Investing in Commodities
November 29, 2008One of the most positive developments in our economy the past few months has been falling oil and gasoline prices. The first few times I filled up my car with gas under $2 a gallon, I did a double take to check the receipt since it seemed so much lower than just a month or two earlier. Crude oil began 2008 at a then-unheard-of $100 per barrel. It climbed all the way to $147 per barrel in July, and then prices came crashing down. By early December the price had fallen to $41 per barrel as the global economic slowdown curtailed demand. Many different commodities ranging from energy to livestock to grains to metals experienced similar volatility, rising the first half of the year and falling in the second half of the year. Although commodities can be very volatile, over the long-term they have provided strong growth during certain time periods and additional diversification to a portfolio of stocks and bonds. While we believe it is still early to invest much in commodities now, we expect they will become more attractive as the economy begins to recover. In light of this, we wanted to give a brief introduction to commodities and the expanded future role they might play in our portfolios.
What are commodities and commodity futures?
Commodities are physical assets. They are raw materials and are oft en the initial inputs in the manufacturing process. Commodities can be divided into categories including energy, grains, precious metals, industrial metals, livestock and soft s (food and fiber). Examples include crude oil, natural gas, corn, gold, aluminum, lean hogs, sugar, and cotton. See the chart on the right for the group weightings of the commodity categories for the Dow Jones AIG Commodity Index, a popular commodity index. Investors typically do not trade the actual physical assets. Instead they invest in contracts called commodity futures that are traded on an exchange. A commodity futures contract is an agreement to buy or sell a specifi ed quantity of a commodity on a future date at a specified price. By selling the contract prior to the delivery date and buying a contract with a later delivery date, investors can gain exposure to the commodity without taking physical delivery of the goods.1
How are commodity futures different from stocks and bonds?
Stocks and bonds are long-term financial assets. Companies use stocks and bonds to raise capital for the business. They are claims on the future cash flows of the business over very long ti me horizons. Investors are compensated for bearing the risk of the change in future cash flows. In contrast, commodity futures don’t raise capital for a company. They are short-term contracts based on real assets. They allow a company to lock in the price of its future inputs or outputs. For example, a corn producer can lock in the price he will be paid per bushel of corn when his harvest comes in. He is then protected from an unexpected drop in the price of corn. An investor bears that risk by buying a commodity future. To take this risk an investor will require that she be paid an “insurance premium.”
Why invest in commodity futures?
Over the long-term, commodity futures demonstrate risk and return characteristics similar to stocks. They typically perform well during periods of high or rising inflation, and because they react differently to market dynamics, often do well when stocks and bonds are doing poorly. This is not always the case, as deflationary pressures in recent months have shown. Commodities can be volatile. However, because of the tendency to behave counter-cyclically to stocks and bonds, commodities can actually dampen the overall volatility of the portfolio.
What are the sources of return for commodity futures?
There are a number of drivers of commodity future returns. First, investing in futures requires only a small percentage of the contract to be paid up front. Investors can invest the remainder (often in T-bills) earning a return on the collateral. A second source of return comes from the “insurance premium” commodity producers will pay to hedge the risk of price changes to output. A third source of return comes from rebalancing a diversified portfolio of commodities. Because individual commodities are oft en not highly correlated with each other, an investor earns a return by selling those commodities that have gone up in price and buying those that have gone down in price. Fourth, for some commodities when inventories are low, commodity buyers will pay a “convenience yield” to guarantee access to that commodity. Investors earn a return by selling a commodity future contract expiring sooner at a higher price and buying a cheaper more distant contract. Finally, unexpected changes in commodity prices can contribute to or detract from returns on commodities.
How would commodity futures fit in a Brightworth portfolio?
We believe commodity futures can generate solid long-term returns and can provide valuable diversification as part of our overall portfolio strategy. To earn these benefits investors need to be willing to hold a sometimes-volatile asset class over a long time horizon. If we decide to add commodity futures to the Brightworth portfolio they would be added as part of the Alternative and Real Assets portion of the investment strategy. We would likely gain exposure through investing in a mutual fund or exchange traded fund that tracks one of the common commodity futures indices.
When to use commodities.
In the near term, we expect a weak global economy will continue to put downward pressure on commodity prices. Commodities have typically performed best from the beginning of an economic expansion through the peak of the business cycle. The voracious appetites of emerging economies such as India and China should once again provide a long-term tail wind for commodity prices. Inflation should remain low until the economy starts to recover, but it could increase after that, given the large fiscal and monetary stimulus programs from central banks around the globe. Commodities have historically done well during inflationary periods. “We believe it will still be some time before the global economy improves and inflation begins to pick up. However, markets tend to move in advance of the actual economic changes, and now may be a good time to begin building a small position in this asset class.”
1Dow Jones AIG. Commodity Index Sector Weightings as of 11/30/08
