Sources of Risk, Return, and Diversification among Natural Resource Investments

Commodities, farmland, and timberland possess varying return drivers and cycles. For instance, commodities are instantaneously priced on public exchanges, while the land has irregular pricing methodologies and may include inaccurate estimates.

Moreover, commodity prices have risk and return drivers that are often related to the timing of the economic cycle. This means that the factors influencing commodity prices may not always align with the economic cycle that affects the prices of common equity and debt securities. For instance, the price of Gold can increase during economic downturns as investors seek safe-haven assets, which is contrary to the typical behavior of equity and debt securities.

Commodities

Supply and Deman Dynamics

Short-term shifts in physical commodity supply are production in the case of hard commodities, seasonal crop yields in the case of soft commodities, short-term inventory levels, and, secondarily by the actions of non-hedging investors. On the other hand, the ultimate demand for these commodities is influenced by the needs of end users and, secondarily, by the actions of non-hedging investors.

Factors Determining Commodity Supply and Demand

The primary influencers of commodity supply are production and inventory levels, while the actions of non-hedging investors hold a secondary role. For instance, a substantial surge in gold purchases by investors can promptly elevate the demand and price of Gold. Conversely, the demand for commodities is primarily shaped by the requirements of end users, with the actions of non-hedging investors holding a secondary position. Investor actions possess the ability to either moderate or stimulate commodity price shifts, particularly in the short term.

Gold as a Physical Commodity

Gold, a physical commodity and precious metal, is often a preferred safe haven due to its historical use as a store of value among investors and as a non-currency-based reserve among central banks. For example, during times of economic uncertainty, investors often buy Gold as a way to preserve their wealth.

Challenges in Altering Commodity Supply Levels

Producers face limitations in swiftly adjusting commodity supply levels because of the considerable time required to influence production. For instance, adjusting agricultural output may necessitate planting more crops and modifying farming methods, but visible results typically require at least one complete growing cycle.

Furthermore, external factors like weather can considerably impact output beyond the control of producers. Expanding infrastructure for heightened oil and mining production might extend across numerous years, involving the development of the mine itself, as well as the requisite transportation and refining elements.

Motivations for Investing in Commodities

The allure of investing in commodities lies in its potential for generating returns, diversifying portfolios, and shielding against inflation. Investors may opt for commodities when they anticipate price rises in the short or medium term.

Commodity futures contracts present investors with opportunities like liquidity premiums, fostering the possibility of achieving a favorable actual return. For instance, an investor might engage in a wheat futures contract if they anticipate a future increase in the price of wheat.

Farmland and Timberland: Unique Asset Classes

Farmland and timberland are less regularly traded and derive their value in the following ways:

• Farmland: The value accrues over multiple growing seasons, much like a vineyard yielding grapes over years.
• Timberland: Value is based on tree growth cycles and lumber demand, akin to the appreciation of a pine forest as trees mature and pine wood demand escalates.

For instance, the US’s  National Council of Real Estate Investment Fiduciaries (NCREIF) offers appraisal-based indexes for various assets, including timberland and farmland. Over 30 years (Q3 1992 – Q2 2022), the following has been observed:

• Farmland yielded higher annualized returns.
• Timberland exhibited a greater standard deviation in returns.

This performance analysis can be compared to how indices like the S&P 500 track major US companies.

Risks and Considerations in Farmland and Timberland

Investing in farmland timberland presents unique challenges. Farmland has limited liquidity and can face negative cash flows due to high fixed costs, such as maintenance and inputs.

The risks associated with farmland and timberland are similar, but the effect of weather conditions is unique and more exogenous to farmland and timberland and has different effects compared to real estate. For instance, drought and flooding can impact crop yields and hence expected revenue.

Farmland and timberland are exposed to more global risks than real estate. Real estate is mostly locally located. On the other hand, farmland and timberland result in commodities consumed and traded globally.

Investing in undeveloped (or unprepared for construction) raw land is more risky than farmland or timberland.

Inflation Hedging and Diversification Benefits of Natural Resource Investments

Commodities as a Hedge Against Inflation

Commodities, particularly energy and food, are often considered as a hedge against inflation. This is because the prices of these commodities are integral components of inflation calculations, and they significantly impact the cost of living for consumers.

The volatility of commodity prices, especially those of energy and food, is much higher than the volatility of reported consumer inflation. This is because consumer inflation is calculated from a variety of products, including housing, whose prices change at a slower pace compared to commodity prices.

Additionally, inflation calculations also incorporate statistical smoothing techniques and behavioral assumptions. For example, the Consumer Price Index (CPI) in the United States is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care.

Portfolio Diversification with Natural Resources

Portfolio diversification involves spreading investments across various asset types to reduce risk and enhance potential returns. Incorporating alternative asset classes, such as farmland, timberland, and commodities, is a strategy to achieve this diversification.

Alternative assets like farmland, timberland, and commodities typically show low to zero correlation with traditional assets, such as bonds and stocks. This means their performance isn’t strongly tied to the ups and downs of the stock and bond markets.

For instance, Gold, often seen as a “safe-haven” asset during economic turbulence, might also appreciate by 3%. Even though your stocks took a hit, the gains from your alternative assets could offset those losses, stabilizing your portfolio’s overall performance. The diversified assets act as a cushion, mitigating the impact of stock market volatility. This exemplifies the benefits of diversifying into alternative asset classes.

Question #1

Which of the following statements is most likely accurate regarding natural resources?

1. Commodities, farmland, and timberland all perform poorly during periods of low or declining inflation.
2. Farmland and timberland may not suffer during periods of low or declining inflation, unlike commodities, which often have low returns.
3. Farmland and timberland perform better than commodities during periods of low or declining inflation due to their high correlation with inflation.

The correct answer is B.

Farmland and timberland may not suffer during periods of low or declining inflation, unlike commodities, which often have low returns. This statement is accurate based on the information provided. During periods of low or declining inflation, the performance of different asset classes can vary significantly. Commodities often have negative returns during such periods. However, the investment performance of farmland and timberland may not suffer.

This lack of correlation between farmland and timberland with inflation is more likely due to their resilience during periods of low or declining inflation. Farmland and timberland are real assets that have intrinsic value and can generate income, which can help to offset the impact of low or declining inflation. In contrast, commodities are more directly impacted by changes in inflation and can suffer negative returns when inflation is low or declining.

A is incorrect. The statement that commodities, farmland, and timberland all perform poorly during periods of low or declining inflation is not accurate. While commodities often have negative returns during such periods, farmland and timberland may not suffer.

C is incorrect. The statement that farmland and timberland perform better than commodities during periods of low or declining inflation due to their high correlation with inflation is not accurate. The performance of farmland and timberland during periods of low or declining inflation is more likely due to their resilience, not their correlation with inflation.

Question #2

Consider an investor who is looking to diversify his portfolio by investing in alternative asset classes. He is particularly interested in farmland, timberland, and commodities such as gold and oil.

Based on his understanding of the correlation between these asset classes, which of the following statements is most likely to be correct?

1. If the price of timber increases, there’s a good chance that the price of farmland will decrease.
2. If the price of timber increases, there’s a good chance that the price of farmland will also increase.
3. If the price of commodities like gold or oil increases, the price of farmland and timberland will also increase.

The correct answer is A.

If the price of timber increases, there’s a good chance that the price of farmland will also increase. This is because both timberland and farmland are types of real assets, and their prices are often influenced by similar factors. For example, both are affected by weather conditions, changes in commodity prices, and changes in demand for agricultural and forestry products.

Therefore, if the price of timber increases due to factors such as increased demand for wood products or favorable weather conditions, it is likely that the price of farmland will also increase due to similar factors. Additionally, both types of assets can be influenced by broader economic trends, such as inflation and changes in interest rates. Therefore, they often move in the same direction in response to these factors.

B is incorrect. As explained above, the prices of timberland and farmland are often influenced by similar factors and tend to move in the same direction. Therefore, it is unlikely that an increase in the price of timber would lead to a decrease in the price of farmland.

C is incorrect. Although commodity prices, such as gold and oil, can impact real asset prices like farmland and timberland, it’s not a guarantee that a rise in commodity prices will result in higher asset prices. For instance, increased oil prices might elevate production costs for farmers and foresters, potentially causing a decline in farmland and timberland prices.