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Updated: October 9, 2010 21:26 IST

When commodities are ‘on fire’

D. Murali
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Many investors have reached a fork in the investment road, observes John Stephenson in ‘The Little Book of Commodity Investing’ (www.wiley.com). “They can continue down the one they’ve always travelled – their portfolios stuffed full of stocks, bonds, and real estate. But from 2000 to 2009, that road led nowhere. Alternatively, investors can choose the road that isn’t particularly well travelled but that’s been proved to chop risk and boost returns by including commodities in an investment portfolio.” For, this road, he says, directly links the West with the East, the epicentre of future economic growth.

Feedstock of urbanisation

The global economic playing field has tilted irrevocably towards Asia, the author opines. In the rise of Asia – a trend more than 30 years in the making but made plain by the financial collapse of 2008-2009 – he sees goods news for commodities, the critical feedstock of urbanisation and industrialisation.

For instance, as Chinese and Indian consumers cross the income threshold at which cars and other big-ticket items become affordable, they will become the spark to ignite the commodity price rally, reasons Stephenson. “Cars, homes, and appliances are the big influences on the global demand for commodities.”

Rubber that meets the road

Exhorting investors to open their minds to the world of commodities, and to realise that commodities are ‘the rubber that meets the road in any economic expansion,’ the author instructs that since currencies, real estate, inflation, stocks and bonds are all impacted when commodities are ‘on fire,’ countries rich in natural resources are great places to look for solid investment opportunities, not just in commodities, but in real estate, currencies, and the stocks of the commodity-producing companies too.

“Knowing something about commodities means that everyday activities like shopping for groceries or paying at the pump are no longer simply chores – they become important windows on the world. Adding commodities to your investment portfolio is an investment move that isn’t just timely – it’s savvy.” A solid understanding of commodities, as the author notes, can give you insight into the way the world works and into why some investments soar while others slump.

Golden truths

A golden era may be upon us as concern mounts over the monumental debt being racked up by the US government, foresees the author, in a chapter titled ‘Going for gold.’ With the banking system in distress, inflation running amok, and the US dollar in decline, gold is the go-to investment, he avers. “When times are tough, people gravitate towards something tangible, something they can hold in their hands, like gold coins or bars. And lately, the demand for gold bullion has been high…”

It may be of interest to know from the book that nearly 90 per cent of the known gold in the world, with a rough value of $4.5 trillion, has already been mined; to put things in perspective, however, US dollars in circulation add up to ‘more than $8 trillion,’ and the world stock market capitalisation is estimated at ‘roughly $40 trillion.’

“And stack gold up against the outstanding notional value of the world’s derivatives market – a whopping $800 trillion – and the value of physical gold looks puny. In fact, the ratio of gold to paper currencies is currently at an all-time low, which suggests that the stage is being set for a powerful rally.”

Metal lessons

Once global industrial production (IP) begins to accelerate, commodity prices for hot rolled steel, copper, aluminium, and zinc are the first to move, informs Stephenson, citing research. Given that the average mine takes a rock-bottom minimum of five years to bring into production, supply will indisputably lag demand as the global economy begins to expand, and this will mean sharply higher metals prices for a long, long time to come, he predicts.

The most actively traded metal contracts on the fast and furious LME (London Metals Exchange) are those of aluminium, copper, zinc, and nickel, one learns from the chapter titled ‘Digging it.’ The author explains that unlike other futures markets where one-month contracts are the norm, the actively traded metals futures on the LME are rolling three-month contracts – ‘a reflection of the average time that a metal spends in process inventory; that is, the time it takes to move from mine mouth to smelter, including the time it spends at sea.’

Take the plunge

To those who have decided to take the plunge into commodities, a chapter titled “Gettin’ Goin’” clarifies that owning a farm, mine, or oil field just is not a practical way to add commodities to your investment line-up. Also of help is the insight that the concept of market capitalisation (shares outstanding multiplied by stock price) just does not apply to commodities.

“Commodities are held in a variety of forms, including over-the-counter investments, offsetting futures positions, and physical producer stockpiles – the combination of which makes complete accounting impossible and the calculation of commodity market capitalisation an elusive target.”

Without the availability of market capitalisation figures, commodity index creators have been left to their own devices, constructing and weighting the various components as they see fit, the author cautions. The result, as he alerts, is a wide range of methodologies that can dramatically skew the weights of the index and its relevance as a barometer for gauging activity levels in commodities.

With some basing their weights on an assessment of the economic importance of each commodity, while others base them on a quantity of production basis, subjectivity often plays a major role in this process, rues Stephenson. For example, “In November 2009, the target weights for energy in the S&P GSCI were a whopping 67.83 per cent, yet the Reuters/Jefferies CRB Index set its energy target weight at just 18 per cent – a difference of nearly 50 per cent.”

Futures fascination

You can make a lot of money in futures trading if you know what you are doing, the author advises. “And if you don’t – well, let’s just say you can lose your shirt in a hurry.”

While commodity futures are just contracts for the future delivery of a given commodity, what can complicate matters is that most futures contracts trade monthly and need to be rolled forward, unless you want to take physical delivery of the commodity you just bought, he guides. “And discovering you’re the proud owner of a thousand barrels of No. 2 heating oil, currently waiting for you at New York Harbour, can sure throw a wrench in your weekend plans.”

For starters, the futures curve, which is nothing more than a compilation of individual futures contracts, can either be upward sloping (contango) or downward sloping (backwardation). “If, many months into the future, the price of a commodity is significantly higher than it is today (contango), it may pay to hoard the physical commodity in the hope that you can sell it later for a profit. Oil traders and companies did just that during the 1970s when they hired tankers to store crude oil for months until they could sell it at a profit…”

Having tried the different methods of commodity investing, the author’s recommendation is to go for ‘a well-chosen basket of commodity-producing companies.’ Because, with futures there is the ‘roll risk’ to manage, plus a wide variety of new markets to study up on, and because most commodity index funds are far too dependent on the shape of the curve to give you the kind of exposure you are looking for, he argues.

Therefore, commodity producers are the way for most investors to profit from a roaring commodity bull market, wraps up Stephenson.

Imperative addition to your ‘investment’ reading list.

**

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