A version of this piece first appeared on Trustnet.

Commodities have had an impressive start to the year. In Q1 of 2022 the MSCI All Countries World Index Energy gained 21.46% in US dollar terms. The broad MSCI All Countries World Index was down 2.6% at the end of the first quarter.

Supply shortages, covid recovery and Russia’s invasion of Ukraine have all contributed to skyrocketing prices. It is easy to see why you would want to hold natural resources in this economic environment – but should they be there permanently?

Why hold natural resources?

We run a multi-cap UK fund with significant exposure to small- and mid-caps, which can generate strong returns but also be volatile. To counterbalance this, we have two buckets in the portfolio we call ‘stabilisers’ – large cap holdings (currently [20%]) and natural resources companies (currently [13.6%]).

The largest holding in our natural resources bucket is Serica Energy, an oil and natural gas producer with operations based in the North Sea. In 2020, the company reported a £13m profit before tax – this is forecast to reach £384m by year-end 2022, in large part due to increased gas prices.

Exposure to natural resources companies always sits between 5% and 15% of the portfolio. So we always have some exposure to commodities but why?

The traditional argument for holding commodities is for diversification. Natural resources shares tend not to be strictly correlated with the stock market so they can help to minimise losses when other sectors are experiencing difficult periods.

For example, rising input prices are a challenge for many companies; they may struggle to pass them on in full. Businesses in the industrial sector have a particularly difficult time due to the large amounts of fuel many of them require. For example, one of our holdings, Morgan Advanced Materials produces sophisticated ceramics for thermal insulation in high temperature environments. They need kilns to reach extremely high temperatures and have to keep them at that heat. Dialling down the thermostat is not an option! We find that holding energy companies, which often benefit from price increases, helps to mitigate potential losses from industrials in the portfolio during periods of very high energy costs.

This use as a hedge against inflation has been noted by others. Research from Vanguard, showed that over the previous 30 years to March 2021 a 1 per cent rise in unexpected inflation led to a 7 to 9 per cent increase in commodities prices on average.

While we believe commodities should be a permanent feature of the portfolio, we actively manage the asset allocation. But how do you time these shifts in tactical allocation?

When to buy?

A colleague once described natural resources as ‘two-decision’ stocks – you have to buy them right and you have to sell them right. Generally, we tend to buy when the price-to-earnings ratio is high and sell when it is low. A high P/E is usually an indicator that the price of the raw material is going to shoot up, while a low P/E suggests it is about to fall.

In 2021, we increased our natural resources weighting as some smaller energy companies appeared to us to be undervalued. Oil majors like BP and Shell had been making substantial disposals of gas and oil fields to try to meet their net-zero commitments. This allowed smaller companies, like Serica and Jadestone, to snap up cash-generative assets in stable territories – the North Sea, in Serica’s case; Australia, in Jadestone’s. They have the potential to add some value to or even extend the life of these assets. We thought these assets would contribute to their free cash flows and the benefits of these acquisitions were not being reflected in the valuations of these smaller players, making them very attractively priced.

A question we are asking now is: can these companies repeat the trick? Gas is back in fashion and there will likely be more hands at the bidding table during the next round of asset disposals. This could make it more difficult for smaller companies to achieve the same kind of gains. It demonstrates the challenge of investing in this space. As with any investment, you have to buy and sell at the right time, and carefully. But the beauty of holding natural resources companies, rather than the commodity itself, is that even when commodity prices fall, these businesses usually still deliver some income.

Which natural resources?

We currently favour energy companies in our natural resources bucket. Energy stocks have outperformed the rest of the market so far this year, with gas being the standout stock – the S&P UK Natural Gas index gained 98.1% in the first quarter.

Companies with a focus on gas are particularly interesting, especially if we consider longevity. Gas generates lower levels of carbon emissions and in February the European Commission announced that it will include natural gas and nuclear energy as transition activities. Companies that are pivoting towards majority gas production might benefit from a longer duration cash flow while reducing their carbon footprint.

The transition to a low-carbon world is an exciting one. But we will need a lot of resources to support the shift to widespread alternative energy use. We hold two mining companies: Rio Tinto and Anglo American. Anglo American has interests in four copper operations, a huge amount of which is used in generating renewable energy. A single three-megawatt wind turbine contains over 4 tonnes of copper and solar power systems can contain over 5 tonnes per megawatt. The average copper content of a plug-in hybrid electric vehicle is 60kg and this number jumps to 83kg for a pure EV.

We also hold Jubilee Metals, which recovers metals from secondary materials produced from mining operations, reducing waste from the mining industry as well as its carbon footprint.

The commodity market is cyclical, so of course, commodities will not be in favour forever, but with little sign of inflation abating, we do not expect to reduce our commodities exposure meaningfully quite yet. It has been a difficult market for smaller companies this year and our commodities stabiliser has done exactly what it is there to do for the portfolio and our investors.

James Henderson is co-manager of the Henderson Opportunities Trust