Natural Resources (Level II 2022)

Natural resources are assets comprising commodities and raw land utilized for farming and timber.  

Commodities may be classified as hard or soft commodities. Hard commodities are mined or extracted. Examples of such commodities are oil, copper, and gold. On the other hand, soft commodities are bred or grown for many years. Examples of soft commodities are livestock and cash crops, among many others.

Examples of raw lands include timberland and farmland.

Characteristics of Natural Resources

Commodities

• Commodities are tangible goods that can be standardized in quality, location, and delivery in the process of investing.
• Price fluctuations generally determine commodity investment returns as opposed to income.
• Holding commodities occasions incurrence of transportation and storage costs. Therefore, investors prefer to trade commodity derivatives.
• The commodity derivative index price volatility is significantly connected to the price volatility of the underlying physical items.
• Supply chain participants use futures to hedge their physical commodity purchases and sales. The commodity forward curve is upward sloping when futures prices are higher than spot prices. The prices are in contango, and this is when there is no or little convenience yield.
• Commodities have a low correlation with asset classes such as stocks and bonds, which is suitable for diversification.

Timberland and Farmland

A title to real estate property represents ownership, in which land use rights are reflected in the title deed. The characteristics of farmland and timberland include:

• Timberland and farmland offer income generated from selling inflation-protected crops from holding land. Besides, they enjoy a degree of insulation from financial markets volatility due to global usage. Global usage in this sense refers to the implication that everyone is entitled to food and shelter.
• A major challenge of timberland and farmland is their long market cycle, particularly start-ups in timber and picked fruit farming.
• Timberland provides an income stream based on the sale of wood, trees, and other timber products, which are lowly correlated to other assets
• Timber can be grown and easily stored by not harvesting them, allowing investors to harvest them when prices are up and delay them when prices are down.
• Farmland has three primary return drivers: commodity prices, harvest quantities, and land price changes.
• Farmland consists mainly of rows of crops planted and harvested and permanent crops that grow on trees.
• Since crops consume carbon in the air, their value depends on harvesting, human activity, and water rights. As such, environmental, social, and governance (ESG) might apply.

Risk and Return Characteristics of Natural Resources

Commodities

The logic behind investment in commodities includes the possibility of returns, portfolio diversification, and inflation protection. That is, investors’ interest in commodities is inspired by the belief that price will increase in short to intermediate periods. Moreover, since commodities directly influence the inflation index, they are appropriate in hedging against inflation risk, even when the return is minimal or there is no real return.

Production cannot be adjusted immediately. Producers require some time to adjust to demand. Investors will therefore seek to anticipate changes by closely monitoring economic conditions.

The demand for commodities is affected by global manufacturing fluctuations and economic growth. As such, investors in commodities need to be keen on their inventories and economic conditions, such as government policies and growth estimations.

Timberland and Farmland

Farmland and timberland provide low liquidity and a high risk of negative cash flow since fixed costs are relatively high, and revenue depends on the weather conditions. As such, weather is a unique risk for timberlands and farmland compared to real estate.

An additional primary risk in farmland and timberland is the international competitive landscape risk. Note that productive lands create commodities that are traded and consumed globally. As such, events such as interruptions of world trade and increasing agricultural competition may lead to lower commodity prices.

Diversification Benefits of Natural Resources

Apart from seeking profit, investors’ interest in natural resources is anchored upon the following factors:

Commodities

• Commodities are effective hedges against inflation. Their prices have historically been positively correlated with inflation.
• Commodities are effective for portfolio diversification. Returns have had a low correlation with returns on other investments.

Farmland and Timberland

• Investors can comply with ESG principles of responsible and sustainable investing by including timberland and farmland in their portfolios.

Instruments of Investing in Natural Resources

Commodities

Investment in commodities can be done through derivatives such as futures, swaps, forwards, and options. Although physical commodities can be traded, it is often characterized by price obscurity, tax issues, and huge costs.

Apart from the physical commodity investment and use of derivatives, achievement of commodity exposure can be done through the following:

1. Exchange-traded products (ETPs): ETPs are appropriate for investors focused on simplicity via a standard brokerage account. ETPs are applicable to both commodities and commodities futures.
2. Managed futures (or Common Trading Advisors, CTAs): Commodity trading advisors (CTA) are individuals or organizations registered for providing commodities trading advice. CTAs can invest in numerous types of futures contracts such as commodities, equity, foreign exchange futures, or might concentrate on one commodity such as livestock or grains.
3. Specialization in specific commodity sectors: A fund is set up to specialize in a particular sector. For instance, private energy partnerships allow an institution to be exposed to the energy sector.

Timberland and Farmland

The main investment in timberland and farmland is public and private investment funds. An example of a public investment fund is real estate investment trusts (REITs) in the US. A private investment fund may include limited partnerships. Through investment funds, investors can own land in a foreign country, in which they can plant different crops.

Question

Which of the following is most likely an effect of little or no convenience yield on prices?

1. Backwardation.
2. Contango.
3. Convenience yield.

Solution

The correct answer is B.       

Contango is when futures prices are higher compared to spot prices. This occurs when there is little or no convenience yield.

A is incorrect. Backwardation is when futures prices are lower than spot prices. This happens when the convenience yield is high.

C is incorrect. Convenience yield is the benefit or premium associated with holding an underlying product or physical good rather than the associated derivative security or contract.