Commodities Investing

Date: August 2007

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Types of commodities trades

The two basic types of commodity trades are spot and futures trades. In the spot markets, immediate demand for delivery of commodities is being balanced by the expiring futures and the current supply. In the case of the futures, a price of commodity to be delivered at some date in the future is set today on the basis of forecasted demand and supply at that future date.

Different types of commodities

The three basic types of commodities are commodities that are inputs into production (e.g. oil, coal, wheat, maize, potassium, aluminum and so on), commodities that are final goods (e.g. precious metals, gem stones, natural stones, etc) and commodities that act as financial instruments (precious metals).

The value of the commodities in the first category is determined by the demand for goods that use this commodity as an input. This value can be linked to the relatively simple demand/supply relationships as in the case of many agricultural commodities, or by complex interactions of demand in several sectors competing for the same commodity, e.g. aluminum that is used in both airplanes and household items.

Due to their unique character, commodities comprising the second group are rarely traded in the open financial markets.

In contrast, the third group of commodities represents a set of purely financial instruments. It is in these markets where the four main forces of interest rates, exchange rates, macroeconomic volatility and risk-return performance of non-commodities markets, play the most important role in determining the value of commodities.

Four major forces impacting on commodities market

This year, following mixed results in 2006, majorcommodities indices have been posting big gains for investors. These returns have been driven by several seemingly disconnected forces: a rise in prices of raw materials, rising demand for gold, silver and platinum, and continuation of extremely low global interest rates environment.

Consider these sources for growth in the context of the first group of commodities.

Increases in the prices of industrial commodities – such as steel, oil, aluminum etc – has been driven in part by:

• Continued demand from the US, where economic growth remains positive, gaining strength in economic activity across the EU27 and most notably across some Euro-zone countries, such as Germany and Spain
• Robust growth in other OECD economies, including Canada, Australia, and Japan
• Continued rapid growth in the BRIC countries (Brazil, Russia, India and China), wherethe latest OECD Employment Outlook shows that the four countries have generated roughly 22 million net new jobs annually between 2000 and 2005. These trends are expected to continue, with India in particular expecting to accelerate jobs creation. The BRIC economies today account for more than a quarter of the world’s GDP and this share is growing
• Strong demand for industrial commodities from other regions around the world, most notably South East Asia, Korea and parts of Latin America.

On the supply side, commodities are notoriously slow to respond to spikes in demand, as delivering industrial commodities to the market requires large capital expenditures associated with exploration, development, mining and processing. For example, despite high oil prices and no shortage of areas to explore, additions of new reserves of oil have been lagging the demand. Refining capacity is also falling increasingly behind the rapid acceleration in demand. Another important aspect curtailing supply of industrial commodities is the increasing trend toward state control over natural resources. In the early 1990s, only about 40% of the world’s oil reserves were in the hands of national governments. Today, this figure stands at around 85%.

At the same time, increases in the prices of agricultural commodities have been driven by two factors:

• Rising demand for food from the world’s main growth regions, such as the BRIC countries
• Increased competition for main agricultural commodities from the energy markets and in particular, from bio-ethanol producers in the OECD countries

Increasing global reliance on ethanol as an alternative source of fuel is driving a conflict between the objectives of ensuring an adequate supplies of human food, animal feed and fuel. Research by Dr Pearse Lyons, the founder and CEO of Alltech shows that both, the US and the EU plan significant increases in demand for ethanol over the next 5 years. The current US mandate for ethanol use in 2012 is 7.5 billion gallons. This will consume 20% of all US corn crops. The US plans to replace 20% of its gasoline consumption with ethanol by 2017, targeting production of 35 billion gallons of bio-fuel and there is a bi-partisan push for the ethanol use to reach 60 billion gallons by 2017. The EU has roughly the same plans.

Dedicating all current US corn and soybean production to biofuels would meet only 12% of gasoline demand and 6% of diesel demand in the US. If the United States follows the biofuels programme through to its logical conclusion, some 60% of US grains will be devoured by fuel.

These problems will be further exacerbated by the rapidly growing demand for animal feed. Today’s global feed production is approximately 700 million tons. By 2020, China alone will be consuming 600 million tons of feed. Doubling production of world’s largest grain exporters – Brazil, Ukraine, Argentina and the USA – will not deliver sufficient capacity to meet China’s growing appetite for meat and poultry.

The main conclusion is that agricultural commodities prices are likely to keep on rising into the near future worldwide.

Future outlook for the commodities market

All of these forces are set to continue through 2007 and most likely 2008, generating significant upside pressure on demand for main industrial and agricultural commodities.

This is precisely why the commodities indices, like GSCI index formerly owned by Goldman Sachs, are favoured by pension funds, endowments and high net worth individuals. These indices offer investors highly liquid and low cost access to commodities that have posted strong gains in recent years.

Taking just two examples, S&P GSCI index is up by more than 15% so far in 2007, recouping fully the losses it made in 2006 when front-month oil contracts started trading at a discount (this market reversal is known as contango in the financial community). This was the situation in late 2005 and early 2006 when oil and metals prices were pushing down. However, as prices rebounded in 2007 – oil prices are up almost 40% since January 2007 – the contango situation turned into what is known as backwardation (the markets condition when prices rise from the beginning of the year toward the later months). Backwardation allows the funds to roll over cheaper contracts signed in the early months of 2007 into more expensive spot markets. Just as S&P GSCI, another commodities-tracking index, DJ-AIG recorded 6% growth in 2007 so far.

The reason for these gains in commodity indices goes beyond the simple price increases in what has been a prolonged bull run on commodities. Instead, the commodity indices make money on the spot-price vs futures price differentials. As futures contracts expire, the funds must sell these contracts and buy into new contracts marked for the next period. If the spot price rises, you get more for your expiring contract, but if the price increases are expected to persist into the future, than the futures contract the fund is buying is also trading at a premium. The contango market occurs and the fund loses money.

Take the spread between September 2007 and September 2008 crude contracts. In May 2007, these contracts traded at USD4.20 premium. By July 2007, the same contract spread has fallen to USD1.80. Thus, contango in the oil markets has diminished substantially, pointing to the possibility of a reversal in the futures price curve trend. Such a reversal would imply that the funds holding contracts expiring in the near future are likely to see the new contracts trading at the discount, so buying new futures will be cheaper – a situation in which the funds will make profits, orbackwardation.

The returns earned from the roll-over of expiring contracts via purchasing of new contracts are known as the roll yield and constitute the main determinant of returns from commodity funds. Additional non-trivial income from such funds is the interest earned on the collateral placed in underwriting the contracts. This collateral is deposited into bonds, yielding fixed and short-term risk free interest rate.

As contango in the oil markets narrows (having fallen from some 4% monthly spread in 2006 down to roughly 3% annual spread today), the interest on collateral funds held in fixed income securities is more than sufficient to generate positive returns.

These returns are likely to be amplified by short-term volatility in prices that are driven by increasing demand and lagging supply of major commodities, including oil.

How retail investors can access the commodity market

For retail investors, there are two low risk, low cost options for accessing strong growth potential in the commodity markets. One option is to invest in a diversified mutual fund-type vehicle with significant exposure in stocks of the commodities-producing companies such as gold mines, steel mills and coal producers. Another option is to buy shares in the index funds linked to commodities futures.

The first option offers several benefits. As commodities prices rise, shares of the companies supplying commodities to the markets will tend to rise as well. Diversification across commodities and within each commodity sector, offered by larger funds, provide some added security against the adverse shocks to specific companies, commodities or jurisdictions. The potential downside to this is the fund-specific risk which is linked to the quality of the management team and to their strategy. There is also an added ‘smoothing’ component to the overall funds’ returns that implies that in exchange for lower risk, investors surrender their ability to generate abnormal returns to investments in narrowly targeted commodities, such as gold. Finally, an added benefit of investing in funds dealing in companies’ stocks is the security arising from owning capital-intensive and, usually, blue chip companies.

The second option provides an opportunity to enter a technically sophisticated and increasingly exotic futures markets for commodities without the need to conduct extensive research and take increasingly risk-leveraged trading positions in the options and futures markets. Instead, a professionally managed fund executes trades and secures leveraging of the capital. 

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