What are Commodities?
Commodities are classified as alternative investments because they are fundamentally distinct from stocks, bonds and cash. Each commodity generally has its own price driver. Investors can buy the physical commodity or invest in securities, which we will discuss below. Common investable commodities include oil, natural gas, gold, silver and other metals, agriculture and livestock to name a few. A common feature of all commodities is that they tend to be volatile. The supply-demand balance on a global scale sets the price of these securities. Political factors, weather seasonality, and the economic cycles of various countries can affect supply and demand. As such, Hemispheres Investment Management, with its global equities focus, can assess these factors and opportunistically invest for our clients.
Why Invest in Commodities?
Diversification
Weather, politics, global supply chain issues, global production, economic cycle variance between countries can all affect commodity returns. As such, the correlation between commodities and securities such as stocks and bonds are low. A low or negative correlation between asset classes results in an overall reduction in risk for the portfolio.
Inflation Hedge
Real assets, such as commodities historically have positive and reliable returns during periods of inflation. Knowing that this relationship generally holds true, investors demand for commodity related securities increases during inflationary periods. This is true for both investment in securities and in the physical asset. For example, investors view gold as a store of value. Many investors hold physical gold in security deposits at their bank during periods of high inflation.
Types of Commodity Investments
Physical Investment in Commodities
Investors can buy and store physical commodities. Large manufacturers or refiners generally make this type of investment to lock in prices as of a specific date. An example would be a cereal producer who buys wheat as an input in the cereal produced. For individual investors this rarely makes sense to hold agricultural or energy commodities physically because of the large volume of the product per contract and for the potential for waste. Metals from a retail dealer are the most common investment among individual investors. Kitco or BullionVault are examples of precious metal dealers.
Commodity Futures Contracts
Large institutional investors generally use either forward or futures contracts to buy the physical commodity in the example above. The contracts specifies the price, quantity, quality and delivery date. If an institution anticipates rising prices, the contracts essentially lock in the price.
For commodity traders, either institutional or individual investors that utilize the instruments for speculative purposes, commodity futures are of very short duration generally. The motive for short term trading is profit potential, not inflation hedging. Leveraged instruments with high volatility, futures operate in enormous and highly liquid markets. Investors trade futures contracts through brokerage accounts approved for futures trading.
Individual Commodity Stocks
Investors can buy commodity company stocks through a brokerage account, or your investment advisor can purchase the securities for your account. The correlation between individual stocks and the movement in the commodity itself is positive. While positive, correlations are generally not 100% because many other factors, most of which are company-specific issues, affect them.
Commodity Sector ETFs and Mutual Funds
Commodity sector specific ETFs and Mutual funds hold a broad basket of stocks that track the price of the commodity. These funds offer limited diversification benefits as they all move in tandem with the underlying commodity price. One benefit however is that the broad basket limits exposure to any one stock that may experience a negative, one-off event. When investors allocate a small portion of their otherwise diversified portfolio to commodity ETFs or mutual funds, they can add considerable value.
Key Factors Influencing Commodity Prices
Geopolitical Factors
Geopolitical events are political, social, and economic occurrences within or between countries that impact market performance. These events include geopolitical tensions, wars, trade agreements, political instability, and natural disasters. In the commodities market, geopolitical events can disrupt supply chains, cause price volatility, and alter demand for certain commodities. This in turn, affects futures and forward prices as well as stock and bond prices for companies working with the commodities in question.
Political factors can have a strong effect on commodity prices. For example, the government wants to reduce reliance on fossil fuels to slow global warming. Significant private and public resources continue to invest in transitioning away from fossil fuels. However, this same political pressure resulted in less capital investment in oil field development in the last several years. This will lower US oil production in the US unless capital expenditure budgets increase. If renewable energy supply does not keep pace with energy demand, a reduced supply of oil would result in higher oil prices.
Supply-Demand
Commodity prices are based upon the available supply of the commodity versus the demand for that commodity. An example of the impact of demand vs supply would include gold. Because gold serves as an inflation hedge, small investors and countries like China have increased their gold reserves, which has driven up prices. Hemispheres portfolios have historically benefited from holdings in precious metals, energy and agricultural stocks when valuations are compelling.
We anticipate a shift in supply and demand balance by looking at forward curves and other measures. For example, we use global jet fuel demand as a proxy for global oil demand, because the two measures highly correlate. We also assess the relationship between WTI/Brent crude price spread and the time spreads (spot price vs 12 month forward price) as an indicator of price movement. Hemispheres closely follows inventories and demand figures published by agencies such as EIA, IEA, OPEC, etc.
Economic indicators
Economic indicators provide investors with signs of economic expansion or contraction. Unfortunately, many indicators point in conflicting directions. Waiting for confirmation with multiple indicators provides greater clarity but could very well result in a lost investment opportunity. Hemispheres Investment Management buys quality stocks at compelling valuations rather than trying to predict the economic cycle. In general, the stock is selling at a compelling value at or near the bottom of the cycle.
Globally, not all countries are in the same phase of the economic cycle. For example, the Chinese economy is slowing currently and this will impact commodity prices. Lower commodity prices represent a buying opportunity for an investor who will reap profits as the economy recovers.
Risks and Challenges of Commodity Investing
Volatility and Leverage
Commodities are volatile and futures prices fluctuate constantly and rapidly. Traders use margin to trade futures contracts. Futures contracts are leveraged instruments. Equities in commodity related industries are much less volatile than futures although there is a direct correlation between the stock price and the underlying commodity price.
Hedging Risk/Benefit
Most commodity related companies hedge commodity risk. Breakfast cereal companies that know they will need wheat at the end of the growing season can lock in the price with a farmer, for example, and take physical delivery of the wheat at that time. This action allows the company to know how much they need to charge for the cereal to maintain profit margins. Hedging can also pose challenges. First, these companies are competing with others and a firm may have to lower its profit margin to sell product. Second, if the cereal producer locks in the price of wheat and then wheat prices decline in the marketplace at the time of delivery, the company’s hedge will reduce profits.
Transportation and Storage
Other challenges include agriculture and energy-related entities facing increased costs for transporting and storing commodities. They can also incur losses or waste associated with both transportation and storage.
Regulation and Environmental Factors
Many companies in the commodities sector, such as precious metal mining firms, face intense regulatory and environmental scrutiny that increases costs and adds uncertainty. For example, U.S. gold mining companies must monitor water purity in nearby streams and build chemical leaching liners to protect the soil and surrounding environment. While these regulations protect the population, they also raise production costs.
Conclusion
Investing in commodities can subject the investor to several risks including: geopolitical risk, supply and demand factors, varying economic conditions across the globe, commodity price volatility and other factors as described above. However, investing in commodities has several major advantages, it is a separate asset class that provides diversification benefits, thereby lowering risk to an aggregate portfolio. When investors purchase a stock at a low valuation and the commodity price increases, they can realize a large profit potential.
A skilled and experienced investment manager plays a crucial role in global commodity investing. An experienced advisor can assist you navigate the geopolitical, regulatory, country economic and market risks.
Hemispheres Investment Management’s team of seasoned professionals have a 35-year track record of successful investment strategies, including deep proficiency investing in US, international developed and emerging markets. Hemispheres can assist you diversify your investment portfolio through the addition of commodity stocks. The Global Equities product is Hemispheres flagship product.
Please contact Hemispheres Investment Management for a free consultation. We provide guidance and strategies to assist you optimize your investment policy and help you achieve your investment goals. Book a meeting.
