Goldman Sachs' latest commodities methodology: A beginner's guide to commodities for portfolio managers

Table of ContentsI. The Dual Anchor Mechanism of Price FormationII. The Term Structure Doesn't LieIII. The Constraints of Inventory: Stratification Across Commodity VolatilityIV. Functional Division of Market ParticipantsV. The Quantitative Logic of Rollover YieldsVI. The Three-Part Framework for Inflation HedgingVII. Considerations for Commodity Portfolio AllocationVIII. Summary of Core MethodologiesIX. *Introduction to Commodities for Portfolio Managers*I. The Dual Anchor Mechanism of Price FormationCommodity 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 production cost, which is the lowest price that the highest-cost producer, the last one needed by the market, is willing to invest in. This anchor point moves slowly but has a profound impact.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" (utilizing existing assets to improve utilization) to the "investment stage" (requiring the development of new capacity), driving a systemic rise in the central oil price. In practice, long-term futures prices (usually 5-7 year distant-month contracts) are the best tool for representing marginal costs because producers' pricing decisions are concentrated within this period. The short-term anchor is adjusted immediately by inventory levels. The price difference between spot and forward prices (timespread) is a direct reading of inventory tightness, not 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, and the latter reflects the current physical market tightness. II. The Term Structure Doesn't Lie The signal value of term spreads is extremely high, and under arbitrage mechanisms, they are self-enforcing: Backwardation = Near-month price higher than far-month price → Real scarcity exists in the market. Buyers are willing to pay an "immediate delivery premium" to take delivery immediately. Contango = Near-month price lower than far-month price → Ample inventory. Holders prefer to sell spot and buy forward, thus incurring storage costs. The reliability of this signal lies in its arbitrage constraint: if the discount is artificially maintained when inventories are ample, holders will immediately sell spot goods and buy forward contracts, smoothing out the price difference. Therefore, a sustained large discount necessarily corresponds to a genuine scarcity of physical goods. The extreme case during COVID-19 (WTI futures prices falling into negative territory) is a mirror image of the contango limit—inventories were filled to the point of having nowhere to store, and the spot discount became negative after deducting storage costs. OPEC's role deserves separate consideration: the oil-producing alliance can control inventory levels through supply management, thereby affecting the curve shape (maintaining a continued discount structure), but it cannot move the long-term anchor—high-cost producers (US and Canadian shale oil) are the determiners of marginal costs. III. The Constraints of Inventory: Stratification Across Commodity VolatilityStorage costs are the underlying explanatory variable for all differences in commodity behavior, forming predictable stratification across commodities:Methodological Significance:Copper is called "Dr. Copper" and used as a barometer of the global economy precisely because low storage costs allow prices to be priced in forward 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 prematurely priced expectations. IV. Functional Division of Market Participants The three types of participants each have their own economic functions, and none can be omitted: 1) Commercial Hedgers: They 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 structural 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: They are passive liquidity providers. They buy long-term futures against commercial hedgers, collecting the risk premium, 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: 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 consumption; when the forecast is high, speculators exit, causing prices to fall and accelerating consumption.This immediate adjustment allows the market to smoothly complete the reduction or replenishment of inventory in advance, rather than waiting until a physical shortage occurs before violently correcting itself. The significant increase in price volatility after the ban on onion futures is a counter-example of price stability driven by speculators.V. Quantitative Logic of Roll YieldThe excess return of commodity futures consists of two parts:Futures Excess Return = Price Yield + Roll YieldPrice Yield comes from changes in spot prices, which are concentrated at the front end of the curve (demand shocks cause near-month contracts to rise sharply, while far-month contracts have limited changes due to anchoring marginal costs). Roll gains come from the change in contract value as it approaches the delivery date: * **Discount Market:** The passage of time increases the contract value (getting closer to the higher price for immediate delivery each day), generating positive roll gains. * **Contango Market:** The passage of time causes the contract to bear more storage costs, generating negative roll gains (roll losses). The 2024 Brent crude oil case is an extreme example: the spot price remained almost stagnant throughout the year, but investors achieved double-digit returns solely from roll gains. **Enhanced Roll Strategy:** Hold near-month contracts below the discount curve to maximize roll gains; roll to more distant month contracts below the contango curve to reduce roll costs. This is a core active management tool for enhancing long-term returns from holding commodity futures. VI. The Three-Part Framework for Inflation Hedging Treating "inflation" as a homogeneous whole is a common mistake – three inflation mechanisms correspond to three completely different hedging tools: Scenario 1: Late-Cycle Inflation → Allocating to Cyclical Commodities When the economy is overheated, the output gap is positive, demand consistently exceeds supply capacity, and inventories continue to decline. In the late cycle, inventories are nearing depletion, oil prices and industrial metals rise sharply, bonds have weakened, and stock returns begin to dull – commodities provide just the right diversification. The key signal is: inventories remain consistently below historical seasonal levels, and the rate of decline is accelerating. Scenario 2: Supply Disruption and Inflation → Broad Commodity Basket (Excluding Precious Metals)Supply shocks (geopolitical events, extreme weather, policy-induced supply disruptions) cause inflation to rise while growth declines, putting pressure on both bonds and stocks. Commodities, as "inputs of disruption," 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: National inward focus → subsidizing domestic supply → overcapacity depressing global prices → high-cost producers exiting the market → supply consolidation → major players possessing the ability and motivation to weaponize supply → further national inward focus. Currently, approximately 90% of rare earth refining is concentrated in China, signaling the cycle has entered its third/fourth stage, indicating a substantial increase in supply disruption risk. Scenario Three: Institutional Credibility Risk → Gold. When rising inflation expectations are driven by questions about fiscal discipline or central bank independence, or doubts about the neutrality of reserve currencies, gold is the only neutral asset that does not rely on any government credit. The classic case from the 1970s (US fiscal expansion + political pressure intervening 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. Commodity Portfolio Considerations 1) The Fundamental Difference Between Commodity Equities and Commodity Stocks The correlation between commodity equities (miners, energy companies) and spot commodities is approximately 0.55, while the correlation with large-cap stocks is also as high as ~0.55. At the moment when the hedging properties of commodities are most needed—when stocks fall simultaneously due to inflation and weakening growth—commodity equities often fall along with the market and bear additional company-level risks (operational disruptions, cost structure exposure). Taking the 2026 Hormuz event as an example: This event disrupted approximately 20% of global oil and gas flows, causing a sharp rise in commodity prices. However, producers in affected regions were unable to realize the high prices (operational losses), while producers in other commodity sectors faced rising energy costs that squeezed profit margins.2) The "counterintuitive" contribution of volatilityBCOM's annualized volatility is approximately 15%, higher than US Treasury bonds (~8%) but lower than US stocks (~19%). The key is that commodity volatility peaks during periods of simultaneous stock and bond declines (high inflation + weak growth). Therefore, 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 CPI is far less than 100% (a doubling of oil prices does not mean a doubling of inflation), and a small position is sufficient for effective protection.3) Benchmark Selection and Geographical Adaptation·S&P GSCI: Production-weighted, energy percentage ~52%, volatility approximately 20%·BCOM: Relatively balanced, energy/metals/agricultural products approximately 29%/35%/36% respectively, volatility approximately 15%, currently a mainstream investment benchmarkImportant Note: Both benchmarks use US natural gas (Henry Hub) to represent natural gas exposure. For European investors, TTF should be used instead, and for Asian investors, JKM should be used instead; 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)," using long-term futures to represent the former and 1M-13M spreads to represent the latter. 2. Commodity Selection: Using storage economics as the axis, distinguish between "present-day" energy and agricultural products and "forward-looking" metals, corresponding to different analytical frameworks and holding tools. 3. Inflation Hedging: Strictly distinguish between the three inflation mechanisms, rejecting 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 enhanced roll strategies. 5. Risk Signals: Monitoring the Stage of the Commodity Control Cycle – As global supply concentration continues to rise (the third stage signal appears), the structural allocation value of supply disruption risk increases accordingly. [Image 1] [Image 2] [Image 3] 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. Inventories solve 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 storage cost's constraint on price—this shapes price volatility, limits the forward-looking capabilities of commodity markets, and pulls prices back to current physical reality. Not all inflation is the same. 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 is precisely when bond prices weaken and stock returns begin to falter.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 inputs 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 Reputation Risk: Hedging with gold.3) Institutional Reputation Risk: Hedging with gold. Gold is a key neutral asset when concerns about institutional credibility and macroeconomic policy drive up inflation expectations, its value not dependent on any government backing. Portfolio stability can be achieved through commodity volatility. Commodities are highly volatile, but their prices often surge when stock and bond prices fall simultaneously—i.e., during periods of high inflation and weak growth—so a small allocation to commodities can reduce overall portfolio volatility rather than increase it. Gaining exposure is crucial. Traditional benchmarks like the BCOM are a practical starting point. Investors seeking more customized hedging can consider regional exposure (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 from holding commodity futures long-term. I. How Commodities Work 1.1. Seize the Present, Invest in the Future The US corn harvest lasts only a few weeks in the fall, but the crop produced during this short window must meet demand in the US 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 depletes inventory at the right pace by slowing or accelerating consumption (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 SurplusBut prices have another task: ensuring planting for the next harvest. If the marginal cost of future production rises—due to soaring fertilizer prices, declining yields, or prime farmland becoming scarcer—the price anchor will also rise, and prices will adjust accordingly, consuming stocks 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 (depending on geology, technology, and capital intensity), while 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 (e.g., agriculture) or continuous (e.g., 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. Anchoring to the Forward 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. Projects only proceed when the locked-in price covers costs, making long-term futures prices a practical proxy variable for marginal cost: the lowest price at which the highest-cost, ultimately needed producer is still willing to invest. As shown in Chart 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 costs) to the investment phase, requiring the establishment 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 depletion of spare capacity. 1.3. Term spreads don't lie. Since 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, pushing spot prices higher than futures prices. The resulting downward-sloping curve—the spot premium—simply reflects that contracts nearing delivery are more valuable than forward contracts when inventory is tight, rather than an expectation of price declines (red portion in Chart 3).·Abundant inventory eliminates the need to pay a premium for immediate delivery. Choosing to wait for delivery requires holding inventory of the goods during the period—which can be a significant expense when inventory is high. Therefore, 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 an expectation of price increases (blue portion in Chart 3). The COVID-19 pandemic pushed oil futures premiums to extremes. With economies stagnating, oil demand collapsed, and storage facilities were completely full. With nowhere to go, oil prices plummeted into negative territory. [Image of image] Chart 3: The extent to which spot prices deviate from their long-term futures anchor 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) without genuine scarcity. The reason is that if spot prices are maintained above futures prices when inventories are ample and there is no real need to pay a premium for immediate delivery, holders of inventory 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 do the same, selling pressure in the spot market increases, pulling spot prices down relative to futures and quickly pushing the market back to a futures premium. OPEC can shape the curve, but cannot move the anchor. While term spreads cannot lie about physical reality, sufficiently large participants—such as groups of producers—can influence physical reality itself. This is why oil typically trades at a spot premium: by managing supply, OPEC can control the inventory levels reflected in the term spread, thus 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 during price spikes. Lower volatility, in turn, reduces the incentive to substitute oil, supporting long-term oil demand. This supply management keeps inventories tight, maintains a premium on the spot price curve, and allows OPEC to sell at spot prices higher than its peers (hedged with lower futures prices) and generate larger 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 is 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 does not have enough spare capacity to replace all of these high-cost supplies. 1.4. The Constraints of Inventory Inventory compensates for 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 of storage costs on prices. These storage constraints shape the behavior of commodity markets—how much price volatility occurs, how far ahead the market can anticipate, and how quickly prices are pulled back to current physical reality. Storage economics is a constraint that commodities cannot escape. 1.5. Ease of Storage, Lower Volatility Inventory mitigates volatility by allowing markets to gradually absorb shocks. Without this buffer, prices must react immediately, leading to greater volatility—as in the electricity market, where large-scale storage is challenging, requiring supply and demand to be matched second by second. Natural gas is expensive and difficult to store, offering 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, they are much less volatile (Chart 4). Chart 4: Easy to Store, Lower Volatility1.6. Unlike bonds and stocks, commodities cannot be anticipated far in advanceExpected shortages are typically not priced into commodity prices 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 lead to near-term surpluses. ... With excess inventory having nowhere to go, rising storage costs force prices down—usually well before anticipated shortages arrive. This is particularly evident in the energy and agricultural sectors, where supply can react quickly to price increases, and high storage costs lead to rapid inventory build-up and swift price corrections. This is less pronounced in the metals sector: because supply adjustments are slow and storage costs are low, inventory build-up is generally 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 trades commodities, and why? Three distinct groups of participants—commercial institutions, index investors, and speculators—are active in commodity markets, each helping to bridge the time gap between supply decisions and consumption (Chart 6). Chart 6: Index investors are the smallest of the three groups; speculators and commercial institutions dominate. Commercial institutions—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, 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 harvest-end stocks, providing a public benchmark for the expected supply and demand balance. As shown in the left chart of Chart 8, lower USDA stock forecasts coincide with larger speculative long positions. When stocks are expected to run out before the end of the season, speculators buy, pushing up prices and slowing consumption; when there are expected surplus stocks at year-end, speculators exit. By instantly translating inventory expectations into prices, 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 Don't Drive Price Movements Chart 8: The Close Link Between USDA Stock Forecasts and Speculative Positions Shows How Corn Speculators Transform Stock Expectations into Prices, Driving Price Discovery in Real Time Case Study: The Backlash Against the Onion Futures Ban Sometimes, speculators are scrutinized for their role in commodity markets. However, a market without speculators tends to be more volatile, not less so—as the famous example of the onion market illustrates. In 1955, Vincent Kosuga, an onion farmer turned futures trader, and his partner Sam Siegel manipulated the onion market at the Chicago Mercantile Exchange. By the 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 were rising. Under pressure from rising storage costs, they changed tactics—threatening to flood the market unless onion growers bought their stocks. When onion growers intervened, the duo established massive short positions 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 per bag to just 10 cents—below the cost of the bag itself. Kosuga and Siegel made millions from their short positions. Many farmers went bankrupt. This event led to the passage of the Onion Futures Act by the U.S. Congress 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. However, the ban had the opposite effect. Without speculators introducing information into prices and adjusting inventory consumption in real time, onion prices became more volatile—not less volatile (Chart 9). Chart 9: Onion prices are more volatile than most other commodities (including corn). 1.8. The Role of Roll Yields in Commodity Returns Commodity futures returns (the portion exceeding interest rates) have two components: price returns and roll yields. We use a simple assumption to illustrate the role of roll-over gains. Price return. Increased demand tightens inventory and pushes the spot price up by $20. As shown in Chart 10, this $20 growth is concentrated at the front end of the curve, while the back end remains anchored to marginal cost. Roll-over gains. A commodity futures contract is essentially a claim to future physical delivery—for example, in August 2026. Over time, the contract gets closer to physical delivery. Therefore, even if the spot price itself doesn't change, its value can rise or fall due to 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 could depreciate over time because storage costs are included in each week's movement. When inventory is plentiful, these storage costs can be substantial. In the hypothetical example in Chart 11, simply moving one month towards the delivery date results in a $12 loss because storage costs completely offset any immediate delivery premium. This reduces the initial $20 spot price increase to only $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 movement might only incur a $1 cost. Chart 11: Holding a contract can incur costs over time in a well-supplied futures premium market·In a scarce, spot premium market, time is on your side. The value of holding a claim on a currently unavailable commodity increases with each day closer to the delivery date, even if the spot price remains unchanged (Chart 12). The power of rollover gains can be significant. In 2024, the Brent crude spot price started at $75.89 per barrel and ended at $75.93—virtually unchanged—yet investors earned double-digit returns solely from rollover gains.Chart 12: When a contract is nearing delivery in a tight physical market, its value automatically increasesTherefore, 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 Portfolios2.1. Not All Inflation is the Same – Different Inflationary Shocks Require Different Hedging ToolsSome investors view commodities and gold as single inflation hedges. In reality, inflation typically arises through three different mechanisms—late-cycle inflation, supply disruptions, and institutional credit risk—each requiring different hedging tools. Chart 13: Inflation typically arises through three different mechanisms, each requiring different hedging toolsMechanism 1: Late-cycle – Hedging with cyclical commoditiesWhen 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 up, 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 often provide 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 sustained depletion of inventories. Late in the cycle, inventories, long depleted and nearing exhaustion, drive 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, nearing exhaustion late in the cycle—supporting strong commodity returns. The Return of the Old Economy Late in the cycle is when an expansionary economy encounters its physical constraints—what our team calls the "Return of the Old Economy." In the long run 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, underinvestment 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 transitions from the extraction phase (where demand growth is met by increasing the utilization of existing capacity) to the investment phase. In the investment phase, long-run commodity prices must rise structurally because easily exploitable reserves are depleted, spare capacity dries up, and now every additional barrel or tonne requires new capital to produce. Uncertainty can perpetuate the underinvestment cycle. Capital tends to remain on the sidelines when investors fear the resurgence of cheap supply as new projects come online—whether due to potentially reversible policy support restricting low-cost foreign supply (such as tariffs or price floors) or the potential eventual unwinding of current geopolitical supply constraints. Paradoxically, the uncertainty that drives up prices in the short term may itself delay the investment needed to pull prices back 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 this time, commodities, as inputs 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. Commodity Control Cycle While the exact timing of disruptions cannot be predicted, the risk of disruption often increases 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 (Chart 15). As countries turn inward, governments take measures to isolate supply chains through tariffs, subsidies, and state-backed investments, replacing imports as much as possible and stockpiling when substitution is not possible. These supply-stimulating incentives can lead to supply exceeding domestic demand. The resulting surplus is exported, depressing global prices. Lower prices force high-cost producers elsewhere out of the market, ultimately concentrating supply in the hands of fewer players. 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, disruption risks tend to rise structurally—through a self-reinforcing “commodity control cycle”Investors seeking to hedge portfolio disruption risks through commodities may consider operating when the commodity control cycle is nearing or has reached step 3, i.e., when countries turn 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 economic or geopolitical leverage. ... Chart 16: Increasingly Concentrated Commodity SupplyMechanism 3: Institutional Reputation Risk – Hedging with GoldIn the first two inflation mechanisms—late-cycle inflation and supply disruptions—gold is not an effective hedging tool. Instead, gold typically falls in the initial stages: higher inflation may lead to market expectations of interest rate hikes, thus increasing the opportunity cost of holding non-interest-bearing assets, while a stock market decline may trigger margin calls and liquidations of gold, as it is highly liquid and a readily available source of cash. ... Gold hedges against a narrow form of inflation: when inflation expectations rise due to concerns about institutional credibility or macroeconomic policy, leading to a real sell-off of bonds and stocks simultaneously. At this time, gold stands out as a key neutral asset, its value independent of any government backing. The 1970s are a classic example. Massive fiscal expansion in the US and political pressure to cut Federal Reserve interest rates 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 Diversification During Key Periods As shown in Chart 17, in every 12-month period where real returns on stocks and bonds were negative, commodities or gold generated positive real returns. The "golden age" of the 60/40 portfolio from the late 1990s to 2022 coincided with highly globalized supply chains and strong institutional trust, rendering Mechanism 2 (supply disruption) and Mechanism 3 (institutional credibility risk)—two of the most destructive inflationary mechanisms for traditional portfolios—essentially absent. When supply chain fragmentation and/or concerns about institutional credibility and macroeconomic policy rise, the rationale for allocating to commodities and/or gold re-emerges. [Chart 17: Gold or commodities generated positive real returns during periods when both bond and stock real returns were negative] While in the later stages of the cycle, positive stock returns could still offset negative bond returns, the upward momentum of stocks began to weaken, the stock-bond correlation turned positive, and the diversification effect diminished. At this stage, commodities can provide additional diversification because they tend to perform strongly late in the cycle. 2.3. Commodity-Related Stocks Cannot Replace Physical Commodities Some investors seek commodity exposure through commodity-producing stocks (miners, energy producers, and agricultural companies) in hopes of leveraging upside gains. Profitability, reserves, and cost discipline can amplify returns relative to changes in the underlying commodity price. However, this amplification effect is two-way—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, as well as critical chemical inputs, and impacted agriculture and metals. Rising commodity prices do not necessarily translate into superior performance for commodity-related stocks. Producers of affected commodities may not be able to profit from higher prices if their operations are hampered. Producers in other commodity sectors, despite rising prices for their own commodities, may face squeezed profit margins—because energy is a critical input for mining, smelting, and agriculture. 2.4. Achieving Portfolio Stability Through Commodity Volatility Commodities are volatile: the annualized volatility of the BCOM (British Commodity Exchange) is approximately 15%, higher than the approximately 8% of US fixed income, but lower than the approximately 19% of US stocks. However, the largest gains in commodities typically 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 obtain a higher return for the same level of risk. Commodity allocation does not need to be a large proportion to be an effective hedging tool. As inputs, commodity price increases only partially translate into consumer prices—a doubling of oil prices does not necessarily mean a 100% increase in inflation. Therefore, even a small amount of commodity allocation can play a significant role and, under normal circumstances, does not require a large portion of the portfolio's risk budget, serving its purpose when stock-bond diversification fails. Chart 18: Commodities and Gold May Allow Investors to Take on Lower Risk for the Same Expected ReturnIII. Considerations for Constructing a Commodity Basket3.1. Traditional BenchmarksTwo standard commodity benchmarks are the S&P GSCI and the BCOM. The S&P GSCI is production-weighted—intended to approximate a global consumption basket—and therefore has a large energy weighting. 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 that of the S&P GSCI (20% vs. BCOM's 15%). Chart 19: S&P GSCI is heavily biased towards energy, while BCOM (currently the more widely used benchmark) offers a more balanced exposure across energy, metals, and agriculture3.2. Geographical FactorsStandard commodity benchmarks tend to be US-centric and may therefore be slightly under-hedged, failing to adequately hedge energy and food inflation relevant to non-US 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 US Henry Hub natural gas contracts included in BCOM and S&P GSCI. 3.3. Leaning Towards a Target Inflation Mechanism Investors seeking to hedge against a specific inflation mechanism may want to adjust their commodity basket 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 Hedging Late-Cycle Inflation, Broad Baskets of Commodities (e.g., Including Precious Metals) Hedging Supply Disruption Risk, Gold Hedging Institutional Reputation RiskSpecifically targeting supply disruption inflation, the effectiveness of a commodity as a hedging tool 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 weights, 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 a large-scale disruption, even with only an indirect impact on consumer prices (e.g., as an input to automobiles), could generate significant spillover effects. 3.4. The Dollar and Commodities Commodities are priced in dollars and are important to non-dollar investors, but the relationship between the dollar and commodities varies by industry. In the energy sector, the causal relationship typically flows from commodities to the money market. Energy is a significant item on the current account, and given that the U.S. 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 primarily set by the local currency. Cyclical forces can also simultaneously drive both commodity and money markets. 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 serves 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 Roll Strategy As described in Section 1.8, commodity index returns have two components: spot price returns and roll gains—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 generates gains. Most index investors use enhanced roll strategies to manage the returns of holding commodities over time: automatically investing in the front end of the curve to capture roll gains when there is a spot premium, and extending further down the curve to minimize roll 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 item that regulates 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. The term spread moves with inventory tightness—reflecting whether the market pays a premium for immediate availability or incurs storage costs. Therefore, the term spread directly reflects the current physical tightness, reflected as the inventory utilization ratio. Depending on the tightness, the market either pays a premium for immediate availability or incurs storage costs (Chart 21). ·Scarce physical supply (low inventory utilization ratio) makes immediate delivery valuable. Immediacy premiums dominate, driving spot prices higher than futures prices – resulting in a downward-sloping curve and a positive term spread (spot premium).·Abundant inventory (high inventory utilization ratio) eliminates the need to pay a premium for immediate delivery. Choosing to wait for delivery requires holding commodity inventory during the period – which can be a significant expense when inventory is high. Storage costs dominate, driving spot prices lower than futures prices – resulting in an upward-sloping curve and a negative term spread (futures premium).Chart 21: Term Spreads Reflect Inventory TightnessWhy Forward Curves Perform Differently Across Different CommoditiesTwo elasticities determine the strength of the term spread's response to inventory tightness:·γ: The steepness of the rise in immediate premium as inventory decreases.·δ: The steepness of the rise in storage costs as inventory increases.These elasticities vary by commodity. In the energy sector, γ and δ tend to be high because depleting inventory can have devastating economic effects, 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 Commodities (Especially Energy) Cannot Look Far Ahead Our framework explains why commodities (especially energy) are primarily spot assets and cannot sustainably price fundamentals beyond their supply adjustment cycle. To understand why, consider a scenario where the market attempts to determine inventory levels for a timeframe beyond 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 a reasonable adjustment rate would suggest. Therefore, inventory coverage 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 term spreads and inventory utilization ratios (Charts 22 and 23). The speed at which spot prices are forced to fall as inventories accumulate depends on δ, the elasticity of storage costs. * **Energy:** High δ, short T. Storage costs rise rapidly as inventories accumulate. High spot prices slow demand and encourage a relatively rapid supply response, leading to inventory accumulation and increased storage pressure. Spot prices fall rapidly relative to the forward anchor FT (in Chart 22, the red over-adjustment point shows a large deviation of S_t relative to F_T). High storage costs thus enforce discipline—it is impossible to plan inventory for periods exceeding T without incurring a significant price penalty. * **Metals:** Low δ, long T. Storage costs rise only slowly as inventories accumulate. Therefore, inventories 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 inventories to accumulate without immediately forcing spot prices down.