Hot from the ground

Published in The Market magazine, June 2012. Original article here.

Hot from the ground
Oil and gold may be the most popular, but there is a world of commodities out there for investors who want to bet on all things grown or mined from the ground. We take a look at the ins and out of the exciting world of commodities trading.

Commodities represent trading in perhaps its purest form: to take something from ground and exchange it. While oil and gold are the best known commodities, almost anything you can imagine coming from the earth, either by digging or growing, can be traded as a commodity, be it platinum, nickel, propane or coffee.

Some of these products, like sugar and oats, will have a pretty straightforward path from producer to user, with pricing largely driven by sun and rain. But commodities will frequently have pricing driven by industrial demand; they call it ‘Doctor Copper’ because the metal is instrumental in so many different products, from electronics to power generation, making its demand a health check for economic growth.

Oil records
“The prices of commodities definitely reflect news from the outside world. Oil especially works as an economic indicator,” says Ole Hansen, head of commodity strategy at investment bank Saxo Bank. Oil is the biggest traded commodity in the world, with the Brent crude oil classification used to price two-thirds of the global oil supply. The price of Brent has been on a major upswing in the past few years, hitting a peak of $128 this March. Most people will find themselves in need of a petroleum-based product on a daily basis, be it fuel or plastics; Procter & Gamble and Unilever were among global goods manufacturers which recently complained that commodity prices were denting profits. “Price increases affect everyone,” concludes Hansen. “While central banks can set interest rates, it is hard for governments to do anything about commodity price fluctuations. This is a good reason for investors to follow them.”

Political unrest will cause ripples in the oil price, which is further influenced by rising demand from economic growth. “Oil prices enjoyed a good first quarter, helped by improved economic growth in the US,” says Chris Beauchamp, market analyst at derivatives trader IG Group. “But [oil has done well] also by the worrying prospect of conflict in the Middle East, as Iran and Israel ratcheted up their rhetoric.” On top of this comes the fact that oil producers are churning out not much more than customers demand; the numbers vary depending on source, but it is clear there is a very small buffer between oil supply and demand. The issue of placing sanctions on dealings with Iran may be political in nature, but it affects oil prices by impinging on the buffer needed to maintain stable prices.

A volatile supply
Because the world of commodities is so volatile, it has the potential of being a risky investment. Still, for stockmarket investors used to handling 5-10% fluctuations in their trades, Hansen believes commodities should not take too long to get used to. At the core, commodities pricing is affected by the basic principles of supply and demand; how much corn is grown, and how much corn do we need. Furthermore, the relatively unprocessed nature of commodities means there are fewer variables to consider for investors used to dealing with companies, which are complicated by product developments and competition pressures. Still, the market will move commodity prices based on the news of the day, either by big events like the Deepwater Horizon oil spill of 2010, or by constant speculation from traders picking up news bulletins or rumours.

“Comments from central bank governors about more or less money printing will cause gold and its racier cousin, silver, to move quickly, as investors look to alter their holdings of tangible assets relative to cash,” says Beauchamp. “Good economic data from major nations like the US and China will cause shifts in the price of copper, oil and other associated commodities used by industry, on the assumption that businesses will use more of these products. … Gold, of course, was the star trade from 2009 to mid-2011, but has since become a lot choppier, as bouts of risk appetite alternate with renewed worries about the eurozone. Like most things, it gained ground in late 2011 to early 2012, but has since edged back.”

A futures game
Most commodities are traded as ‘futures’, where investors pay today for delivery of an asset in the future, usually set to one, three or six months out. As few traders want to take delivery of a stack of gold bars, most futures contracts will be ‘rolled’ forward, a mechanism where the contract near maturation will be sold and a new one bought. The commodity ‘spot’ price represents the price for immediate delivery.

On top of trying to anticipate the price direction, investors will need to look out for potential losses as futures contracts are rolled over. The phenomenon known as ‘contango’ happens when a futures contract trades above the spot price, while the opposite is called ‘backwardation’. During contango, investors have to pay more to maintain their position when rolling over the contract. The performance of indirect investments, such as exchange-traded products, will also be affected by contango, usually by a slight reduction in the holding to cover the cost of each roll.

“A key example of contango is US natural gas. The price has collapsed while oil keeps rising, so people are attracted to it,” says Hansen, explaining how the spot price may be low, but the futures price is starting to reflect expectations of recovery. But to roll this forward month after month while waiting for things to improve could become expensive, meaning potential investors need to examine the futures ‘curve’; this slope indicates the likely price direction. “Contango is not such a big problem now as it was during the recession, when spot prices were low but futures prices were high in anticipation of recovery. It led to some very nasty effects,” says Hansen.

The success of ETPs

“People often approach the firm wanting to ‘buy gold’. While we cannot facilitate them buying into the commodity itself, it is possible to invest in a product that will track the value of it,” says Lauren Charnley, stockbroker at Redmayne-Bentley Stockbrokers. “There will be certain commodities well known for volatility, but with leveraged products and more stable funds available, investors can effectively choose their own risk exposure.”

Exchange-traded products (ETPs) have proved very popular among commodity investors, with global influx having reached about $1.6 trillion for all types of ETPs, according to Vanguard Investment Strategy. Before the launch of ETPs, commodities trading was mostly a professional’s game, as few private investors could dedicate enough time to track these markets. “There is a vast array of ETPs in the market at the moment,” says Charnley, explaining how some of these are ‘physical’ ETPs where the fund provider actually holds a vault containing the commodity; alternatively investors can buy a ‘synthetic’ ETP, where the issuer does not hold all the underlying assets.

“With over 4000 ETPs to choose from across the globe, investors must decide on a few key elements,” says Charnley: “Which commodity to invest in; which issuer to invest with; whether you are willing to accept a synthetic product, and what level of risk to take on.”

Synthetic risk
The choice between a physical or a synthetic ETP is instrumental to the decision about risk, because a synthetic product gains exposure to the commodity through derivatives contracts or a total return swap. “[The risk with synthetics] is primarily what is referred to as counterparty risk, which is the risk that the underlying liability will not come to the fund, and investors can lose money because of it,” said Joel Dickson, principal at Vanguard Investment Strategy, in a company webcast. “You are relying on an investment bank to give to the fund the index’s return that is being promised. If the [total return] swap provider goes out of business, or defaults on that obligation, then it is possible under certain scenarios to have investors lose some money, or be exposed to risks that maybe they did not fully understand.”

Providers will have mechanisms in place to guard against counterparty risk, however, with regulation also setting boundaries on how much risk they can take on. Still, investors should check the appropriateness of their particular product before handing over their money.

“An ETP works well for investors who require complete control over the commodity they invest in,” says Charnley. “Many are in a basket of good form, giving exposure to a group of commodities rather than individually selected ones. Investment trusts could be a different play to consider; the manager of the trust would take control of the investments made within certain guidelines. Investment trusts tend to hold equities that give exposure to a certain sector, meaning they are relatively diversified within the realms of their specialty.”

Commodity exposure can also be gained through buying shares in miners, explorers or agricultural producers, or you could go the other way with a derivative such as a CFD (contract for difference) or spreadbetting. With the latter, investors can start betting as little as a few pounds, says Beauchamp: “The most interest we see is in the various individual commodities, with the old stalwarts of gold, oil, silver and copper being client favourites. They are traded in the same way as any other asset on the [spreadbetting] platform, and so when getting started the same general rules of thumb apply.”

Hard and soft

As each commodity has its own unique patterns for production and use, investors will need to take a moment to look at each one before investing. If oil is affected by global politics, and gold is a play on economic sentiment, cotton prices will trail along with prosperity: when times are good, people buy new clothes. Gold and silver have traditionally been viewed as safe havens, however commodities which are basic food staples will also benefit from a relatively constant demand.

“For agricultural commodities, the big unknown is always the weather. In times of prosperity people buy more coffee, for instance, and they eat more chocolate which affects the cocoa price,” says Hansen. “But it does not take much of a failing on the supply side to create pricing volatility.” This is also because the production of perishable goods does not allow for the creation of large buffers. Investors can look to the politics and weather in Brazil and Colombia for an inclination on the coffee prize, or to Vietnam for instant coffee prices. Similarly, Ghana is an important cocoa market, while sugar is largely produced in the US, India, Thailand and South America.

“This is why we tend to look for baskets of commodities, so we are better protected against incidents such as a 30% price spike due to frost in Brazil,” says Hansen. Diversification also protects investors against having to exit a position at an undesirable time due to a sudden political event.

The growth of China has changed the picture for commodities over the past decade, driving up prices for most metals through increased production. With 45% of the world’s copper demand now emanating from China, Hansen argues the copper story is less about world economic prosperity and more a bet on China; “All industrial metals are affected by the Chinese economic growth story now.”

The long game

Most private investors will treat commodities as a short-term trade, where they can cash in on a rise or fall of a certain asset, but there is also a long-term case for commodities. Oil, for instance, will eventually run out, whereas economic growth booms in new markets will drive demand for a range of metals and foodstuffs. Similarly, increasingly erratic weather from climate change may agitate the price volatility for agricultural commodities, which will also have to meet the needs of a growing global population.

“With commodities you are trading something physical, and that can be attractive to investors,” says Hansen. This is true especially for those concerned about the future value of money amidst economic uncertainty, and continued low interest rates will drive investors out looking for alternatives for a while to come. It is of course possible to buy gold bars and store them under the mattress, or perhaps in a vault, but diversification comes highly recommended for investors taking the long view on commodities. After all, if investing to protect against an uncertain future, it pays to spread those eggs between many baskets.