The Handbook of Commodity Investing (Hardcover)

Chapter One

Frank J. Fabozzi, Ph.D., CFA Professor in the Practice of Finance School of Management Yale University

Roland F?ss, Ph.D. Professor of Finance Endowed Chair of Asset Management European Business School (EBS) International University Schloss Reichartshausen

Dieter G. Kaiser, Ph.D. Director Alternative Investments Feri Institutional Advisors GmbH Research Fellow Centre for Practical Quantitative Finance Frankfurt School of Finance and Management

Commodities are currently enjoying a renaissance due to institutional investors such as pension funds and traditional portfolio managers. Many market participants attribute the recent dramatic price increases in commodities to increased demand for consumer goods, particularly from the populous countries of India and China. Demand from Brazil and Russia, two of the fastest-growing economies currently, has undoubtedly also played a part. (Collectively, these four countries are referred to as the BRIC countries.)

Globalization and economic and political convergence have been behind the stimulated growth in these economies to a large extent. Besides increased investment on an enterprise level, increasing state investment in infrastructure in China has also led to enormous demand for commodities. This has caused a shock to the worldwide supply and demand dynamics, leading to at least short-term price increases.

Such dramatic increases in commodity prices are often explained by the commodity super cycle theory. According to Heap, a super cycle is a lasting boom in real commodity prices, usually brought on by urbanization and industrialization in a major economy. Hence, super cycles are driven by demand caused by an expansion of material-based production due to intense economic activity. The economic situation in China is of crucial importance to the commodity markets. China has greatly increased its share of global commodity consumption over the past few years, and is seen as the major driver of the current commodity boom.

For example, between 2001 and 2005, China''s demand for copper, aluminum, and iron increased by 78%, 85%, and 92%, respectively. This clearly shows China''s considerable influence on commodity pricing. This super cycle, however, is not characterized by a continuous growth phase, as the events of May 2006 show. Many commodities were under pressure during that time, and actually lost about one-fourth of their value.

Under market conditions like these, the question inevitably arises as to whether this is a temporary price correction or a general trend change. Following the super cycle theory, a long-lasting upward trend in commodities in the future is likely, as most remain far below their historic highs when adjusted for inflation.

Compared to foreign exchange or equity markets, there is almost no way to intervene in commodity markets. Because the production side reacts very sluggishly to market distortions, short-term supply and demand shocks are compensated for only by price movements. These inherent asset class volatilities are the main reason many investors have refrained from investing in commodities, despite the fact they can provide valuable diversification benefits to traditional security portfolios because of their low correlation with bonds and stocks.

This chapter first discusses the basics of commodity markets by describing the market participants, the commodity subsectors, and the different kinds of commodity investment vehicles available to investors. Subsequently, we illustrate the return components of index-based, that is, passive long-only, commodity futures investments in the context of the price discovery process, and we investigate the risk/return characteristics of commodity futures indexes. Following this, we provide an empirical analysis of portfolio allocation of traditional security portfolios, explicitly taking commodity futures into account.

MARKET PARTICIPANTS

Futures market participants are normally classified into hedgers, speculators (traders), and arbitrageurs. Commodity producers pass on the price risk that results from highly volatile and difficult to forecast commodity futures markets to speculators, and therefore pay a premium. Commodity producers have a distinct interest in hedging the price of their product in advance (a short hedge).

For example, consider the situation in the classic agricultural market. Farmers face a weather-dependent, volatile supply that is met by a relatively stable demand. Contrary to the maintenance cost for cattle breeding or the purchase cost of seed, the selling price generally is known only upon completion.

We see the opposite in the manufacturing industry: As the manufacturing industry hedges increasing commodity prices (a long hedge), the contrarian position to the commodity producers'' short positions is taken. Airline companies, for example, often appear as long hedgers to guard against increasing fuel prices, the underlying in which the airline companies are short. If an existing or expected cash position is compensated for via an opposite future, the market participant is classified as a hedger. Hence, for the commodity producer, there is a fixed net profit; for the commodity manufacturer, there is a fixed purchase price.

Speculators represent the largest group in the futures markets. Their main task is to provide liquidity on the one hand, while balancing the long and short hedges on the other hand. Contrary to the commodity producers or the manufacturing industry, which try to avoid susceptibility to unfavorable price developments, the intention of speculators is to take a distinct market position and speculate for a price change. To make a profit, speculators deliberately take on risk by betting on rising or falling prices. As opposed to hedging, speculation is subject to both huge gains and huge losses, since speculators do not hold compensating cash positions.

The third and smallest group of market participants is the arbitrageurs, who try to take advantage of time- or location-based price differences in commodity futures markets, or between spot and futures markets, in order to generate riskless profits. Clearly, this group also intends to make profits, but their trading activity does not involve taking risky positions. Moreover, they use economic and financial data to detect existing price differences with respect to time and location. If these price differences exceed interlocal or intertemporal transfer costs such as shipping, interest rates, warehouse costs, or insurance costs, riskless profits can be realized. Consequently, price differences among the markets are adjusted, price relationships among the markets are restored, and arbitrageurs guarantee market balancing.

In the case of cash and carry arbitrage, the resale price of today''s leveraged spot position is simultaneously set by selling the commodity futures. This short futures position implies an unconditional commitment to purchase the underlying at maturity. At maturity of the futures, the specified commodities are tendered against the maturing short futures. If the profit from the spot trade of the physical commodity exceeds the value of the futures plus the cost of debt financing, the arbitrageur will realize a profit from what is known as a basis trade.

COMMODITY SECTORS

Investments in international commodity markets differ greatly from other investments in several important ways. First, commodities are real assets-primarily consumption and not investment goods. They have an intrinsic value, and provide utility by use in industrial manufacturing or in consumption. Furthermore, supply is limited because in any given period, commodities have only a limited availability. For example, renewable commodities like grains can be produced virtually without limitation. However, their yearly harvest is strictly limited. In addition, the supply of certain commodities shows a strong seasonal component. While metals can be mined almost all year, agricultural commodities like soybeans depend on the harvesting cycle.

Another important aspect of commodities as an asset class is heterogeneity. The quality of commodities is not standardized; every commodity has its own specific properties. A common way to classify them is to distinguish between soft and hard commodities. Hard commodities are products from the energy, precious metals, and industrial metals sectors. Soft commodities are usually weather-dependent, perishable commodities for consumption from the agricultural sector, such as grains, soybeans, or livestock, such as cattle or hogs. Exhibit 1.1 show the classification of commodity sectors.

Storability and availability (or renewability) are also important features of commodities. However, because storability plays a decisive role in pricing, we distinguish between storable and nonstorable commodities. A commodity is said to have a high degree of storability if it is not perishable and the cost of storage remains low with respect to its total value. Industrial metals such as aluminum or copper are prime examples: They fulfill both criteria to a high degree. In contrast, livestock is storable to only a limited degree, as it must be continuously fed and housed at current costs, and is only profitable in a specific phase of its life cycle.

Commodities such as silver, gold, crude oil, and aluminum are nonrenewable. The supply of nonrenewable commodities depends on the ability of producers to mine raw material in both sufficient quantity and sufficient quality.

The availability of commodity manufacturing capacities also influences supply. For some metals (excluding precious metals) and crude oil, the discovery and exploration of new reserves of raw materials is still an important issue. The price of nonrenewable resources depends strongly on current investor demand, while the price of renewable resources depends more on estimated future production costs. The monetary benefit from holding a commodity physically instead of being long the respective futures is called the convenience yield. The convenience yield reflects market participants'' expectations regarding a possible future scarcity of a short-term nonrenewable commodity.

COMMODITIES AS AN ASSET CLASS OF THEIR OWN

There is a broad consensus among academics and practitioners that commodities compared to other alternative assets can be considered-in a portfolio context-as an asset class of their own. By definition, an asset class consists of similar assets that show a homogeneous risk-return profile (a high internal correlation), and a heterogeneous risk-return profile toward other asset classes (a low external correlation). The key properties are common value drivers, and not necessarily common price patterns. This is based on the idea that a separate asset class contains a unique risk premium that cannot be replicated by combining other asset classes. Furthermore, it is generally required that the long-term returns and liquidity from an asset class are significant to justify an allocation.

To describe existing asset classes, Greer explains the decomposition into so-called super classes: capital assets, store of value assets, and consumable or transferable assets. Continuous performance is a characteristic of capital assets. Equity capital like stocks provides a continuous stream of dividend payments, while fixed income guarantees regular interest payments in the absence of the default of the obligor. Redemption of invested loan capital can then be allocated among other investments.

Common to all capital assets is that their valuation follows the net present value method by discounting expected future cash flows. In contrast, real estate as an asset class has a hybrid classification. On the one hand, real estate can be classified as a capital asset because it promises a continuous rental stream and has market value. On the other hand, some features of real estate assets can justify their classification as store of value assets (for example, if the real estate is used for the owner''s own purpose). Such store of value assets cannot be consumed, nor do they generate income; classic examples are foreign exchange, art, and antiquities.

Commodities belong to the third super class-consumable or transferable (C/T) assets. In contrast to stocks and bonds, C/T assets, physical commodities like energy, grains, or livestock, do not generate continuous cash flows, but rather have an economic value. Grains, for example, can be consumed or used as input goods; crude oil is manufactured into a variety of products. This difference is what makes commodities a unique asset class.

Hence, it is obvious that commodity prices cannot be determined by the net present value method or by discounting future cash flows. Thus, interest rates have only a minor influence on the value of commodities. Moreover, commodity prices are the result of the interaction between supply and demand on specific markets. In this context, it is not surprising that the capital asset pricing model (CAPM) cannot adequately explain commodity futures returns. As we have noted, commodities are not capital assets.

The line between the super classes is blurred in the case of gold. On the one hand, gold as a commodity is used in such things as electrical circuitry because of its excellent conductivity. On the other hand, gold as a store of value asset is a precious metal and is used for investment, similarly to currencies. The rising demand of commodities since the stock market downturn in 2002 clearly demonstrates this characteristic. Because gold can be leased, Anson has even classified it as a capital asset.

Another specific criterion that differentiates commodities from capital assets is that commodities are denominated worldwide in U.S. dollars, while the value of a specific commodity is determined through global rather than regional supply and demand. In comparison, equity markets reflect the respective economic development within a country or a region.

Prospects for Commodity Market Participation

In general, there are several ways to participate in commodity markets via a number of different kinds of financial instruments. The most important are (1) direct investment in the physical good; (2) indirect investment in stocks of natural resource companies or (3) commodity mutual funds; (4) an investment in commodity futures, or (5) an investment in structured products on commodity futures indexes.

Buying the Physical Good

First, it seems obvious to invest directly in commodities by purchasing the physical goods at the spot market. However, immediate or within-two-days delivery is frequently not practical for investors. According to Geman, precious metals such as gold, silver, or platinum are an exception, as they do not have high current costs and do not require storage capacity. However, a portfolio consisting solely of precious metals would not be a sufficiently diversified portfolio for investors to hold.

Commodity Stocks

An investment in commodity stocks (natural resource companies), which generate a majority of their profits by buying and selling physical commodities, may conceivably be considered an alternative investment strategy. In general, the term "commodity stock" cannot be clearly differentiated. It consists of listed companies that are related to commodities (i.e., those that explore, mine, refine, manufacture, trade, or supply commodities to other companies). Such an indirect investment in commodities (e.g., the purchase of petrochemical stocks) is only an insufficient substitute for a direct investment. By investing in such stocks, investors do not receive direct exposure to commodities because listed natural resource companies all have their own characteristics and inherent risks.

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Excerpted from The Handbook of Commodity Investingby Frank J. Fabozzi Copyright © 2008 by Frank J. Fabozzi. Excerpted by permission.
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