Commodities as an Asset Class for Investors

Mike Davis, Global Director, Platts Risk Management

Commodity investments are gaining new respect as investors discover they hedge inflation and perform at their relative best exactly when stock and bond markets are most vulnerable.

RECENT YEARS HAVE SEEN A PROFOUND re-appraisal by many financial market players of the merits of commodity-related investments, both in terms of the companies that extract, refine, transport and market such key building blocks of modern economies and directly in those commodities themselves, their financial derivatives, and especially in indices of those commodities.

The current market cycle has seen (at least until the recent turmoil around sub-prime mortgages) most asset classes appreciate in price in a high-liquidity, low inflationary environment, fuelled by easy credit conditions and additional liquidity from arbitrage between low- and high-yielding currencies. Correlationswith prices tending to move in a similar direction or magnitudeincreased across many asset classes, and risk premia between lower- and higher-risk investments were pared in the search for returns from a seemingly exponentially expanding pool of global investment capital. Whilst these processes have played themselves out, commodities have once again risen to prominence, after a long period in the shadows. The stock market fall-out of 2000-2003 temporarily reduced some attractiveness of equities for long-side investment, while falls in interest rates put yields for more secure investment grade bonds under pressure. As a result many investment managers have returned to commodities in one form or another in their search for alpha returns, and for themes to attract the ever-growing global pool of funds looking for a home.

Commodities have attracted their attention for a number of reasons, not least their recent upside price performance, their negatively-correlated portfolio diversification benefits against stocks and bonds, and as a hedge against inflation. According to recent research, they have a happy knack (when aggregated in indices of commodity futures, at least) of tending to perform at their relative best exactly when stock and bond markets are at their most vulnerable, during the late periods of expansion and early periods of cyclical downtrends in the business cycle.

So Why Commodities and Why Now?

In a single word: China. Although growth is taking place at a healthy clip in many economies, it is the pace of growth (accelerating to 11.9% year-on-year GDP growth at the end of Q2 2007) in an economy already the size of China's, the sheer scale of the infrastructure building, and growth of consumption of the core building blocks of a modern economy that are adding much of the marginal demand to world commodity consumption. China's demand for energy, cement, steel, and key industrial metals in parallel with an unprecedented exodus of workers from her rural hinterland to the mushrooming eastern seaboard cities, and her shifting consumption patterns in all respects, including agriculture, have all combined to crucially tip the supply/demand equation for many commodities.

One of the key characteristics of such commodity "super-cycles" is that commodities are needed to extract or process other commoditiesthe super-cycle is in effect self-perpetuating. To extract or transport more oil or gas, new oil wells, pipelines and transport ships need specialized steels. Those are also needed to build the extra cars that Chinese and Indian consumers are clamoring for, as well as to extract marginal crude oil and process it into the gasoline to run them, or mine the metals for catalytic converters to reduce emissions. In our search for more marginal energy sources, such as tar sands or corn-derived ethanol, we use in some cases a significant proportion of the energy ultimately produced in order to extract it, according to the EROEI (Energy Return On Energy Invested) ratio. Conventional Arab Gulf or other land-based crude oil extraction runs as high as 30:1 per this ratio, but many biodiesels come out between 1.3:1 and 2:1 for various feedstocks. Broadly, energy supply growth is lagging demand growth by between 0.5% and 1% per annum. The cushion of spare capacity over demand in oil, for example, may have shrunk to the marginal 500,000 to 1 million barrels per day that Saudi Arabia may or may not be able to pumpexpert opinions disagree.

This upturn in the attention paid to commodities and their prices has been in sharp contrast to the decade following the first Gulf War, when producers of such raw materials saw little encouragement in margin terms to increase capacity or production, and certainly none to invest in new plant with a likely poor or even negative long-term return on capital. Refineries were retired early, remained unbuilt, or not upgraded; mines were abandoned or marginal energy sources unexploited; and marginal agricultural land was left fallow or built upon. Since 2002/3 especially, these trends have sharply reversed, as producers and processors of commodities have struggled to keep pace with resurgent demand. The accompanying growth in capacity to meet that demand, often requiring long lead-time strategic investments, will take time to surface after such a long period of under-investment, and has some serious catching up to do. As second-line commodity price and availability constraints create further hurdles for raising production and processing capacity, many prices have exploded upwards.

Current or expected medium-term conditions seem unlikely to reverse commodities prices for any number of reasons. As stock markets plunged in July and August, the UK saw its first bank depositors' panic in a century, and crude oil and gold rose to all-time and 28-year highs, respectively, in nominal terms. As long as policy makers in the US and the UK must walk a tightrope between sanctioning interest rate cuts to shore up heavily-indebted consumer-dependent economies and trying to prevent inflation accelerating from its entrenched base, any puncturing of the commodities' bull case is likely to be delayed, with stagflation a genuine possibility. If monetary authorities err on the side of relatively unfettered credit growth, thus subverting the market's own corrective impulses, there will be less likelihood of downward pressure on the forces that have supported consumption at recent levels, and hence on commodity prices.

Added to that are increasing de-coupling of Asia's growth trends from those of Europe and the US, and a growing interdependence of Asian economies via intra-Asia trade, lessening dependence on consumer-dominated and heavily indebted non-Asian economies that may be the first into the next recession. Asia is far more than just China: Japan is still the second-largest global economy and India is a far more internal consumption-oriented than export-led economy.

Commodities Take the Stage

The result of these interlinked trends has been an intense increase in interest in commodities and their prices: as an influence on the wider global economy, as an indicator of pent-up inflation, and as a deflator of consumer spending power. Commodity prices in the end may do what governments and monetary authorities are not prepared to do: puncture demand. In turn, commodities' suitability as investments in their own right certainly is to the fore.

Commodities' usefulness as a vehicle and asset class for investors is founded on multiple heads of value now, be they M&A/equity-oriented hedges, private equity, mutual fund managers looking for an asset play around direct investment either in commodity futures or actual physical infrastructure, or those seeking an efficient diversification play with negatively correlated stocks or property. Alternately, there are those looking for an inflation hedge away from fully-priced index-linked securities, endowments looking for a rival to stocks as a dominant and less-risky long-term investment, or large corporations seeking to protect themselves from increases in baskets of raw material costs without the complexities and costs of hedging individual components. Exchanges that trade or clear commodities have also seen a rapid rise in their market capitalization.

Commodity indices based on baskets of commodity futures are one of the most versatile and popular vehicles for corporate investors to access the investment benefits of commodities, as the quantity of funds flowing into commodity index vehicles testifies. Their popularity comes to a large degree from avoiding the volatility and liquidity issues of individual commodities, and the short-term gyrations, seasonality and supply/demand spikiness that can unsettle those who choose to take a position in individual commodities and their derivatives.

Academic support for the performance of commodity indices has been underscored by the well-known 2005 Gorton/Rouwenhorst paper, Facts and Fantasies about Commodity Futures, which showed that over a 45-year period (1959-2004) such an index performed at least comparably, in average annual returns, to the S&P 500 stock index. More surprisingly, the risk skews from this and other, supporting research revealed that a commodity basket showed lower downside risk in generating its returns, plus a negative correlation to stocks and bonds, and a strong positive correlation with inflation, emphasizing the diversification and inflation-hedging benefits of commodities independent of sheer upside performance. These characteristics are increasingly marked as holding periods lengthen, which may well suit pension or endowment vehicles.

In sum, a (collateralized) commodity futures index performs as well as a stock/equity one, carries slightly lower risk, and reacts to the economic cycle differently enough to be a good diversification play for those holding stocks whilst being a good inflationary hedge. Adding commodities to any stock portfolio is going to reduce risk, the research says.

Not everyone agrees with all of these findings, or the comments of such commodities "super bull" investment gurus as T. Boone Pickens or Jim Rogers, with some arguing that the reliance on China's growth in particular is a weakness. But the point is that historic holdings for many long-term funds in the 2-3% range for commodities are far too low for such a useful diversifying and inflation-hedging asset class. Continuing investment fund interest in commodities can be expected if these views are borne out.

Some funds are already there. For example, the highly-regarded Harvard endowment has relatively large holdings in commodities (timber especially) which produced a 16% per annum return in the five years to 2004, a period when stocks yielded a negative result. Overall commodity allocation of that closely watched endowment is said to be over 13%.

Hot Picks vs. Balanced Investing

To some extent, the renewed interest in commodities has been self-fulfilling. As investors have seen healthy profits from commodities over recent years, spectacular busts such as Amaranth notwithstanding, more have been encouraged to enter the fray. The hope for those involved with commodity indices is that such interest does not coincide with a generalized downturn in those markets as interest rates rise. It would not be the first time that the marketing for this year's hottest investment product peaked just as the opportunities receded, as many a mutual fund investor can attest.

Earlier in 2007, as some critics are keen to point out, a number of key commodities were below their highs of 2006. Even then, before recent renewed upward spikes took many commodities higher again, there were strong signs that inflation is not dead. China is struggling to hold back inflation as it accelerates well over 5% there, and in a global context, is likely to be 'exporting' inflation, via its trade flows as wages there begin to bridge the yawning gap with the West. One facet of recent turmoil in global markets was that longer-term interest rates rose, as credit tightened, impacting relative returns for other asset classes too.

What investors should perhaps concentrate on is the longer-term value of commodity index vehicles as part of a portfolio, and the suitability and liquidity of the individual vehicles of the commodity class in general. Jim Rogers has alluded to the typical commodities cycle as running 12-15 years. That would suggest that, although there may be major swings to come, this bull run has some way to go, as the current run has lasted five years at most. High commodity prices may be the surest cure for high prices, but three years of historically high prices haven't supplied a cure. Long-term decisions are needed for heavy, sustained investment in supply infrastructure, as two 1-billion-population nations' industrialization revolutionizes our world.