With prices rallying, commodities have become mandatory in any investors’ portfolio. The S&P GSCI index, one of the mostly highly regarded commodities indices, has more than doubled in the past two years. This is not surprising because the index includes oil. But the few commodity-unaware investors left in the world would find some interesting surprises among the other components of the index. The agricultural segment is indicative: it has almost doubled in the past 12 months and has risen by 177% since the beginning of 2005.
In the past couple of years, almost all commodity prices rose, fuelled by increased demand, particularly from the emerging economies with developing industries, increased urbanisation and a growing middle class that has increased its meat consumption and started experimenting with western food, including coffee and sugar.
With an estimated investment market of $174bn, commodities are so hot that fears of a bubble have emerged. However, Kevin Norrish, director of commodities research at Barclays Capital, believes that fundamentals drive price rises. “Although [prices rises] are also due to investors’ interest, what is happening is based on fundamentals: rising costs, supply and demand and climate change,” he says.
In a recent survey by Barclays Capital, 260 of its institutional-investor clients expressed interest in holding commodities and 34% said they planned to allocate more than 10% of their portfolio to this asset class over the next three years.
Private banks’ clients are also increasingly interested in this area as they discover that the ways to gain access to commodities are multiple. Investing in commodity-producers’ stock is one option but, somewhat surprisingly, it has a low correlation with commodities prices. First, the majority of producers sell more than one commodity. Gold is usually found with copper so a producer of the latter would also be involved with the former. Second, if a company has troubles – for example, if copper miners went on strike – its share price would go down due to lack of activity while the copper price would rise due to diminished supply.
Cleaner exposure
So, for investors who seek a cleaner exposure, there are commodities price indices, such as the one set up by Goldman Sachs and Merrill Lynch. For the more sophisticated investors, and the ones with a higher budget, active managers and teams of structurers can outperform the market and create tailor-made exposures through notes structured around those indices and around specific baskets of commodities.
The variety of indices, exchange-traded funds and structured notes are increasing, and banks are increasingly inundated with requests from clients to research into less explored areas.
| Christophe Cordonnier, director of derivatives and structured products with the commodity markets division of Société Générale, says: “People are looking for more and more underlyings, they want underlyings that have not outperformed the market yet. We receive queries ranging from peanuts to uranium.” If commodities prices have generated a good deal of euphoria, certain elements of investing in this area also need to be discussed, especially with clients that venture into this space for the first time. |
A different class
The physical aspect of commodities is what differentiates them from other asset classes. Commodities contracts need to be periodically settled, either with the exchange of the actual commodity or in cash. This means that to maintain a prolonged exposure to them, the investor needs to roll the contract to the next period. If the commodity’s price is then higher than the spot price, the investor will receive a sum for the current contract that will be lower than the sum they will have to pay to enter into a new contract and roll their position. With commodities prices rising, this has been the case for the past couple of years and it is expected to continue, at least in the short term.
Investing in the spot price without considering the futures price might lead to a disappointed investor. Gary Dugan, chief investment officer of global wealth management at Merrill Lynch, Europe, the Middle East and Africa (EMEA), says: “In the past couple of years, almost every commodity went up so clients felt that they could make money very easily. There are many technical complexities to present to the client to avoid miss-selling what is going on.”
Besides their increasing value, commodities appeal to investors as a hedging tool, too. They have a low correlation with equity investments and bonds, and a high correlation with inflation. So when the economy starts to slow, commodities-value keeps up. Gold, which has reinforced its status as the best hedge against US dollar depreciation, has been in a tough competition with other commodities as hedges against inflation.
Commodities sub-sectors
As investors become more commodity savvy, advisers feel that there should be some differentiation between the different commodity types.
“Before, the question was whether to buy them or not,” says Lionel Semonin, global head of commodity investor derivatives at BNP Paribas. “Now the question is what specific commodities to invest in. Investors are looking into sub-sectors, such as agriculture.”
Mr Dugan agrees. “In 2008, we need to be a bit smarter about the markets that we want to stick with,” he says. “We want to remain in commodities but we will have a preference for agricultural products, which are more a staple commodity, less sensitive [than others] to the economic cycle and reflect changes in consumer patters: increasing consumption of meat and demand of biofuels.”
Meat consumption, which has been increasing due to higher demand from emerging countries (last year China contributed to a spike in pork prices), has an effect on crop prices too. More meat means more livestock, which means higher crop consumption.
Furthermore, rising oil prices and climate-change concerns have spawned a profitable alternative business allocation for corn, wheat, sugar and soybean, which can be used to produce biofuels. Barclays Capital’s Mr Norrish, says: “The effects of biofuels on the environment are debatable, but their production has certainly created great investment opportunities”.
Biofuel production has had an effect on other commodities, too. Given the limited amount of agricultural land, if more corn is to be produced, less land will be available for other productions. Land is not the only limited resource. The number of farmers is also scarce: “Nobody is becoming a farmer anymore,” says Jim Rogers, founder of the Rogers International Commodity Index. “We can’t just snap our fingers and say that we want more farmers. The land is limited, the tractors are limited, the tyres are limited, farmers are limited.”
Supply and demand
As evidence of demand outstripping supply, Ana Cukic Munro, co-head of the multi-asset group at Insight Investment, points out that agricultural inventory levels have been at their lowest in 20 years because of higher demand. “The wheat stock-to-use ratio is today around 40 days. In 1985, it was 160 days,” she says.
The trend is set to continue, driven by higher emerging-markets demand. In Asia, about 850 million people will move to the cities in the next 20 years. China’s urban population alone is expected to increase by about 300 million in that time. “With any other good, the more you produce, the cheaper it becomes, but it doesn’t work in the same way with agricultural commodities,” says Ms Cukic Munro. “The more you plant, the more you need to access fertile land and the more fertiliser you need. Production becomes more and more expensive.”
Scarcity of land and resources, and more expensive production costs contribute to higher prices. Nature’s cycle plays a role too because it constrains the ability of agricultural supply to catch up with the increased demand: coffee trees need up to five years to grow coffee cherries, which then need between seven and 11 months to mature and be ready for harvest.
The future of water
If commodities are the hot investment- area of the moment, there is a natural resource that is set to become the hot investment of the future: water. Affected by climate change and by increasing demand from developing countries, water is a popular resource. It is so much in demand that some countries might prefer to import it than to use their own.
When a country imports corn, for example, from another country, it not only imports corn, but also imports the water that was used to grow the corn. The importer might find this more cost- efficient than producing corn in its own country with its own water resources.
That is why investing in water-intensive agricultural commodities and livestock also gives an exposure to water. The theme can be taken from an equity stock angle, with a wide range of companies that would benefit from the next big problem that the world will face.
“The range of options in water is phenomenal,” says Philip Watson, head of investment analysis and advice group at Citi Private Bank, EMEA. “We talk to clients about exposure to water-bottle producers, to companies involved in desalination, dam construction right through to waste-water treatment and pipe manufacturing.”
Mr Rogers agrees on the potential of water. “There is no question about it, water has a very exciting future. It is becoming in short supply everywhere [in the world] and biofuels are making it worse because their production requires a lot of water,” he says. “You can’t buy water but you can find companies that trade water or transport water – and if you can find anybody that can help the water problem then you are going to make a fortune.”
