Goldman Sachs Group Inc. has reason to be bullish on commodities again. Actually, it has three.

In a Feb. 1 note, Goldman analysts said they are the most bullish on commodities that they've been in a decade, thanks to the "3R's" -- reflation, releveraging and reconvergence.

The "3R's" create a positive feedback loop that has bred optimism among commodities traders -- more reflation drives more releveraging drives more reconvergence. "Based on this increasingly supportive growth backdrop we have upgraded our commodity forecasts across oil, copper, iron ore and coal," analysts said.

This is what you need to know about the "3R's," how they feed into one another and what that means for investing in commodities.

Source: Goldman Sachs


In the second half of 2017, commodities were the best-performing asset class with a hefty 18% return.

"Strong demand growth against limited supply growth due to OPEC and Chinese supply curtailments created significant reflation in commodity prices last year," Goldman said.

Source: Goldman Sachs


"Given the high level of debt held by commodity producers, not only do higher commodity prices reduce the number of bad loans and free up capacity on bank balance sheets, higher commodity prices also help strengthen (emerging market) currencies and weaken the dollar via the accumulation and recycling of excess savings," analysts wrote.

That in turn lowers EM funding costs, leading to releveraging.

Source: Goldman Sachs


Following releveraging in emerging markets, there comes EM growth and subsequent reconvergence in the markets, "reinforcing even more synchronized global growth and, ultimately, reflation pressures -- creating a feedback loop."

Source: Goldman Sachs

What Does it Mean?

Goldman hiked its forecast for Brent crude oil to $82.50 a barrel from $62.

Analysts expect returns on the benchmark commodity index S&P GSCI of 15% over the next six months and 10% over the next 12 months.

"In addition, with low and declining inventories in key commodity markets, we expect commodity price volatility will rise from the current historically low levels," Goldman noted.

"Accordingly, we are initiating a new 2018 top trade and recommending a long 6-month call option on the S&P GSCI excess return index struck 5% out of the money. With a cost of 2.3%, the breakeven is a 7.3% return with a 4.4 to 1 expected payout based upon our 6-month return forecast of 15%," analysts said.

The feedback loop would likely only be destroyed by supply issues, but those don't seem likely in the near term, Goldman wrote. OPEC seems disinterested in lifting production cuts and possibly overtightened the markets, plus shale producers can't access more capital until financial markets improve. And metal supplies will remain tight given the financial, economic and environmental success of Chinese supply-side policy reforms.

During the selloff in commodities from 2014 to 2016, the feedback loop reversed, sending oil prices to as low as $26 a barrel, the euro to $1.06 and many emerging economies into a recession.

But in the period from 2004 to 2008, the "3R's" feedback loop reinforced higher commodity prices and reflation, created a weaker dollar in reconvergence and bred stronger demand growth in releveraging. Oil went to $114 per barrel, the euro was at $1.60 and credit growth was 1.4 times GDP growth, Goldman found.

Analysts said 2018 will likely not repeat the boom from 2008 but it will "rhyme" the period, as physical assets are likely to "finally" outperform financial assets.

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