Features and Investment Characteristics of Commodities

Commodity Investment Features

Source of Value

Unlike traditional investments such as stocks and bonds, commodities do not generate cash flows. Instead, they often incur costs, which are typically associated with the transportation, storage, and insurance of the physical commodities. For instance, an investor in gold would need to consider the costs of securely storing and insuring the gold bars.

The primary aim of commodity investors is to profit from the appreciation of the commodity’s price, which should ideally exceed the cost of carry. This appreciation is based on the future economic value of the commodity rather than the actual use of the underlying asset.

Government Role

Over the years, there has been a substantial rise in government participation within natural resource markets. Governments often provide subsidies to maintain consumer-friendly food prices and extend price support to farmers. They also commonly regulate the extraction rights of natural resources, including energy resources and mining. In numerous emerging markets, strategic energy production or mining resources are controlled by governments or government-owned enterprises.

In certain countries, landowners’ rights are restricted to cultivating the land and extracting specific minerals. Often, the government possesses and oversees subsurface rights, retaining the authority to extract particular resources like oil, gas, coal, gold, and silver.

Environmental Factors and Natural Resource Investments

Environmental factors have a direct influence on natural resource investments. Governments worldwide are implementing environmental safeguards to meet climate objectives and control activities with significant climate impacts, such as mining, agriculture, and energy extraction and production. Many countries are adopting national programs that align with these goals. The policy objective of reducing reliance on fossil fuels has led to a shift in focus towards electric vehicles and advances in battery technology.

The growing dependence on low-carbon energy technologies may result in an increased need for numerous minerals and metals, like lithium, cobalt, and nickel, crucial in manufacturing batteries for electric vehicles. Yet, the rise in mining activities for these vital metals can have substantial effects on nearby water systems, ecosystems, and communities. For instance, lithium mining in Bolivia has triggered water scarcity problems in local communities.

ESG Investors and Sustainable Practices

ESG (Environmental, Social, and Governance) investors are increasingly focused on advocating sustainable farming techniques and employing timberland investments for carbon offset purposes. For instance, certain investors are backing sustainable coffee cultivation in Brazil, which serves to diminish carbon emissions while enhancing the well-being of local farmers.

Commodity Investments: Distinguishing Characteristics

Commodity sectors cover precious and base metals, energy, and agricultural products, as summarized below:

$$\begin{array}{l|c}
\textbf { Sector } & \textbf { Examples } \\
\hline \text { Energy } & \text { Oil, natural gas, electricity, coal } \\
\text { Base metals } & \text { Copper, aluminum, zinc, lead, tin, nickel } \\
\text { Precious metals } & \text { Gold, silver, platinum } \\
\text { Agriculture } & \text { Grains, livestock, coffee } \\
\text { Other } & \text { Carbon credits, freight, forest products } \\
\end{array}$$

Commodities can be further classified based on physical location and grade (quality). For example, there are different grades and locations for wheat and crude oil.

Commodities cover a broad spectrum of resources, and their importance fluctuates based on societal needs and preferences. Factors like rapid industrialization in countries like China and India have increased global demand for commodities. Emerging technologies also play a role in driving demand for new materials while reducing it for others.

Most of the commodity investing is done through derivative contracts. These contracts specify the quantity, quality, maturity date, and delivery location.

The attractiveness to use of derivatives is due to the following factors:

• Physical commodities are often associated with tax obligations and costs associated with storage,
  insurance, brokerage, and transportation of commodities.
• Physical commodity markets often lack price transparency.
• Benefits of financial derivative instruments: Since derivative instruments are traded on organized
  exchanges, they are very liquid and provide opportunities for price discovery.

Derivaties used to establish exposures to natural resources include mostly commodity futures and forwards and sometimes options on futures. Futures contracts are obligations to buy or sell a specific quantity of a commodity at a fixed price, date, and location.

Since futures are exchange-traded, they are marked to market daily. Settlement can either involve the physical delivery or just a financial settlement. Counterparty risks are managed through the clearinghouse/exchange and clearing brokers.

Alternative Investment Avenues: ETPs, CTAs, and Specialized Funds

Beyond futures contracts, several other investment avenues provide exposure to commodities:

• Exchange-Traded Products (ETPs): Investors limited to equity shares or seeking straightforward trading via a standard brokerage account can also attain commodity exposure using Exchange-traded products (ETPs), such as funds (ETFs) or notes (ETNs).
• Commodity Trading Advisers (CTAs): CTAs engage in directional investments primarily in futures markets utilizing technical and fundamental strategies. Individual investors can set up separately managed accounts (SMAs) tailored to their unique investment preferences and risk tolerance, which are then managed accordingly.
• Specialized Funds: Specialized funds focus on particular commodity sectors, like private energy partnerships, and offer institutional exposure to the energy sector. These investments typically involve direct or indirect ownership of physical assets rather than ownership of residual (equity) or fixed (debt) cash flows.

It’s worth noting that while commodities offer various investment benefits, they also come with associated risks, making a thorough understanding crucial for potential investors.

Basics of Commodity Pricing

For investors keen on tapping into direct commodity price movements, derivative instruments are a popular choice. These include exchange-traded futures, options, and forwards.

Under the derivative instruments, the underlying assets are individual assets or an index. Various commodity indexes comprise distinct commodities and feature significantly different index weights. These variations lead to different exposures, not just to particular commodities but also to entire commodity sectors.

Commodities can be traded in both physical and financial markets. As such, there is a one-to-one relationship between prices in physical and financial markets. One common relationship is the no-arbitrage condition.

The no-arbitrage principle implies that the price differential between the cash (or spot) markets and derivative markets should equal the cost of carry. This cost of carry embodies:

• The opportunity cost associated with holding the asset.
• Storage, transportation, and insurance costs.

Physical commodity holders often anticipate compensation through a forward price exceeding the current cash price. However, there can be instances where holding the physical commodity offers non-monetary advantages. This convenience yield emerges when market players show a preference for the physical asset over its derivative. A practical example would be a coffee shop owner choosing to store actual coffee beans to guarantee consistent supply, even if it means facing a higher forward price.

Recall the pricing relationship between the spot price (cash) \(S_0\) and forward price at time \(T\), \(F_0(T)\) can be expressed as follows:

$$F_0(T)=S_0e^{(r+c-i)}$$

Where:

\(c\) = Cost of carry.

\(i\) = Convenience yield.

\(r\) = Risk-free rate.

\(T\) = Time to the expiration of the forward contract.

From the above equation, it is intuitively right to say that the convenience yield decreases the forward price since it is a benefit and hence accrues to the owner.

Still, in the equation above, there are two relationships between the convenience yield and the cost of carry. When the spot price is above the forward prices, there is backwardation, a downward-sloping or inverted forward curve. This can occur for physically settled contracts when the convenience yield is positive and the benefit of holding the commodity outright exceeds the cost of carry.

On the other hand, when the spot price is below the forward prices, there is contango because the cost of ownership exceeds the benefit of a convenience yield, and the forward price will be above the underlying spot asset price. Intuitively, a contango scenario generally decreases the return of the long-only investor, and a backwardation scenario increases it.

Commodities & Portfolio Diversification

Commodities, due to their low correlation with conventional assets like stocks and bonds, can offer enhanced portfolio diversification. In turbulent stock market conditions, certain commodities, like gold, might exhibit robust performance, acting as a hedge against market downturns.

Question 

An investor is considering investing in the S&P GSCI Commodity Index, which includes a wide range of commodities from energy to agricultural products, with each commodity assigned a specific weight. If the investor is seeking improved portfolio diversification, how would investing in this index likely impact their portfolio during a period of stock market volatility?

1. The performance of the portfolio would be unaffected by the stock market volatility.
2. The portfolio would likely perform poorly due to the high correlation between commodities and traditional asset classes.
3. The portfolio would likely perform well due to the low correlation between commodities and traditional asset classes.

The correct answer is C.

Investing in the S&P GSCI Commodity Index would likely improve portfolio diversification and perform well during a period of stock market volatility due to the low correlation between commodities and traditional asset classes. Commodities often have a low or even negative correlation with traditional asset classes such as stocks and bonds. This means that when stocks are performing poorly, commodities may perform well, and vice versa.

This low correlation makes commodities a good tool for diversification, as they can help to reduce the overall risk of a portfolio. During periods of stock market volatility, a diversified portfolio that includes commodities can help to stabilize returns and reduce the impact of large swings in the stock market. Therefore, investing in a commodity index like the S&P GSCI Commodity Index can be a good strategy for an investor seeking to improve portfolio diversification and potentially enhance returns during periods of stock market volatility.

A is incorrect. The performance of a portfolio that includes commodities is not unaffected by stock market volatility. While commodities can help to reduce the overall risk of a portfolio and potentially enhance returns during periods of stock market volatility, they are not immune to market movements. Therefore, it is not accurate to say that the performance of the portfolio would be unaffected by stock market volatility.

B is incorrect. While it is true that commodities can sometimes exhibit a positive correlation with traditional asset classes, this is not always the case. In fact, commodities often have a low or even negative correlation with stocks and bonds, making them a good tool for diversification. Therefore, it is not accurate to say that the portfolio would likely perform poorly due to a high correlation between commodities and traditional asset classes.