The Motley Fool

Why commodities are set to offer more than just high volatility in 2017

The best word to sum up the performance of commodity prices in recent years has been ‘volatile’. Their prices have swung violently and left many resources companies and investors nursing heavy losses at times

For example, since Donald Trump’s election victory the price of gold declined by as much as 13%, while during the same time period the oil price has risen by 12%. Similarly, iron ore is up over a third from three months ago and has left behind a trail of considerable volatility.

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Looking ahead, commodities could continue to be volatile. After all, the outlook for the global economy is highly uncertain. However, they may also offer significant profitability for those investors who are able to buy and hold through what may prove to be yet more yo-yoing prices.

Supply and demand

Clearly, commodity prices are always heavily dependent upon changes in supply and demand. In the case of oil, the outlook for 2017 is relatively positive. OPEC agreed in November to reduce production by 1.2m barrels of oil per day.

This was somewhat surprising and was followed by a cut among non-OPEC members. Although demand growth has been somewhat sluggish in recent years, the imbalance between demand and supply is expected to narrow in the coming months.

In fact, the International Energy Agency (IEA) predicts the current oil surplus will become a deficit before the end of the first half of 2017. Given that forecast, it seems likely that the oil price will continue to move higher in the short term at least. Therefore, it would be unsurprising for oil-focused companies to record strong returns in the coming months.

An uncertain outlook

While the price of gold came under pressure following Trump’s election victory, it has recovered strongly in 2017. It is up 3.5% since the turn of the year and it could keep rising during the coming months.

A key reason for this is the high degree of uncertainty that faces the global economy. In the US, Trump’s economic policies are likely to include significantly higher spending on infrastructure, coupled with lower tax rates.

The effect of this is likely to be higher rates of inflation which the Federal Reserve may or may not be able to slow down through higher interest rates. During periods of a rapidly rising price level, demand for gold increases because it is seen by many investors as a store of wealth.

In addition, gold’s outlook could be positive because of uncertainties in Europe. The precious metal’s status as a defensive asset may come into play as Brexit negotiations start within the next nine weeks.

French elections could also increase the attractiveness of risk-off assets such as gold. Similarly, a slowdown in China’s growth, caused by a more protectionist global economy, may also cause gold’s price to rise this year.

A changing China

While gold and oil offer clear catalysts for price growth, iron ore’s future is somewhat more opaque. It has benefited in recent months from the Chinese government’s stimulus programme, as well as continued rising steel production in the world’s second-largest economy.

Furthermore, the mothballing of various large projects within the iron ore industry has caused investors to anticipate a more favourable price in the long run, given the current relationship between demand and supply.

However, the reality is that China’s economy is not only slowing, it is also transitioning. It is currently the largest importer of iron ore in the world, but its move away from infrastructure-led growth and towards consumer-led growth could mean demand for iron ore falls in the long run.

Therefore, while the iron ore price could rise in 2017, it is perhaps less likely to do so than other commodities such as oil and gold.

The Foolish takeaway

While commodity prices could remain volatile during 2017, they also offer the potential for high profits. Therefore, investors who are able to live with prices that lack the consistency and stability of shares in other sectors may have an opportunity to benefit.

Certainly, the outlook for gold and oil is relatively positive. In gold’s case, it could benefit from the uncertainty which looks set to be a key feature of 2017.

Similarly, oil’s price could respond positively to demand catching up to supply over the coming months. While iron ore’s future may be less attractive than that of oil and gold, lower than expected supply and increasing steel production in China could push its price higher during the course of the year.

As such, now could be a good time to buy shares in resources companies. Due to the high volatility and falling commodity prices in the past, wide margins of safety and low valuations appear to be on offer. While paper losses seem likely to be recorded at times during the year, by the end of 2017 there could be a tidy profit awaiting those investors brave enough to buy resources companies now.

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