Commodities are the worldâs raw materials. As natural resources, they are used in the production process of all manufactured goods, putting them at the heart of the economic cycle. The vital role in the worldâs economy, combined with the specific characteristics of commodity markets, make this an asset class that can add real value to your investment portfolio.
Commodities are materials in every product we use: the grains in our food, the wooden table on which that food is served, the steel in the car outside the restaurant. There are many different commodities and many different commodity classifications. From non-perishable or âhardâ commodities, such as metals like copper, lead, and tin, to perishable âsoftâ commodities, such as agricultural products, coffee, cocoa, and sugar.
Trends in resource prices have changed abruptly and decisively since the turn of the century. During the twentieth century, resource prices fell by a little over a half per cent a year on average. But since 2000, average resource prices have more than doubled. Over the past 15 years, the average annual volatility of these prices has been almost three times what it was in the 1990s.
This new era of high, rising, and volatile resource prices has been characterized by many observers as a resource price âsuper-cycleâ. Since 2011, commodity prices have eased back a little from their peaks, prompting some to question whether the super-cycle has finally come to an end. But the fact is that, despite recent declines, on average commodity prices are still almost at their levels in 2006â2008 when the global financial crisis was building up.
International crude oil prices used to trade in the range of US$9â$40 dollars from 1988 to 2004; since then we have seen US$30â148. Even since the 2008 crash and peak in commodity financial contracts called âfuturesâ US$125 has been tested several times.
Commodity futures are financial contracts on regulated markets around the world that allow investors to trade directly the wholesale price of a huge variety of everyday commodities. These futures contracts are still a relatively unknown asset class, despite being traded around the world for many hundreds of years. This may be because commodity futures are strikingly different from stocks, bonds, and other conventional assets, plus, historically, the controls around marketing them to the general public have been very strict as they tended to be much more volatile than other investment products and were therefore aimed at high net worth investors and professional traders. Among these differences are:
- (1)commodity futures are derivative securities: they are not claims on long-lived corporations;
- (2)they are short maturity claims on real assets;
- (3)unlike financial assets, many commodities have pronounced seasonality in price levels and volatilities.
The economic function of corporate securities such as stocks and bonds, that is, liabilities of firms, is to raise external resources for the firm. Investors are bearing the risk that the future cash flows of the firm may be low and may occur during bad times, like recessions. These claims represent the discounted value of cash flows over very long horizons. Their value depends on decisions of management. Investors are compensated for these risks. Commodity futures are quite different: they do not raise resources for firms to invest. Rather, commodity futures allow firms to obtain insurance for the future value of their outputs (or inputs). Investors in commodity futures receive compensation for bearing the risk of short-term commodity price fluctuations.
Commodity futures do not represent direct exposures to actual commodities. Futures prices represent bets on the expected future spot price. Inventory decisions link the current and future scarcity of the commodity and consequently provide a connection between the spot price and the expected future spot price. But commodities, and hence commodity futures, display many differences. Some commodities are storable and some are not; some are input goods and some are intermediate goods.
World commodities can be broken down into six core categories (see Table 1.1).
Table 1.1
The Six core categories of world commodities
Categories | Typical examples |
|---|---|
Energy | Crude oil, natural gas, gasoline, power |
Precious metals | Gold, silver, platinum, palladium |
Base metals | Aluminium, copper, nickel |
Ferrous metal | Steel, iron ore |
Agricultural | Wheat, coffee, cocoa, sugar |
Livestock | Feeder cattle, live cattle, lean hogs |
Commodities are clearly crucial to everyoneâs daily life. Without food, we cannot eat. Without energy many aspects of developed society cease to function. This fundamental role of natural resources is a strong driver of demand for commodities: a demand that will only intensify with the worldâs growing population, increasing urbanization, and rising living standards, trends to which emerging markets like China are contributing heavily.
As producers, such as mining and oil companies or large-scale farms, try to meet this growing demand, their output relies on the availability of and their access to the relevant commodities. A variety of factors play an important role here, including weather conditions and regulations, as well as the geopolitical environment, as seen for example in 2011 when unrest in oil-producing countries affected oil prices (e.g. the Libyan crisis).
In recent years, investible commodity indices and commodity linked assets have increased the number of available commodity based products. Alongside this a fast growing commodity-related hedge fund industry, commonly referred to as alternative investments, has enabled investors to gain access to a variety of interesting new commodity markets and strategies.
Historically, commodities like precious metals have always been valued by people as important possessions, often as jewellery. Today, private investors are increasingly keen to own commodities alongside their investment portfolio.
The main reasons for this trend are:
- commodities offer diversification within the overall investment portfolio;
- the fundamental link between the economic cycle, commodities, and inflation means investing in real assets offers some protection from inflation;
- commodities can from time to time offer considerable returns, though prices are volatile.
Despite these advantages, investors need to be careful, as investing in commodities also carries considerable risks due to the volatility in commodity returns being generally on the high side: adverse market circumstances can result in losses. In addition, the historical fundamental characteristics and mechanics of commodity markets can evaporate quickly in times of market stress, for example the correlation with other asset classes, normally low, may increase in times of crisis, as witnessed in the fourth quarter of the 2008 crash in all financial markets, commodities, and equity indexes like the S&P for example correlated closely together and for some period of time after the crash. The other risk area that has to be monitored is liquidity in the volume of the commodity market you are investing or trading in as the market for some individual commodities is not large.
Despite some perceived higher risk in the volatility of commodity markets, direct commodity investment can provide significant portfolio diversification benefits beyond those achievable using commodity based stock and bond investments. These benefits stem from the unique exposure of commodities to market forces, such as unexpected inflation as well as the potential of a positive roll return in futures based commodity investment in periods of high spot price volatility. Adding a commodity component to a diversified portfolio of assets has been demonstrated to show enhanced risk adjusted performance for investors.
Investing and Trading via Derivatives Contracts in Commodities
A commodity futures contract is an agreement to buy (or sell) a specified quantity of a commodity at a future date, at a price agreed upon when entering into the contractâthe futures price. The futures price is different from the value of a futures contract. Upon entering a futures contract, no cash changes hands between buyers and sellersâand hence the value of the contract is zero at its inception. How then is the futures price determined?
The alternative to obtaining the commodity in the future is simply to wait and purchase it in the future spot market. Because the future spot price is unknown today, a futures contract is a way to lock in the terms of trade for future transactions. In determining the fair futures price, market participants will compare the current futures price to the spot price that can be expected to prevail at the maturity of the futures contract.
In other words, futures markets are forward looking and the futures price will embed expectations about the future spot price. If spot prices are expected to be much higher at the maturity of the futures contract than they are today, the current futures price will be set at a high level relative to the current spot price. Lower expected spot prices in the future will be reflected in a low current futures price.
Because foreseeable trends in spot markets are taken into account when the futures prices are set, expected movements in the spot price are not a source of return to an investor in futures. Futures investors who buy a futures contract will benefit when the spot price at maturity turns out to be higher than expected when they entered into the contract, and they will lose when the spot price is lower than anticipated. A futures contract is therefore a bet on the future spot price, and by entering into a futures contract an investor assumes the risk of unexpected movements in the future spot price. The interesting angle for futures trading in commodities though is that an investor can first sell a contract and effectively short the market and profit from a decrease in prices and buy back the contract at a lower price and lock in the profit. This ability to short the market means that investors can profit from both upward and downward price movements, beating the just-buy-it-and-hold commodity return scenario. The historical and future drivers in energy, metals, and agriculture (food and raw materials) vary as follows.
Energy
Prior to the 1970s, real energy prices (including those of coal, gas, and oil) were largely flat as supply and demand increased in line with each other. During this period, there were discoveries of new, low-cost sources of supply, energy producers had weak pricing power, and there were improvements in the efficiency of the conversion of energy sources in their raw state to their usable form.
This flat trend was interrupted by major supply shocks in the 1970s when real oil prices increased sevenfold in response to the Yom Kippur War and the subsequent oil embargo by the Organization of Arab Petroleum Exporting Countries. But after the 1970s, energy prices entered into a long downward trend due to a combination of substituting electricity generation for oil in Organisation for Economic Co-operation and Development (OECD) countries, the discovery of low-cost deposits, a weakening in the bargaining power of producers, a decline in demand after the break-up of the Soviet Union, and subsidies. However, since 2000, energy prices (in nominal terms) have increased by 260 %, due primarily to the rising cost of supply and the rapid expansion in demand in non-OECD countries.
In the future, strong demand from emerging markets, more challenging sources of supply, technological improvements, and the incorporation of environmental costs will all shape the evolution of prices. The role of gas in the energy index is important to note. Gas represents just over 12 % of the energy index. There has also been significant regional divergence in global gas prices, as we will see later.
Metals
Overall, real metals prices fell by 0.2 % (an increase of 2.2 % in nominal terms) a year during the twentieth century. However, there was some variation among different mineral resources. Steel prices were flat, but real aluminium prices declined by 1.6 % (an increase of 0.8 % in nominal terms) a year. The main drivers of price trends over the last century included technology improvements, the discovery of new, low-cost deposits, and shifts in demand. However, since 2000, metals prices (in nominal terms) have increased by 176 % on average (8 % annually). Gold, amongst the major metals, has increased the most, driven predominantly by investorsâ perceptions that it represented a safe asset class during the volatility of the financial crisis, rising production costs, and limited new discoveries of high-grade deposits.
Copper and steel prices (in nominal terms) have increased by 344 % and 167 %, respectively, since the turn of the century, even taking into account recent price falls. Many observers of these price increases have pointed to demand from emerging markets such as China as the main driver.
Agriculture
Food prices (in real terms) fell by an average of 0.7 % (an increase of 1.7 % in nominal terms) a year during the twentieth century despite a significant increase in food demand. This was because of rapid increases in yield per hectare due to the greater use of fertilizers and capital equipment, and the diffusion of improved farming technologies and practices.
However, since 2000, food prices (in nominal terms) have risen by almost 120 % (6.1 % annually) due to a declining pace of yield increases, rising demand for feed and fuel, supply-side shocks (due to droughts, floods, and variable temperatures), declines in global buffer stocks, and policy responses (e.g., governments in major agricultural regions banning ...