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Tread Cautiously With Commodities

Commodities can be a part of your portfolio, but restrict such investments to a small allocation…

On March 1, 2011, while Indians were busy analysing the Budget and its implications, the international press was providing ample coverage to rising commodity prices.

That day, Scotiabank released its Commodity Price Index, which measures price trends for 32 of Canada's major exports. The index had advanced by 2.7 per cent month-over-month in January; the seventh consecutive monthly gain and the highest level since September 2008.

Simultaneously, data for the ANZ Commodity Price Index, which measures the monthly price change of New Zealand's 17-main commodity exports, was also released. The index rose 2.7 per cent in February - a cumulative rise of 21 per cent in the past six months.

Be it metals, oil or agricultural products, commodity prices have only been moving in one direction, up. The level of volatility witnessed in commodity prices through 2008 was unprecedented throughout history, when high prices fell dramatically. But in December 2010, the Food and Agriculture Organisation (FAO) reported that the FAO Food Price Index reached record levels, surpassing those of 2008.

Of such concern is the rise in commodity prices that it is back on the international agenda with a vengeance. At the April G20 summit in Washington, this topic will be a priority on the agenda. French President Nicholas Sarkozy, the new G-20 chairman, for one, has warned that rising commodity prices are a threat to the world economy and has blamed financial speculators for the strong increases in commodity prices. This year, the European Commission (EC) has said it will undertake a range of initiatives to improve the regulation, functioning and transparency of commodity markets and prevent excessive financial speculation.

What sends prices skyrocketing?
Often speculation is considered to be the culprit, and not without cause. Take for instance, the rise of cocoa in 2010. Last year, prices began to climb on the back of falling production and increased demand. At that time, UK-based commodities business and hedge fund Armajaro caused a furor in the markets by apparently buying futures contracts of cocoa worth $1 billion. Reports in the international press stated that the hedge fund did not resell the contracts on the London International Financial Futures & Options Exchange (LIFFE) before they expired, but instead took delivery of the cocoa beans to store them in warehouses in Europe. As a result, the price of cocoa rose to its highest in three decades!
But look at what happened to cocoa prices in 2011. This year, cocoa prices rose on the back of political turmoil in the Ivory Coast. The world's largest cocoa bean producer was threatening to temporarily suspend any export, sending cocoa prices to a record high once again.
That is one aspect investors must understand about investing in commodities - there are innumerable factors affecting it: speculation, political turmoil, government policies on import and export, and, of course, the weather. Over the past one year, the world has witnessed many supply shocks on this front; typhoon in The Philippines, drought in Russia and Ukraine (as well as in a few South American countries), floods in Pakistan and more recently in Australia. The severe winter in the Northern Hemisphere will result in late planting and naturally lower yields. According to Scotiabank's Commodity Price Index report, it may take several crop years before the currently tight US corn and soybean supplies are significantly rebuilt. Wheat markets are expected to tighten further in 2011-12 due to the poor winter wheat crop in the US and recently dry growing conditions in Russia.
If one looks at a precious metal like gold, geopolitical factors, the movement of the dollar, global interest rates and price of oil all affect its price.

The basic economic equation
Irrespective of the factors mentioned above, what cannot be ignored is the fundamental demand-supply economics which is causing a rise in prices. Nobel Prize-winning economist Paul Krugman argued in The New York Times in December 2010 that commodity prices rising is not just solely speculation run amok. It's a reminder that we are living in a finite world where the growth of emerging economies is placing pressure on the limited supplies of raw materials and pushing up prices. “As more and more people in formerly poor nations are entering the global middle class, they're beginning to drive cars and eat meat, placing growing pressure on world oil and food supplies....And those supplies aren't keeping pace.”
Grain inventories have fallen. The soaring global population is consuming more than we are producing while agricultural land stays limited. As incomes rise in the developing world, individuals opt for better quality food. As diets shift to meat protein and milk, it would logically free up demand for cereals. Unfortunately, this does not happen since it requires even more cereal to produce the meat protein. To illustrate, China has moved from being an exporter of soybeans to an importer of that product.
It is precisely such a scenario that has led legendary investor and commodity guru Jim Rogers, chairman of Rogers Holdings to publicly state that the fundamentals (for agriculture) have gotten better. Since inventories have been at their lowest since decades, he foresees serious shortages of food everywhere in the world and prices going through the roof.
A report in March by Commodity Online spoke about a recent study by the Organization for Economic Cooperation and Development (OECD) which stated that speculators are not to be solely blamed for commodity price hikes. The report, to be put together ahead of the G-20 summit, cites global demand as growing faster than supply as the prime cause of the price rise of wheat, sugar, cotton, metals, oil and other commodities.
Currently, the political unrest in Libya, Algeria and other Persian Gulf oil producing countries has resulted in turbulence in the oil market. The prices of copper, gold and silver are also on the rise.
In 2010, copper outperformed other base metals and this year has already began creating waves as the price keeps rising. Fundamental factors such as a tight supply situation and surging industrial demand won't see the price fall in a hurry.
The world's top silver miner, Mexico's Fresnillo, stated that 2010 was the best year in the company's history due to a combination of strong cost control, increased production and high metal prices.
In the case of gold, while the supply is relatively inelastic, the demand from emerging markets like China, India and Turkey is increasing at an extraordinary rate. The surface level gold has all been discovered and supply is failing to match demand as the diminishing number of new reserves fails to compensate for dying mines. While reserves are depleting faster than new ones can be discovered, once discovered it would take around 4-5 years for a gold mine company to start producing gold. So while the price of gold may go up and down in the short run, the demand and supply economics favour gold. Gold demand for jewellery, industrial applications and as a form of investment, thanks in part to gold exchange traded funds (Gold ETFs), has not fallen. According to Marc Faber, in his latest Gloom, Boom and Doom report, the risk concerning gold is not whether it goes up or down, but it lies in it not being present in your portfolio. He advises investors to buy gold and silver by dollar cost averaging every month.

Taking a call
So while speculation does have a role to play, there is a fundamental demand for such commodities. As long as populations keep increasing and world growth is on track, prices of commodities will rise. There may be ups and downs along the way, but the overall trend is up. Which brings us to the question of how a retail investor can invest in such an asset class? First of all, to speculate is way too dangerous. Tactically, one can take a view, which we would not recommend (see Our View). However, if you are convinced that the basic economic scenario holds well for commodities in the long run, then you could have some sort of exposure to this asset class that does not exceed 15 per cent of your overall portfolio (see How you can invest).

What are commodities?
Commodities are raw materials that are mined or grown. Commodities that are typically grown are called soft commodities, while those that are mined are called hard commodities.
A more categorical description would include
• Agricultural commodities - Eg: corn, oats, wheat, coffee, soybeans, cotton
• Base Metals - Eg: copper, steel
• Precious Metals - Eg: gold, silver, platinum
• Energy - Eg: crude oil, gas

How you can invest
• Physical - This is only possible in the case of precious metals where you can buy gold bars or silver coins. However, affordability, insurance, storage and selling of asset are issues that have to be considered.
• Exchange Traded Funds (ETFs) - Gold can be purchased via ETFs.
• Mutual funds (see table) - These funds invest in stocks of companies in the relevant business. Numerous factors come into play - PE ratio of the stock, hedging policy of the company, M&A activity, financial performance, strong management, labour issues, exploration risks, depletion of reserves, decline in production, mounting production costs which eat into profits. The actual factors would depend on whether the company is into metals or agriculture or any allied business. The stocks here can be very volatile, which will eventually get reflected in the performance of the funds. Be ready for a rocky ride.
• National Spot Exchange - The E-Series functions like the cash segment in equities. Gold, silver, copper and zinc are offered in small denominations in the demat form. Arrangements are made with National Securities Depository Limited (NSDL) and Central Services Depository (India) Ltd. (CDSL) as the depository for holding commodity units in the electronic form.

Our View
There is no denying that money can be made by investing in commodity funds. However, there is a risk factor that cannot be ignored. This asset class is extremely volatile. There are numerous factors that determine its price movement - interest rates, geo-political developments, import-export laws of nations, labour laws, speculation and even the weather.
If you do believe the fundamentals are sound enough to make for a strong investment, go ahead. In that case, be prepared to live with sharp corrections and movements.
Finally, if you are taking an exposure to such a fund (or funds), limit it to a maximum 15 per cent of your overall portfolio.

Schemes  1-yr ret (%)  Inception date  Benchmark  Expense ratio (%)
AIG World Gold NA May-08 FTSE Gold Mines 0.75
BSL Commodity Eqt- Global Agri 16.62 Oct-08 S&P Global Agribusiness 2.5
BSL Commodity Eqt- Global Multi Commodity 14.87 Oct-08 MSCI World Index 2.5
BSL Commodity Eqt- Global Precious Metals 18.95 Oct-08 Dow Jones Precious Metals 2.5
DSPBR World Energy 18.6 Jul-09 MSCI World Energy (70%) MSCI World (30%) 0.73
DSPBR World Gold 26.04 Aug-07 FTSE Gold Mines 0.64
DSPBR World Mining 16.68 Dec-09 HSBC Global Mining Capital 0.72
DWS Global Agribusiness Offshore NA Apr-10 MSCI World Index 0.75
ING Optimix Global Commodities 22.88 Aug-08 Commodity Fund Index* 0.75
Mirae Asset Global Commodity Stocks 11.56 Jul-08 Combination of 3 indices# 2.5
*40% Dow Jones World Basic Materials Index + 40% Dow Jones World Oil & Gas Index + 20% MSCI AC World in INR Terms; #MSCI Energy & Material indices - Brazil , India and Asia Pacific ex-Japan
Returns as on April 13, 2011 Expense Ratio as on September 30, 2010