gold is often not an effective hedge in the first two scenarios, and may even fall due to expectations of interest rate hikes and liquidity needs.

VII. Considerations for Commodity Portfolio Allocation

1) The essential difference between it and commodity equity

Commodity equities (mining and energy companies) have a correlation of approximately 0.55 with spot commodities, and a similarly high correlation of ~0.55 with large-cap stocks. At times when commodity hedging is most needed—when stocks fall due to both inflation and weakening growth—commodity equities often decline along with the broader market and bear additional company-level risks (operational disruptions, cost structure exposure).

Take the 2026 Hormuz incident as an example: the incident disrupted about 20% of global oil and gas flow, and commodity prices rose sharply. However, producers in the affected regions were unable to realize the high prices (operations were damaged), while producers in other commodity sectors faced rising energy costs that squeezed profit margins.

2) The "counterintuitive" contribution of volatility

BCOM's annualized volatility is approximately 15%, higher than US Treasury bonds (~8%) but lower than US stocks (~19%). The key point is that commodity volatility peaks during periods of simultaneous stock and bond declines (high inflation + weak growth), so a small allocation to commodities can actually reduce overall portfolio volatility rather than increase it.

Hedging does not require a large allocation – the transmission rate of commodity price increases to the CPI is far less than 100% (a doubling of oil prices does not mean a doubling of inflation), and a small position can achieve effective protection.

3) Benchmark selection and regional adaptation

• S&P GSCI: Production-weighted, energy sector accounting for approximately 52%, volatility around 20%.

• BCOM: More balanced, with energy/metals/agricultural products at approximately 29%/35%/36% respectively, and volatility of approximately 15%, making it a more mainstream investment benchmark.

Important note: Both benchmarks use US natural gas (Henry Hub) to represent natural gas exposure. European investors should replace it with TTF, and Asian investors should replace it with JKM. Otherwise, there will be a systemic under-hedging of local energy inflation.

VIII. Summary of Core Methodologies

1. Pricing Analysis: Always distinguish between the two dimensions of "forward anchor (marginal cost)" and "term spread (inventory)". Use long-term futures to represent the former and 1M-13M spread to represent the latter.

2. Variety Selection: Based on the economics of storage, distinguish between "living in the present" energy agricultural products and "foresight-oriented" metals, and use different analytical frameworks and holding tools accordingly.

3. Inflation hedging: Strictly distinguish between the three inflation mechanisms and reject the crude judgment of "basket inflation".

4. Profit Attribution: When holding commodity futures, it is essential to separate price gains from roll gains. The latter is driven by the curve shape and can be actively managed through an enhanced roll strategy.

5. Risk signals: Monitor the stage of the commodity control cycle - when the global supply concentration continues to rise (the third stage signal appears), the structural allocation value of supply disruption risk increases accordingly.

Portfolio Manager's Guide to Commodities

0. Execution Summary

This introductory guide provides a practical overview of commodity markets—how they function, when to protect your portfolio, and how to gain exposure.

Seize the present, invest in the future. Commodity prices operate simultaneously on two time dimensions: on the one hand, they are anchored by the marginal cost of future production (depending on geological, technological, and capital intensity) to incentivize new supply; on the other hand, they regulate current consumption to manage inventory. When inventory is low, prices rise to curb demand and prevent depletion; when inventory is abundant, prices fall to accelerate consumption and reduce excess inventory.

The Constraints of Inventory. Inventory solves the inherent time mismatch problem in commodity markets, where supply decisions are made months or years before consumption occurs. But storage is not free. The more difficult a commodity is to store, the stronger the constraint of storage costs on prices—this shapes price volatility, limits the forward-looking ability of commodity markets, and pulls prices back to current physical realities.

Not all inflations are created equal. Three different inflationary shocks require different hedging tools.

1) Late Cycle: Hedging with Cyclical Commodities. When the economy overheats and demand exceeds production capacity, inflationary pressures accumulate as inventories continue to deplete. In the late cycle, as inventories near exhaustion, cyclical commodities such as oil and industrial metals tend to rise—which coincides with weakening bond prices and sluggish stock returns.

2) Supply Disruptions: Hedging with a broad basket of commodities (e.g., including precious metals). When supply disruptions occur (such as Russia cutting off approximately 40% of Europe's gas supply in 2022), inflation rises while growth slows, dragging down bond and stock prices. At this time, commodities, as the input to the disruption, are among the few assets that can provide positive real returns. Because the source and timing of disruptions are inherently unpredictable, a broad basket of commodities (e.g., including precious metals) provides the most robust protection.

3) Institutional credibility risk: hedge with gold. When concerns about institutional credibility and macroeconomic policies drive up inflation expectations, gold is a key neutral asset whose value does not depend on the endorsement of any government.

Achieving portfolio stability through commodity volatility. Commodities are highly volatile, but their prices tend to surge when stock and bond prices fall simultaneously—that is, during periods of high inflation and weak growth—so a small allocation to commodities can reduce overall portfolio volatility rather than increase it.

Gain exposure. Traditional benchmarks such as BCOM are a practical starting point. Investors seeking more customized hedging can consider exposure to specific regions (since US benchmarks may not adequately hedge against energy inflation in Europe or Asia), tilting towards the inflation mechanisms they are most concerned about, and employing enhanced rollover strategies to improve returns on long-term holdings of commodity futures.

I. How the product operates

1.1. Seize the moment, invest in the future

The U.S. corn harvest lasts only a few weeks in the fall, but the crop produced during this short window must meet demand in the U.S. and globally for the next twelve months. To achieve this, prices must perform a balancing act: high enough to avoid depletion before the next harvest, and low enough to avoid excessive inventory at year-end. The right price works by slowing or accelerating consumption, thus depleting inventory at just the right pace (Chart 1).

Chart 1: The right price consumes crops at just the right rate: high enough to avoid depletion, low enough to avoid excessive year-end surplus.

But prices have another task: to ensure planting for the next harvest. If the marginal cost of future production rises—due to soaring fertilizer prices, declining yields, or the scarcity of quality farmland—the price anchor will also rise, and prices will adjust accordingly, consuming inventory around this higher price level.

The corn market illustrates that commodity prices operate simultaneously on two time dimensions: on the one hand, they are anchored to the marginal cost of future production (which depends on geology, technology, and capital intensity), and on the other hand, they ensure that currently available stocks are consumed at an appropriate rate.

This logic applies to all commodity markets, whether production is seasonal (such as agriculture) or continuous (such as oil and copper) – for the latter, the speed at which supply enters the market is largely locked in by decisions made several quarters or years before consumption occurs.

1.2. Anchor in the long term

We can use long-term futures to approximate changes in marginal cost. Producers invest capital and make production decisions well in advance, managing price risk by locking in prices through futures contracts several years in advance. A project will only proceed if the locked-in price covers costs, making long-term futures prices a useful proxy for marginal cost: the lowest price at which the highest-cost, ultimately needed producer is still willing to invest.

As shown in Table 2, marginal costs change slowly but can change significantly over time. In the oil market, since the mid-2000s, marginal costs have risen sharply as idle capacity (mainly built in the 1970s) was depleted in the early 21st century. This has driven the market from the extraction phase (where supply growth comes from increased utilization of existing assets at low cost) to the investment phase, requiring the construction of new, next-generation capacity at significantly higher costs.

Chart 2: Marginal cost of oil (proximated by long-term futures prices) has risen significantly since 2004 due to the depletion of spare capacity.

1.3. Term spreads don't lie.

Because long-term futures reflect the marginal cost of future supply, spot prices are anchored around long-term futures prices.

Any deviation between spot prices and long-term futures prices—defined as term spreads—exists solely for inventory management and therefore directly reflects the current physical condition.

Scarcity gives value to near-term delivery. Buyers pay a premium for immediate delivery to ensure immediate access to goods, driving spot prices higher than futures prices. The resulting downward-sloping curve—the spot premium—simply reflects that contracts closer to delivery are more valuable than longer-term contracts when inventory is tight, rather than an expectation of price declines (red portion in Chart 3).

Ample inventory eliminates the need to pay a premium for immediate delivery. Choosing to wait for delivery requires holding inventory during the period—which can be a significant expense when inventory is high. As a result, spot prices trade below futures prices, creating an upward-sloping curve—the futures premium—which reflects the storage costs inherent in forward contracts rather than the anticipated price increase (blue portion in Chart 3).

The COVID-19 pandemic pushed oil futures premiums to extremes. With economies stalled, oil demand collapsed, and storage facilities were completely filled. With nowhere to go, oil prices plummeted into negative territory.

Chart 3: The extent to which spot prices deviate from long-term futures anchors depends on the easing or tightening of the physical market.

These term spreads don't lie. Spot prices cannot sustainably remain above futures prices (maintaining a spot premium) because there is no genuine scarcity.

The reason is that if spot prices are maintained above futures prices when there is ample inventory and no real need to pay a premium for immediate delivery, inventory holders who do not need the goods immediately can sell at higher spot prices and buy them back at cheaper prices in the forward market for future delivery, while avoiding storage costs in between.

As more holders take the same action, selling pressure in the spot market increases, pulling down spot prices relative to futures and quickly pushing the market back to a futures premium.

OPEC can shape the curve, but it cannot move the anchor point.

While term spreads cannot lie about physical reality, sufficiently large participants—such as groups of producers—can influence the physical reality itself. This is why oil typically trades at a premium to the spot price: by managing supply, OPEC can control the inventory levels reflected in the term spread, thereby affecting the shape of the curve.

By deliberately withholding oil and maintaining spare capacity, OPEC can stabilize inventories during shortages and release supply to curb volatility when prices surge. Lower volatility, in turn, reduces the incentive for alternative oils, supporting long-term oil demand. This supply management keeps inventories tight, maintains a cash premium on the curve, and allows OPEC to sell at higher spot prices than its peers (hedged against lower futures prices) and generate greater price movements with relatively modest production adjustments.

While OPEC can shape the curve, it cannot move the anchor. Long-term prices are set by marginally high-cost producers—and that's not OPEC. High-cost production from the US and Canada sets the anchor: the minimum acceptable price for producing the next barrel of oil. OPEC simply doesn't have enough spare capacity to replace all these high-cost supplies.

1.4. Inventory Constraints

Inventories bridge the inherent time mismatch in commodity markets, where supply decisions are made months or years before consumption occurs. However, holding inventory incurs significant costs. The more difficult a commodity is to store, the stronger the constraint that storage costs place on prices. These storage constraints shape the behavior of commodity markets—how much prices fluctuate, how far ahead the market can anticipate, and how quickly prices are pulled back to current physical reality. Storage economics is an inescapable constraint on commodities.

1.5. Easy to store, lower volatility

Inventories mitigate volatility by allowing the market to gradually absorb shocks. Without this buffer, prices must react immediately, leading to much greater volatility—as is the case in the electricity market, where large-scale storage is challenging, and supply and demand must be matched second by second. Natural gas storage is costly and difficult, with only a small buffer to absorb unexpected changes in demand, resulting in very high volatility. In contrast, metals are easy to store and buffer—therefore, their volatility is much lower (Chart 4).

Chart 4: Easy to store, lower volatility

1.6. Unlike bonds and stocks, commodities cannot be predicted very far in advance.

Anticipated shortages are typically not priced into goods because inventory constraints constantly pull prices back to current physical reality. If prices rise prematurely due to anticipated future shortages, consumption slows, supply increases, and inventory accumulates. Therefore, prolonged shortages can create near-term surpluses. With excess inventory having nowhere to go, rising storage costs force prices down—usually well before the anticipated shortage arrives.

This is particularly evident in the energy and agricultural sectors, where supply can respond quickly to price increases, and high storage costs lead to rapid inventory accumulation and swift price corrections. This is less pronounced in the metals sector: because supply adjustments are slow and storage costs are low, inventory accumulation is typically manageable rather than destructive, allowing metal prices to move further ahead without immediate price corrections (Chart 5).

Chart 5: While stocks can price future shocks, commodity prices (especially energy) are primarily anchored to the present.

1.7. Who traded the goods, and why ?

Three distinct groups of participants—commercial institutions, index investors, and speculators—are active in the commodity market, each helping to bridge the time gap between supply decisions and consumption (Figure 6).

Chart 6: Index investors are the smallest of the three participant groups; speculators and commercial institutions dominate the activity.

Commercial entities—the reason markets exist—are primarily producers. Producers invest capital and plan production well in advance, but prices can fluctuate significantly before the first barrel of oil is shipped. To mitigate this price risk, producers hedge by selling futures contracts, typically at a price lower than the expected spot price. This discount is the risk premium: the cost of transferring price risk to others.

• Index investors—passive liquidity providers—are regular buyers on the other side of long-term futures sales in exchange for a risk premium. They do not hold a directional view on prices; they simply go long on commodities as an asset class and mechanically roll over their positions over time. Therefore, they do not drive price movements (Chart 7).

Speculators—price discoverers—bring new information into prices and help adjust the rate of inventory depletion in real time. In the corn market, the link between forward fundamental expectations and speculative buying is particularly clear because the USDA publishes forward-looking estimates of ending stocks, providing a public benchmark for the anticipated supply-demand balance.

As shown in the left chart of Table 8, lower USDA inventory forecasts coincided with larger speculative long positions. Speculators bought when they anticipated inventory would run out before the end of the season, pushing up prices and slowing consumption; they exited when they anticipated surplus inventory at year-end.

By translating inventory expectations into prices in real time, speculators enable the market to adjust in advance and smoothly (Chart 8, right). Without them, prices would not adjust until shortages had already occurred—leading to more abrupt and destructive corrections.

Chart 7: Index investors do not drive price changes

Chart 8: The close link between USDA inventory forecasts and speculative positions shows how corn speculators translate inventory expectations into prices, driving price discovery in real time.

Case Study: The Backfire of the Onion Futures Ban

Speculators are sometimes scrutinized for their role in commodity markets. However, a market without speculators tends to be more volatile, not less volatile—as illustrated by the famous example of the onion market.

In 1955, Vincent Cosuga, an onion farmer turned futures trader, and his partner Sam Siegel manipulated the onion market at the Chicago Mercantile Exchange. By fall, they controlled over 99% of the onions on the Chicago market, accumulating approximately 14,000 tons (30 million pounds). Onions were shipped from all over the country to Chicago, warehouses were overflowing, and storage costs soared.

Under pressure from rising storage costs, they changed tactics—threatening to flood the market unless onion growers bought their stock. When the onion growers intervened, the pair built up a massive short position in onion futures. By the end of the harvest season in March 1956, they had indeed flooded the market, causing prices to plummet from $2.75 a bag to just 10 cents—less than the cost of the bag itself.

Kosuga and Siegel made millions from their short positions. Many farmers went bankrupt. This incident led the U.S. Congress to pass the Onion Futures Act in 1958, completely banning onion futures trading. To this day, one can trade futures for oil, wheat, copper, and even frozen orange juice—but not onions.

But the ban backfired. Without speculators to inject information into prices and adjust inventory depletion in real time, onion prices became more volatile—not less so (Chart 9).

Chart 9: Onion prices are more volatile than most other commodities, including corn.

1.8. The role of rollover gains in commodity returns

Commodity futures returns (the portion exceeding interest rates) have two components: price return and roll yield. We will use a simple assumption to illustrate the role of roll yield.

Price return. Increased demand tightened inventory and pushed spot prices up by $20. As shown in Table 10, this $20 increase is concentrated at the front end of the curve, while the back end remains anchored to marginal cost.

Chart 10: The $20 growth is concentrated at the front end of the curve, while the back end remains anchored to marginal cost.

Rollover benefits. A commodity futures contract is essentially a claim for physical delivery in the future—for example, in August 2026. As time goes on, the contract gets closer to physical delivery. Therefore, even if the spot price itself doesn't change, its value can rise or fall depending on the shape of the futures curve.

In a well-supplied futures premium market, holding a contract can incur costs over time. Even if the spot price remains unchanged, the same August 2026 contract may depreciate over time because storage costs are included each week. When inventory is plentiful, these storage costs can be considerable.

In the hypothetical example in Chart 11, simply shifting time one month towards the delivery date results in a $12 loss, as storage costs completely offset any immediate delivery premium. This reduces the initial $20 spot price increase to just $8. One way to mitigate this drag is to hold contracts further down the curve, where the slope is flatter—for example, at the six-month mark, the same time shift might only incur a $1 cost.

Chart 11: In a well-supplied futures premium market, holding a contract may incur costs over time.

• In a scarce market with a spot premium, time is on your side. The value of holding a claim to a commodity that is currently difficult to obtain increases with each day that the delivery date approaches, even if the spot price does not change (Chart 12).

The power of rollover gains can be significant. In 2024, the spot price of Brent crude oil started at $75.89 per barrel and ended at $75.93 per barrel—almost unchanged—yet investors earned double-digit returns solely from rollover gains.

Chart 12: The value of a contract automatically increases when it approaches delivery in a market with tight physical supply.

Therefore, most index investors employ an enhanced rollover strategy: investing closer to the front of the curve when there is a spot premium to maximize rollover gains, and extending further to the back when there is a futures premium to minimize rollover costs.

II. The Role of Commodities in Multi-Asset Portfolios

2.1. Not all inflation is created equal – different inflationary shocks require different hedging tools.

Some investors view commodities and gold as a single inflation hedge. In reality, inflation typically arises through three different mechanisms—late-cycle inflation, supply disruptions, and institutional credibility risk—each requiring different hedging instruments.

Chart 13: Inflation typically arises through three different mechanisms, each requiring different hedging tools.

Mechanism 1: Late stage of the cycle – hedging with cyclical commodities

When the economic cycle overheats, stocks initially benefit from strong growth. But as the economy begins to exceed its production capacity (what economists call a positive output gap), inflationary pressures build, and real bond returns weaken. Over time, rising input costs compress profit margins, and stock growth begins to falter. It is precisely at this stage—when bond prices weaken and stock returns begin to lose momentum—that commodities tend to offer diversification through stronger returns.

Commodity performance typically strengthens late in the cycle because a positive output gap means demand exceeds supply. In commodity markets, this imbalance manifests as the continuous depletion of inventories. Late in the cycle, inventories are already nearly exhausted, pushing up prices—especially for cyclical commodities such as oil and industrial metals.

Chart 14: A positive output gap means demand exceeds supply, leading to sustained inventory depletion that nears exhaustion late in the cycle—supporting strong commodity returns.

The return of the old economy

The late stage of the cycle is when the expansionary economy encounters its physical constraints—what our team calls the "return to the old economy."

In long periods of ample supply, commodity returns are typically weak, and capital flows to the prevailing growth themes, such as the dot-com boom of the late 1990s. Over time, insufficient investment in new commodity supply and sustained demand growth erode spare capacity, inventories begin to deplete, and the expanding economy becomes increasingly exposed to physical constraints.

At that moment, the market transitioned from the extraction phase (where demand growth was met by increasing the utilization of existing capacity) to the investment phase. During the investment phase, long-term commodity prices must rise structurally because easily exploitable reserves are depleted, idle capacity is exhausted, and new capital is now required to produce every additional barrel or ton.

Uncertainty could perpetuate the underinvestment cycle. Capital tends to remain on the sidelines when investors worry that cheap supply may reappear as new projects come online—whether due to potentially reversible policy supports that restrict low-cost foreign supply (such as tariffs or price floors), or because current geopolitical disruptions that constrain supply may eventually be lifted. Paradoxically, the uncertainty that drives up prices in the short term may itself delay the investment needed to pull prices back up in the medium term.

Mechanism 2: Supply Disruptions – Hedging with a broad basket of commodities (e.g., including precious metals)

When supply disruptions occur (such as Russia cutting off approximately 40% of Europe's gas supply in 2022), inflation rises while growth slows, dragging down bond and stock prices. At such times, commodities, as inputs affected by the disruption, are among the few assets that can provide positive real returns. Because the source and timing of disruptions are inherently unpredictable, a broad basket of commodities (such as those including precious metals) offers the most robust protection.

Product control cycle

While the exact timing of disruptions cannot be predicted, the risk of disruption tends to increase structurally as global economic integration decreases. This unfolds through a self-reinforcing cycle, requiring no malicious actors—each step is a rational response to the previous one (Figure 15).

As countries turn inward, governments are taking measures to isolate supply chains through tariffs, subsidies, and state-backed investments, replacing imports as much as possible and stockpiling when replacements are not possible.

These supply-stimulating incentives could lead to supply exceeding domestic demand. The resulting surplus would then be exported, depressing global prices.

Lower prices force high-cost producers elsewhere out of the market, ultimately concentrating supply in the hands of fewer participants.

Once supply is concentrated in fewer hands, dominant producers can use it as geopolitical and economic leverage—increasing the risk of disruption, commodity price volatility, and inflation. This, in turn, prompts other countries to further isolate their supply chains, reinforcing the cycle.

Chart 15: As the world becomes increasingly fragmented, the risk of disruption tends to rise structurally—through a self-reinforcing “commodity control cycle.”

Investors seeking to hedge portfolio disruption risk through commodities may consider taking action when the commodity control cycle is nearing or has reached step 3, i.e., when countries are turning inward and supply is increasingly concentrated in regions with higher geopolitical or trade dispute risks (Chart 16). At that stage, step 4 becomes a real risk: supply is controlled by a few actors who have both the ability and the potential motivation to use it as an economic or geopolitical lever.

Chart 16: Commodity supply is becoming increasingly concentrated

Mechanism 3: Institutional Reputation Risk – Hedging with Gold

In the first two inflation mechanisms—late-cycle inflation and supply disruptions—gold is not an effective hedge. Instead, gold typically falls in the initial stages: higher inflation may lead to market expectations of interest rate hikes, increasing the opportunity cost of holding non-interest-bearing assets, while a stock market decline may trigger margin calls and liquidations of gold due to its high liquidity and readily available cash.

Gold serves as a narrow hedge against inflation: when rising inflation expectations due to concerns about institutional credibility or macroeconomic policies lead to a real sell-off of both bonds and stocks. In this situation, gold stands out as a key neutral asset, its value independent of any government backing.

The 1970s serve as a classic example. Massive fiscal expansion in the United States and political pressure to cut interest rates by the Federal Reserve led to runaway inflation, while the freezing of Iranian central bank assets raised questions about the geopolitical neutrality of the dollar. As investors sought value outside the financial system—an asset that would neither depreciate nor be frozen—gold prices soared.

2.2. Providing Diversity During Critical Periods

As shown in Table 17, in every 12-month period when the real returns of stocks and bonds were negative, commodities or gold generated positive real returns. The 60/40 portfolio's "golden age" from the late 1990s to 2022 coincided with highly globalized supply chains and strong institutional trust, enabling Mechanism 2 (supply disruption) and

Mechanism 3 (institutional credibility risk) – one of the two most disruptive inflationary mechanisms for traditional investment portfolios – is largely absent. The rationale for allocating to commodities and/or gold re-emerges as supply chain fragmentation and/or concerns about institutional credibility and macroeconomic policy rise.

Chart 17: During periods when both bonds and stocks had negative real returns, gold or commodities generated positive real returns.

While positive equity returns can still offset negative bond returns in the later stages of the cycle, the upward momentum in equities begins to weaken, the equity-bond correlation turns positive, and the diversification effect diminishes. At this stage, commodities can provide additional diversification, as they tend to perform strongly in the later stages of the cycle.

2.3. Commodity-related stocks cannot replace physical commodities.

Some investors seek commodity exposure through commodity production stocks (miners, energy producers, and agricultural companies) in hopes of leveraging upside potential. Earnings, reserves, and cost discipline can amplify returns relative to changes in the underlying commodity price.

However, this amplification effect is bidirectional—and often has a negative impact when investors most need commodity exposure. Commodity stocks are essentially still stocks and are strongly correlated with the overall stock market (~0.55). Late in the cycle, as inventories near depletion, commodity prices may rise sharply, while producer stocks priced based on forward-looking cash flows may weaken along with the broader market as growth slows or interest rate hike risks increase.

Unlike direct commodity exposure, stock investors also bear company-specific risks: operational disruptions, management decisions, balance sheet stress, and input cost risks. These risks are most pronounced during supply disruptions. When supply shocks occur, commodity prices often rise in tandem—as seen in the 2026 Hormuz event, which disrupted approximately 20% of global oil and gas flows and critical chemical inputs, and also impacted agriculture and metals.

Rising commodity prices do not necessarily translate into strong performance for commodity-related stocks. Producers of affected commodities may not be able to profit from higher prices if their operations are hampered. Meanwhile, producers in other commodity sectors may face squeezed profit margins despite rising prices for their own commodities—because energy is a key input in mining, smelting, and agriculture.

2.4. Achieving portfolio stability through commodity volatility

Commodities are volatile: BCOM's annualized volatility is about 15%, higher than the US fixed income of about 8%, but lower than the US stock volatility of about 19%. However, the biggest gains in commodities usually occur when high inflation and weak growth simultaneously drag down stock and bond prices.

Therefore, commodity allocation may reduce overall portfolio volatility rather than increase it. As shown in Table 18, adding commodities to a stock-bond portfolio may allow investors to take on less risk for the same expected return, or to obtain higher returns for the same level of risk.

Commodity allocations don't need to be large to be effective hedging tools. As inputs, commodity price increases only partially translate into consumer prices—a doubling of oil prices doesn't necessarily mean a 100% increase in inflation. Therefore, even small commodity allocations can be very effective and, under normal circumstances, don't require consuming too much of the portfolio's risk budget, serving as a safeguard when equity-bond diversification fails.

Chart 18: Commodities and gold may allow investors to take on less risk for the same expected return.

III. Considerations for Constructing a Product Basket

3.1. Traditional Benchmark

Two standard commodity benchmarks are the S&P GSCI and the BCOM. The S&P GSCI is production-weighted—intended to approximate a basket of global consumption—and therefore has a large weighting for energy. The BCOM is currently the more widely used benchmark by investors, with a more balanced allocation among energy, metals, and agriculture, and therefore its volatility is generally lower than the S&P GSCI (20% vs. 15% for the BCOM).

Chart 19: The S&P GSCI is heavily biased towards energy, while the BCOM (currently the more widely used benchmark) offers a more balanced exposure across energy, metals, and agriculture.

3.2. Geographical Location Factors

Standard commodity benchmarks are often U.S.-centric and may therefore be slightly under-hedged, failing to adequately hedge energy and food inflation relevant to non-U.S. investors. For example, natural gas is a regional market: European investors are better off hedging with European TTFs, and Asian investors are better off hedging with JKMs, rather than with the U.S. Henry Port natural gas contracts included in BCOM and S&P GSCI.

3.3. Leaning towards a target inflation mechanism

Investors looking to hedge against specific inflation mechanisms may want to adjust their commodity baskets accordingly. As summarized in Table 20, cyclical commodities hedge against late-cycle inflation, a broad commodity basket (e.g., including precious metals) hedges against supply disruption risks, while gold only hedges against inflation when concerns stem from market anxieties about institutional credibility or macroeconomic policies.

Chart 20: Cyclical commodities hedge against late-cycle inflation; a broad basket of commodities (e.g., including precious metals) hedges against supply disruption risk; gold hedges against institutional credibility risk.

Specifically, the effectiveness of a commodity as a hedge against supply disruption inflation depends on two factors: its direct or indirect weight in the inflation basket, and the share of supply that may be disrupted. Energy scores highly on the first factor, both historically and currently. Industrial metals and rare earths rank lower in inflation weighting, although their importance has been rising as global electrification increases demand for grid infrastructure and the energy mix shifts towards renewable energy. However, industrial metals and rare earths stand out on the second factor—refining is highly concentrated, with China controlling approximately 90% of global rare earth processing (Chart 16). Such large-scale disruptions, even with only indirect effects on consumer prices (e.g., as inputs for automobiles), could generate significant spillover effects.

3.4. The US Dollar and Commodities

Commodities are priced in US dollars, which is important for non-dollar investors, but the relationship between the dollar and commodities varies by industry.

In the energy sector, causal relationships typically flow from commodities to money markets. Energy is a significant item in the current account, and given that the United States is now a major energy exporter while most economies remain importers, higher energy prices can support the dollar's exchange rate against other currencies.

In the metals and agriculture sectors, this relationship is more inverse—flowing from money to commodities—because supply or cost structures are largely dictated by local currencies. Cyclical forces can also drive both commodity and currency markets simultaneously. Industrial metals are particularly sensitive to U.S. monetary policy and global growth expectations: lower policy rates weaken the dollar and often boost metal demand. Therefore, copper often acts as a liquidity proxy for global growth—and the renminbi exchange rate—reflecting China’s dominant share (58%) in global copper consumption.

3.5. Enhanced Extension Strategy

As described in Section 1.8, commodity index returns have two components: spot price returns and roll-over gains—that is, the gains or costs incurred simply by holding a commodity futures contract as time moves toward the delivery date. In a futures premium market, storage costs exceed any immediate delivery premium, and this time-shifting incurs costs. In a spot premium market, physical shortages push spot prices above futures prices, and the same time-shifting incurs gains.

Most index investors use enhanced rollover strategies to manage the returns of holding commodities over time: automatically investing in the front end of the curve to capture rollover gains when there is a spot premium, and extending the curve to the far end to minimize rollover costs when there is a futures premium.

Appendix: A Simple Framework for Commodity Prices

Spot prices adjust the rate of inventory depletion around a long-term anchor.

In Section 1.1, we showed that spot prices consist of two parts: a slowly moving anchor set by the marginal cost of future supply, and a rapidly adjusting term that adjusts current inventory.

This decomposition means that the term spread—the deviation between the spot price and the long-term futures price—is precisely the measure of inventory tightness: Term Spread = Spot Price - Long-Term Futures Price = Measurement of Inventory Tightness

Term spreads move with the tightness of inventory – reflecting whether the market is paying a premium for immediate availability or bearing storage costs.

Therefore, the term spread directly reflects the current physical tightness, manifested as the inventory utilization rate. Depending on the tightness, the market either pays a premium for immediate availability or bears storage costs (Chart 21).

• Scarce physical supply (low inventory utilization rate) makes immediate delivery valuable. Immediacy premium dominates, driving spot prices higher than futures prices—resulting in a downward-sloping curve and a positive term spread (spot premium).

Ample inventory (high inventory utilization) eliminates the need to pay a premium for immediate delivery. Choosing to wait for delivery requires holding inventory during the period—which can be a significant expense when inventory levels are high. Storage costs dominate, pushing spot prices below futures prices—resulting in an upward-sloping curve and a negative term spread (futures premium).

Chart 21: Term spreads reflect the tightness of inventory levels

Why do forward curves behave differently across different commodities?

Two elasticities determine the strength of the term spread's response to the degree of inventory tightness:

• γ: The steepness of the rise in immediate premium as inventory decreases.

•δ: The steepness of the increase in storage costs as inventory increases.

These elasticities vary by commodity. In the energy sector, both gamma and delta tend to be high because depleting inventories can have devastating economic consequences, and storage costs are high. In the metals sector, these elasticities tend to be lower because the consequences of shortages are less severe, and storage costs are relatively low.

Why can't we anticipate the future for commodities (especially energy)?

Our framework explains why commodities (especially energy) are primarily spot assets and cannot sustainably price fundamentals beyond their supply adjustment cycles.

To understand why, consider a scenario where the market attempts to determine inventory levels over a timeframe exceeding T (i.e., the point at which supply can react). For example, suppose the market attempts to price a forward positive demand shock by pushing up current spot prices.

This implicitly requires more inventory coverage than the reasonable adjustment rate. Therefore, the inventory coverage ratio rises beyond its reasonable adjustment level. The market moves from the correct adjustment point (blue) to the over-adjustment point (red), along the curve connecting the term spread to the inventory utilization ratio (Charts 22 and 23).

As inventory accumulates, the rate at which spot prices are forced to fall depends on δ, the elasticity of storage costs.

• Energy: High δ, Short T. Storage costs rise rapidly as inventory accumulates. High spot prices slow demand and encourage relatively rapid supply responses, leading to inventory buildup and increased storage pressure. Spot prices fall rapidly relative to the forward anchor FT (in Chart 22, the red over-adjustment point indicates a significant deviation of S_t relative to F_T). High storage costs thus enforce discipline—it's impossible to plan inventory for maturities exceeding T without incurring substantial price penalties.

• Metals: Low δ, long T. As inventory accumulates, storage costs rise only slowly. Therefore, inventory can increase without immediately forcing spot prices down (in Chart 23, the red over-adjustment point shows only a moderate deviation of S_t relative to F_T). Therefore, metal prices can be more forward-looking than energy prices.

Chart 22: High storage costs in the energy sector force prices down as inventories accumulate.

Chart 23: Low storage costs in the metals sector allow inventory to accumulate without immediately forcing spot prices down.

Spot gold breaks through $4,500 for the first time

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