Investing in Commodities

Bachelorarbeit von Patrick Maul

Introduction:

Commodities and especially investments in commodities are currently enjoying a high degree of attention by institutional investors such as pension funds and portfolio managers but an increasing interest in commodities can also be found at retail investors. Unlike bonds, stocks, mutual and exchange traded funds, commodities are real, tangible products and part of people’s everyday life. Even though commodities are essential for our survival, recently commodities as an asset class were part of excessive media coverage, investments in that asset class has become interesting for private investors.

In this Bachelor Thesis I give insight into the commodity sector as an investment opportunity especially for private investors in Germany. I will refrain from presenting the historical development of the physical commodity market, but this work shows the facts about the six most important opportunities provided in the financial market to participate in the development in as Jim Rogers describes it, ‘the world’s best market’.

Price development of selected commodities in 2009:

The previously mentioned excessive media coverage is the consequence of apparently infinite price increases of the much-noticed commodities gold and crude oil. The spot price for gold for example has reached a new all-time high in November 2009 with over 1100 USD/oz. and a price increase of 50% in 12 months. The spot price for Brent crude oil has approximately doubled in the same period of time from around 38 USD/bbl. at the end of December 2008 to 78 USD/bbl. in November 2009. Therewith the spot price for one barrel of Brent crude oil has only reached 50% of its peak price on 7th of June 2008. Back then crude oil cost 145.16 USD/bbl. Such performances and prospects for further price increases arouse interest in the mass market and move commodity investments into the focus of all kind of investors. Indeed investment in the asset class commodities has always been profitable for investors as they have usually achieved a higher rate of return in the past as well as in the year 2009 compared to benchmark-investments like the German index of leading shares, DAX (see Table A: Spot prices for Gold & Crude Oil vs. Benchmark (DAX) from Nov. 2008 - Nov. 2009). At the same time commodity investments have been underrepresented in most portfolios of private investors.

What happened before 2009?

Before the outbreak of the financial crisis in 2008, the increasing demand for commodities especially in the fastest growing and most populous countries was for a long time a basis for the price increases. Public and private demand for many kinds of commodities increased, especially in Brazil, Russia, India and China, while investments into the infrastructure and the industrial production came along with an increased purchasing power of the labour force in these areas. Additional to the rising demand in the emerging markets in general and the BRIC-Countries in particular, speculators at the international financial centres bet on rising prices which led to a boom in this particular asset class. So it happened, that after a long trend upwards the most important commodities for investments reached their all time high at that moment early 2008, e.g.: aluminium, platinum, palladium, wheat, but also gold and crude oil like mentioned earlier, or copper and coffee mentioned in the following paragraph.

With the outbreak of the so-called financial crisis most commodity prices came under high pressure and in the second half of 2008 a general decline could be observed with only few exceptions. A particularly sharp fall in prices could be seen with fossil fuels like crude oil and natural gas but also soft commodities like soybeans. The only exceptions were precious metals like gold and some other commodities e.g.: copper or coffee. However the high demand for gold and the relative stability of the prices for copper and coffee could not stop the general decline in the commodity market which can also be found in the performance charts of the three most important Commodity Indices (see Table B: Performance of the DJ-AIG-CI, R/J CRB and S&P GSCI).

Commodities – What is originally meant by that?

By definition a commodity is something of use, advantage or value. As mentioned earlier commodities are real, tangible products – primarily consumption and not investment goods. They provide utility by use in industrial manufacturing or in consumption. Commodities play an important role in our everyday life and we are daily surrounded by up to 80 commodities – some serve as food, some give us light or keep us warm. From others clothing is produced or they serve as an energy source.

Compared to traditional investments like bonds, stocks or mutual funds, commodities provide an intrinsic value deduced from their economic value. Furthermore they only have a limited availability due to seasonal or geographical restrictions.

Soft commodities that are renewable and virtually unlimited depend on the weather and on the harvesting cycle with the consequence that their supply is strongly restricted in any given period. An additional factor in the supply of soft commodities is the influence of the development of new agricultural crop land. As you can see soft commodities represent agricultural products or livestock (see Table C: Components of the commodity sector).

Hard commodities are non-renewable products of the energy-, metal-, or mineral-sector. They exist in finite quantities and the supply of these goods depends on the ability of producers to mine raw materials in both sufficient quantity and sufficient quality. While the supply of soft commodities depends on the harvesting cycle and the development of new agricultural crop land, the supply of hard commodities depends on mining-capacity and the exploration of new reserves as an important issue. Nevertheless, once the existing quantities are used up, they are irrecoverable.

All together these resources make up the global commodities market, which can also be invested in, of course.

Commodities as an asset class of their own:

Historically, commodities played a minor role in the investment decisions of institutional and private investors and still do so today. Nevertheless there is a broad consensus that commodities, compared to other traditional and alternative assets, can be considered – in a portfolio context – as an asset class of their own (see Table D: Asset classes of traditional and alternative investments at a glance).

An asset class is a specific category of assets or investments. Each class is characterized by a large internal homogeneity, which means that assets within the same class exhibit the same characteristics, e.g.: they behave similar in the market and are subject to the same laws and regulations. Thus, shares, bonds, real estate and commodities form separate asset classes, for example. They are characterized by a homogenous risk-return profile resulting from a high internal correlation. Furthermore the asset classes themselves show a low external correlation and a heterogeneous risk-return profile towards each other.

These characteristics qualify commodities as a separate asset class. However, they represent an asset class that demands attention in the same way the other asset classes do. Furthermore a unilateral investment into commodities is not advisable. Rather private investors should take advantage of the chances and risks of this sector to enhance their portfolio.

Table of Contents:

Text Sample:

Chapter 2.1, Why should private investors go into commodities?

There are several reasons why private investors should consider an investment in the commodity sector although most financial products do not generate continuous cash flows like dividend or interest payment. That is why the expected return and the risk the investor takes are harder to determine than for traditional assets. In the past there were commodity producers, industrial enterprises and speculators involved in the commodity market in most instances.

For industrial enterprises, especially in the manufacturing, logistics or transportation industry, commodity prices have a high operational relevance, so they concentrate on hedging against commodity price fluctuations. The same applies to commodity producers who try to avoid susceptibility to unfavourable price developments.

On the contrary, speculators try to make a profit, deliberately taking on risk by betting on rising or falling prices. They represent the largest group in the futures market. In addition they try to take advantage of time- or location-based price differences in commodity futures markets, or between spot and futures markets, in order to generate riskless profits. They then behave like arbitrageurs.

If anything, private investors use commodities as an addition to their existing portfolio to minimize risk-return relations and enhance their portfolio diversification. Indeed diversification remains an important reason for a commodity investment, but certainly there are more opportunities for private investors.

2.1.1, Portfolio diversification:

First of all we will have a look at one of the major benefits of investing in commodities: the low correlation to other asset classes nominates commodities as a portfolio diversifier. As opposed to traditional investments in equities like stocks or bonds, commodity futures, as the most direct way to invest in commodities, show a negative correlation in each case (see Table E: Correlation of Commodity Futures vs. Stocks & Bonds).

Not only do commodity futures have a negative correlation to the asset class of stocks and bonds respectively, it is also true to say that the negative correlation tends to increase with the holding period.

Table F (Efficient Lines of Portfolios with and without Commodities) shows the characteristics of commodities as a portfolio diversifier. These characteristics can be useful for private investors, because a smart investment in this sector can increase the total return of a portfolio with a decrease of the overall standard deviation as a risk-measurement of your portfolio at the same time. But this graph also shows us, that the asset class of commodities is the riskiest compared to bonds and equities regarding their standard deviation.

2.1.2, Hedging against inflation:

When we are thinking about investing in commodities we have to talk about inflation. Besides being a portfolio diversifier, the most important reason for an investment in commodities is the fear of the investor of rising inflation.

Many private investors share the fear of a higher future inflation rate especially in the currency area of the USD and the Euro. The basis for that fear is the massive expansion of the money supply through the central banks. The so called quantitative easing and the excessive national debt of the industrialised countries stoke fears of inflation. Many private investors mistrust the governments in the USA and EU, who claim to reduce the national deficit without inflation. Additionally there is a lack in the ability of many private investors to understand the way in which the central banks plan to deduct the additionally provided liquidity in the financial market in 2008 and 2009 in the future.

Fortunately commodities show an attribute that most other assets do not have: Inflation rates and commodity prices are highly positive correlated (see Table G: Correlation of Inflation rates with Equities and Commodity Futures).

Therewith commodity investments provide a hedging tool against inflation. Only few investments offer that benefit. While equities like stocks and bonds are consistently negative correlated to inflation, commodity futures behave exactly the opposite way. Accordingly, commodity prices rise with inflation or rather inflation is often caused by rising commodity prices. In particular increasing energy prices are reflected in a higher consumer price index.

Applicable in this instance: the positive correlation tends to increase with the holding period.