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Natural Resources

Preqin Special Report: The Future of Alternatives in 2027

In this article

Written by Moses Rahmana, MBA

October 5, 2022

Energy super cycle in full effect

Natural resources will continue to grow as the global energy crisis lingers on
Investors have historically invested in natural resources as a means of diversifying their portfolios. However, natural resources is now offering investors potential well beyond the single use case of diversification we have consistently seen over past years. The asset class offers inflation hedging potential and leads investors toward a new commodity super cycle, which ultimately results in strong performance. With inflation concerns and the prospect of a fresh commodity super cycle, natural resources has been gaining momentum in its rebound and recovery from the COVID-19 pandemic.

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Natural resources was one of the hardest hit asset classes during the pandemic. Energy prices around the world fell to multi-year lows as global lockdowns significantly reduced demand for energy and other commodities while travel, factory production, and countless projects were put on hold. The significant drop in commodities prices, particularly energy, forced producers to adjust their output and reduce production levels to balance the market.

The faster-than-expected recovery in demand post-COVID-19 caught markets by surprise. Many producers either did not have the means to raise production due to supply chain constraints and prolonged periods of underinvestment in fossil fuels, or were simply reluctant to raise output in volatile and uncertain times.

The supply shortage entered a whole new phase after Russia’s invasion of Ukraine, and with the unprecedented sanctions that were imposed on Russia by many of its largest oil and gas importers. These sanctions, combined with broader geopolitical tensions, generated shockwaves that are still rippling through all corners of the global economy.

Natural resources investors have been reaping the benefits of the commodities super cycle that started before the Russia-Ukraine war. Natural resources funds had a strong 2021, posting a one-year horizon IRR of +34.5%, compared with 2020’s one-year IRR of -7.1%.

Geopolitical risks and supply disruptions caused by the war are expected to have long-lasting impacts on the broader commodities markets. The current supply deficit, particularly in energy markets, is likely to last for years. This presents natural resources funds and investors with an exceptional opportunity to ride this super cycle more confidently than ever.

The global market moves in natural resources’ favor

Despite the looming recession prompting turmoil in the equity and fixed income markets, energy prices around the world remain elevated. Oil prices have held steady near $100/barrel, while natural gas prices in some regions have soared to record levels. The spike in fossil fuel prices has led to higher electricity bills for households and industries alike, adding to the inflationary pressure that has become a significant challenge for investors, policymakers, and consumers.

Despite the uncertainty of the pandemic-induced drop in demand for energy in 2020, the asset class has since come into its own. The global investment opportunities within the energy space have been vast as transition to net-zero is becoming more prominent and the Russo-Ukrainian war has highlighted several oil and gas dependencies, particularly in Europe.

Based on our forecasts, the impact of the current environment on natural resources will be significant. Natural resources AUM will grow +6.2% on an annualized basis between 2021 ($208bn) and 2027 ($297bn) (Fig. 7.1). This is substantially higher than the growth between 2018 and 2021 (+1.1%), when many allocators were dissatisfied with their allocations. It is also significantly higher than the annualized growth (+3.9%) between 2015 and 2021. Moreover, our forecasts suggest that performance will remain strong over the next few years and that natural resources will return +8.1% to investors on an annualized basis, up from 8% over the 2018 to 2021 period (Fig. 7.2).

North American energy markets intertwining with Europe

By the end of 2021, North America accounted for 80.7% of the global natural resources AUM with $168bn (Fig. 7.1).
The supply shortages caused by Russian sanctions are expected to worsen and could last for years. Only a few countries, such as those in North America, have the resources and infrastructure to gradually fill that gap. This makes the region the perfect candidate to help Europe weather this energy storm. However, these seismic shifts in global energy supply chains have one major implication: North America’s energy sector is becoming increasingly entangled with Europe’s.

The US has been exporting record amounts of LNG (liquefied natural gas) to Europe. Earlier this year, President Biden announced an agreement to supply an additional 15 billion cubic meters (bcm) of LNG to Europe through the remainder of 2022. The agreement also envisions the US increasing its LNG supply to Europe to 50bcm by 2030, which equates to over 40% of Russian gas imports into Europe in 2021.[1]

Given the increasingly important role of the US in the global energy market, we expect the North American natural resources market to remain highly attractive to investors over the next few years. We forecast North America natural resources AUM to reach $238bn by the end of 2027, compared with $168bn at the end of 2021 (Fig. 7.1). This represents a CAGR of 6.0%, which is significantly higher than the 1.48% increase from 2018 to 2021, and close to the percentage growth achieved between 2015 and 2018 (+6.4%), when the long, post-GFC economic cycle was benefiting further from low global interest rates.
We also expect natural resources funds to post better performance than their recent historical averages. We forecast North American natural resources funds will post a +7.2% return on an annualized basis from the end of 2021 through 2027, higher than the 6.5% from 2018 to 2021 (Fig. 7.2).

European energy markets are changing - fast

European gas prices hit record figures even before Russia’s invasion of Ukraine. Low inventories and a colder winter than usual combined with the region’s intensifying efforts to curb carbon emissions by burning more gas for power instead of coal, sent the Dutch TTF (Title Transfer Facility) natural gas benchmark from just below €20/MWh to record highs of near €100/MWh by the end of 2021. Before 2021, TTF prices had never traded above €40/MWh. With Russia continuing to reduce gas supplies to Europe, prices have soared to over €300/MWh. The extreme price actions make sense. Europe relies heavily on Russian fossil fuels to fulfil its energy needs, sourcing almost 40% of its natural gas, 45% of its coal, and 25% of its oil from Russia.[2] It will take significant visible signs of relief in global energy supplies for this to change.

As the EU presses ahead with the full ban of Russian oil imports by the end of the year, and the flow of Russian gas into the EU remains largely turned off, investments in both renewable and traditional energy assets will likely gain pace. The long-term basis for investing in natural gas for European markets received major support in July 2022, when the European Parliament backed EU rules categorizing investments in gas as climate friendly. The new rules are likely to become law, which will add natural gas to the EU taxonomy rulebook from 2023, allowing investors to label their investments there as green.[3]

The recent geopolitical events in Europe will have some bearing on the dynamics of other natural resource strategies in Europe. Ukraine is a significant exporter of cereal crops to the UK and EU, and while it looks likely that production will be cut severely, this will also depend on the duration of the conflict. We expect this to have a domino effect on livestock farmers who use corn and other cereals in their feed, thus some may turn to soymeal, which will inevitably raise prices for this commodity, too.

All things considered, we expect European natural resources AUM to reach $21bn by the end of 2027, compared with $13bn at the end of 2021 (Fig. 7.1). This represents a CAGR of +7.9%, which is much higher than the -3.6% CAGR from 2018 to 2021, but substantially lower than the rate achieved between 2015 and 2018 (+26.4%).
We also expect Europe-focused natural resources funds to continue to post double-digit performance figures in the coming years. We expect European natural resources funds to post an annual return of 11.4% from end of 2021 through 2027, slightly lower than the 12.0% achieved between 2018 and 2021, but substantially higher than North America’s +7.2% (Fig. 7.2).

APAC’s natural resources small market with significant upside

Asia-Pacific markets have been suffering. Besides resource-rich Australia, one of the largest exporters of LNG and other raw materials, most countries in the APAC region are energy importers and have been grappling with high energy and raw material prices. High oil prices aside, prices of imported LNG into Northeast Asia have skyrocketed to over $70/mmbtu over the European summer.[4] Asia has been competing with Europe for LNG cargoes at such high prices that some countries, such as China, have decided to ramp up coal production to alleviate some of the cost pressure.

However, the unprecedented climate-change-related droughts in China throughout August are clear indicators of the need for a more sustainable approach to the global energy crisis. Japan has already announced plans to bring back online the nuclear plants which were shut down in the aftermath of Fukushima disaster in 2012. This demonstrates the ongoing need for investment in the APAC energy sector.

Though the region may not have prolific oil and gas reserves, countries such as Indonesia and Australia hold vast reserves of ore that are critical to energy transition. Additionally, given the proximity of these countries to China, the largest importer of metals and ore in the world, they can present very attractive opportunities to investors.

APAC still accounts for a small share of the overall total AUM across natural resources. Despite all the challenges, we expect AUM growth in the region to fare relatively well. We forecast APAC natural resources AUM to reach $6.4bn by the end of 2027, compared with $4.4bn at the end of 2021 (Fig. 7.1). This represents a CAGR of +6.4%, significantly higher than the -4.8% from 2018 to 2021, and more than what was accomplished between 2015 and 2018 (+4.7%).
We also expect APAC-focused natural resources funds to post significantly better performance than their recent historical averages. We forecast APAC natural resources funds to post an +11.2% annual return from the end of 2021 through 2027, around double that of the 2018-2021 period. If achieved, this would put APAC’s performance well ahead of North America (+7.2% annualized) and only slightly behind Europe (+11.4%) (Fig. 7.2).

Rest of World markets

Besides Europe, North America, and APAC, there are other regions and countries around the world that are expected to play a critical role in the future global energy industry and broader natural resources. South America is one key region for its abundance of natural resources, including metals such as copper and lithium. These are crucial for electrification, and the main reason why investors should pay attention to this region.

For the rest of the world (RoW), we forecast natural resources AUM to reach $13bn by the end of 2027, compared with $9.5bn at the end of 2021 (Fig. 7.1). This represents a CAGR of +4.7%, notably higher than the mere 1.0% from 2018 to 2021.

We also expect RoW-focused natural resources funds to continue to achieve strong performance in the coming years. We forecast these funds to post a +15.4% annual return from end of 2021 through 2027.

Bright outlook for natural resources investments

Natural resources has been gathering good momentum in the post-pandemic environment, as inflation concerns and the prospect of a fresh commodity super cycle aid its recovery. The super cycle received a major boost from the supply shortages caused by Russian sanctions, which are expected to worsen and last for years. It’s fair to state that the macroeconomic conditions and geopolitical tensions have benefited the asset class, and with no near-term solution in sight, natural resources should continue to attract more capital and achieve high returns.