4. Commodities

Monday, 16th May 2016 09:30 - by David Harbage

After looking at the merits and shortcomings of cash, bonds and property investment, we continue our look at the various asset types available for long term savers by turning our attention to another physical alternative asset: commodities.

Twenty years ago, a direct investment into the likes of energy, precious metals, industrial minerals, agricultural crops and livestock did not feature in most financial institutions’ portfolios, but nowadays most investors show interest in taking a stake in such real assets. To some extent, long term savings managers can claim to have gained indirect exposure by owning businesses or convertible bonds which benefit from higher priced commodities – be they producers, intermediaries or retailers. Today’s investor increasingly wishes to take a more direct investment, cutting out the risk of any company mismanaging or otherwise diluting the potential return, but of course this can expose the investor to different risk.

Amongst the prime drivers for the growing popularity in commodity investment, we would highlight the strength of emerging economies such as China and India, who represent much of the demand for a number of these assets. As an example, China’s huge manufacturing base has driven ever higher consumption of raw minerals and metals - from coal (accounts for 50% of world’s consumption) to copper - while a more prosperous population develops an increasing appetite for meat (the population of 1.38 billion accounts for 25% of global consumption – rising ten-fold over the past 35 years, compared to relatively low 150% growth in US consumption). Similarly, the growing wealth of India has led to increased demand for gold (India accounts for 33% of global gold consumption, with half of that going towards jewellery for the world’s second most populous nation’s circa 10 million weddings per annum. Besides possessing a belief that prices of certain commodities are rising – and wishing to insulate themselves from such inflation as is evident in higher fuel or food bills, (by owning the raw material itself) - many investors like the simplicity and visibility of owning physical assets. Essentially, being able to understand and recognise everyday commodities.

In addition to having confidence in a particular raw material, or basket of commodities, against a backdrop of low interest rates and weak economic performance (featuring a move of financial power and wealth from west to east), the prospect of seeking an alternative or supplement to paper money has appeal. As an example, the US dollar has historically been widely viewed as the world’s dominant currency (in part, reflecting its economy) and a ‘safe haven’ in times of geo-political turbulence. If a currency’s strength or weakness is typically determined (a) by the health of its underlying economy and (b) the rate of interest (often termed ‘carry’) or return it pays – relative to peers, or the global universe of currencies – then perhaps the real monetary worth of the Euro, sterling and even the American dollar is likely to decline further. Take a look at the strength of the Australian dollar (£=A$1.9 today compared to £=A$2.4 five years ago). Rather than try to decide which currency could potentially provide a better return than the investor’s base currency (typically determined by place of domicile and how liabilities will be settled), the prospect of owning gold or silver as a precious commodity - cum alternate monetary currency - may appeal. The monetary policy pursued by central banks in the US, Europe and at home to increase the supply of money (effectively the policy of printing and injecting more money into their respective economies, known as Quantitative Easing) has had the effect of diluting the worth of currency and makes ‘limited supply’ assets like gold or real estate, as discussed in an earlier article, appear more attractive.

There are, however, a number of considerations that a prospective owner of commodities should consider. Firstly, that the price (and therefore performance, as normally there is no income return) of individual commodities has historically been volatile - with many assets being subject to the weather or natural disaster. For example, the spot price of uranium fell by 35% within a few months of the earthquake and tsunami that impacted Japan’s Fukushima nuclear plant (as many countries, including China, reviewed nuclear power). Oil prices tend to reflect both organic natural demand, but also rise upon any prospect of threat to supply (notably via geo-political tensions in the Middle East) - when speculative interest usually appears. Beyond the speculative, long term investors should seek to ensure that their assessment of a commodity’s worth relies primarily on natural supply-demand forces – rather than investment demand which might artificially inflate prices, and could be a short term phenomena. Currently, in part caused by slowing economic activity in China, demand for many natural resources has eased while production of energy (US shale and traditional Middle East sources) and industrial minerals (boosted by new mines) has increased – to cause prices of oil, gas and metals to fall dramatically over the past 18 months. Finally, sterling based investors should also be mindful that most individual commodities tend to be priced in US dollars, for better or worse (upon translation into the base currency), requiring a view on foreign exchange.

Although the likes of gold, silver and diamonds may be purchased in their raw form – or perhaps as jewellery, to add pleasure or lifestyle value – this is clearly not possible for many bulk commodities. So how does one proceed to invest? If a single common commodity is sought (such as oil or gas), one can use Exchange Traded Commodity funds (ETCs) – which are stock market traded vehicles that reflect the underlying spot (current) price. We will be explaining more about this type of investment in a later blog, but for now would mention that the detail of each ETC will vary (for example some can provide exposure to both falling as well as rising prices, with others offering a financially geared position), and so should be scrutinised carefully. Any single commodity investment is almost certainly high risk and will be volatile in the short term, as the true value can be difficult to predict. Accordingly, most individuals who want to invest in commodities choose to do so via a professionally managed, well diversified portfolio of assets. This is not a cheap option, by reference to inherent costs, and the track records of such collective funds tends to be very mixed.

A third way of investing would be to buy the businesses that own the commodities (such as Rio Tinto, which possesses large stores of the world’s aluminium, copper, iron ore, thermal and coking coal). We will review the merits and risks of individual company shares (equities) in a later article, but for now would mention that by owning shares in the producing company – rather than the individual minerals, in this case – one is taking on different risks. In particular, investors are making a judgement on the total worth of Rio’s reserves in the ground, balance sheet strength, its future success in extraction or difficulty in selling (future price), management capability, local conditions (particular customers, weather, political interference in regulation or taxation) corporate action (mergers & acquisitions, share buyback & dividend policy), as well as wider stock market risks.

When looking at different industries within the weekly UK Equity Market Commentary blog, the writer may proffer opinions (but not personal advice) on different commodities. The subject of physical assets (be it real estate, commodities or via more esoteric forms), and their possible suitability within a long term savings (for, or within, retirement) environ, is a big one and we are aware that this article only ‘skims the surface’. We anticipate that the interested reader will progress their expertise and understanding by interrogating the web for data on key drivers, risk factors and other determinants of longer term prospective worth – notably supply (given that these assets are finite), demand by geography and sector (public/consumer/corporate) and seek experienced, expert opinion (from industry or asset managers).  

Next week we will begin to look at equities, as an asset class, with a view to deciding if its traditional dominant position within long term savings proposition – such as pension funds – is justified, looking forward. We will seek to define publically listed companies, explain how the stock market works, investigate the risks, consider the merits of various forms of research, examine how to value equity, make stock selection decisions, looking at both domestic and international opportunities. Beyond individual company shares, we will discuss different means of owning equity (including OEICs, closed ended vehicles, ETFs, structured products), and compare the risk-reward prospects of various assets, by considering the likely impacts of contrasting events on such prime investment types. Finally, we intend to look at how the personal investor might start (if he or she intends to follow the DIY method), as well as consider the basic principles and pitfalls surrounding advised and discretionary portfolios.

David Harbage

26 February 2016