commodities as an asset class

COMMODITIESas an asset class

Guru Raghavan

INDEX

• Commodity characteristics

• Commodity markets

• Commodity pricing

• Commodity risk analysis

• Commodity hedging

• Commodity indexes

• Commodity investment

Characteristics of commodities

Commodities are physical goods, but not all physical goods are commodities. Commodities have certain characteristics that make it feasible to trade them in markets:

- They can be stored for long periods or in some cases for

unlimited periods-

Their value depends heavily on measurable physical attributes and on the physical location of the commodities

Commodities with the same physical attributes and the same physical location are fungible. If a buyer has contracted to purchase petroleum of a certain density and sulphur content or wheat of a certain type and moisture content, it need not be concerned about which well pumped the oil or which farmer raised the wheat

Characteristics of commodity markets

Nature of commodities

Commodities are real assets that are produced and consumed as it is or for producing other finished goods. Where as the other asset classes represent financial claims on different aspects of real assets. This aspect of commodities has a number of dimensions

Consumption goods: Commodities are primarily consumption goods. This means that their demand is not purely price dependent. Some commodities display characteristics not normally found in financial assets. For example, zero or negative price may occur in few commodities due to excessive production or for which there is no demand


Nature of commodities..

Non standard structure: Commodities are generally non standards. This is basically due to heterogeneous nature of commodities in terms of quality or grade.

Cost of production: Commodity prices frequently gravitate towards the cost of production. This is because market supply and demand will adjust over time

Price behaviour: Commodity prices display seasonality.


Market Structure

The commodity market has a number of distinctive structural elements. The commodity market is global but also displays jurisdiction specific factors.

Commodity markets Participants

Producers and consumers

Producers have outright long positions and the consumers have outright short positions. This inherent risk exposure drives the use of commodity derivatives by producers and users. The producers commodity derivatives are driven by pattern of cash flows.

Consumers hedging behaviour is more complex. Their desire to undertake hedges is influenced by availability of substitute products and the ability to pass on higher input costs.

The producers and consumers deal directly with each other and the form of arrangement may include negotiated bilateral long term supply or purchase contracts.


Processors

These participants have limited outright price exposure. They have a spread exposure to the price differential between the cost of the input and the cost of output. The nature of exposure drives the type of hedging activity and the instruments used.

Traders

Where involved the traders act as an agent or principal to secure the sale / purchase of the commodity. Traders increasingly seek to add value to a pure trading relationship by providing derivative / risk management expertise. Traders also at times provide financing and other services. Traders have complex hedging requirements. Acting as an agent will have no price exposure. While acting as a principal, will have outright commodity price risk that requires hedging.


Dealers and Financial institutions

Their participation in the markets is primarily as a provider of finance or provider of risk management products. The dealers role is similar to that in the derivative markets in other asset classes.

Investors

They are financial investors seeking to invest in commodities as a distinct and separate asset class of financial investment

Commodity pricing

Commodity prices display volatility

The volatility of commodity prices is significant and (often) higher than for equity portfolios.

Commodity prices exhibit a skew in returns over certain periods of time. Commodities appear to exhibit a positive skew more often than other financial assets. This is driven by the fact that unexpected changes in price tend to be positive in nature

Commodity pricing

Commodity investments provide yield like returns. In the case of physical commodities, this return can be generated by lending out the commodities itself.

Commodities also display price returns. The price returns on commodity assets are complex. The basic component of price return is commodity price changes. This may be in the form of changes in the price of the physical asset itself, or in the price of the derivative contract that is driven by the underlying commodity price.

Commodity pricingHow prices are set

The method for establishing the price of a contract is set in the contract specifications. These state which currency the price is quoted in and the unit for which the price is quoted. Prices for agricultural futures traded in the United Sates are normally quoted in cents and for some contracts in fractions of a cent. Prices in most other countries and for US financial futures contracts are quoted in decimals rather than fractions .

Commodity pricingThe quoted price

The quoted price is not the price of a contract but of the specified unit. It must be multiplied by the number of units per contract to determine the price of one contract. Consider the International Petroleum Exchange’s Brent Crude contract, which is priced in US dollars even though it trades in London. The quoted price is for a single barrel of oil (42 American gallons or 159 litres). One contract provides for the future purchase or sale of 1,000 barrels of oil. If a given month’s Brent crude contract is trading at $100, one contract costs 1,000X$100 or $100,000. A 10 cent drop in the posted price means a decrease of $100 in the value of a contract

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Commodity pricingPrice movements

Prices in the markets change constantly in response to supply and demand which are affected mainly by news from outside, although in a highly selective way. A fall in New York share prices will be felt immediately in the Chicago Mercantile Exchange pit where futures futures on the S&P’s 500 stock index are traded, but may not be noticed in the nearby cattle futures pits. Investors in commodity futures pay close attention to information that could affect the price of the underlying commodity. For example orange juice futures will soar on reports of frost that could damage the orange crop in Brazil. Investors in financial futures are concerned more with economic data that might signal interest rate changes

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Commodity pricingLimits on price movements

For some contracts the contract specifications limit the amount that the price may rise or fall in a given day. A limit move means that the contract has fluctuated as much as allowed on that day. A contract that has risen the maximum allowable amount is said to be limit up. One that has fallen the permissible maximum is limit down. A locked market has reached its price limit and trading may proceed only at current prices or prices closer to the previous day’s settlement prices .

Commodity pricingThe spot price

The reference price for any futures contract is the spot price, the amount required to go out and purchase those items today. The difference between the spot price of an asset and the price of a futures contract for the nearest delivery month is the basis or the swap rate. As a contract approaches its delivery date its price normally converges with the spot price. The reasoning is intuitive. If the price of Japanese yen to be delivered 30 days from now is far above the spot price, a buyer could purchase yen now in the spot market and put them in the bank for 30 days rather than buying futures contract

Commodity pricingTerm factor

Most of the time the price of a contract rises as the delivery month becomes more distant. This reflects both the greater risk of big price changes over the life of a longer term contract and the fact that the buyer of that contract has money tied up for a longer period. If this price relationship exists, with each delivery date for a particular contract having a higher price than the previous delivery date, the market is called a normal market, or is said to be in contango. If the near term contracts cost more than more distant contracts, the market is said to be inverted or in backwardness

Commodity pricingObtaining price information

The current price of a futures contract is simply the most recent price at which a contract was exchanged. Active traders and investors can subscribe to private information services. In some cases, the information services are able to station reporters on the exchange floor to report on transaction prices; in other cases, the exchange supplies the services with the information. But as prices for heavily traded contracts change constantly, exchange members have an advantage. Only they have the latest information about trades and orders, gained either by being on the trading floor or by monitoring the computer trading system

Commodity risk analysis

Commodity hedging entails a high degree of basis risk. This is driven by greater diversity

in the underlying commodities. This creates significant opportunities for product design and trading. The major types of basis risk include

Commodity risk analysisBasis risk – Quality / Grade

This refers to the basis risk involving product specification (quality, grade and size). In practice there are limited range of traded commodities on which derivatives are

available. This requires the use of correlation relationships to hedge/trade exposures. This creates exposure to basis risk

Commodity risk analysisBasis risk – Location

The underlying commodity must be physically delivered at a specific location. Significant price differences can exist between locations. This reflects the supply demand condition in the relevant location and the cost of

transportation of the commodity between locations. The price differentials between delivery locations can change rapidly

Commodity risk analysisBasis risk – Time

Liquidity conditions may dictate use of hedges with different maturity to the underlying exposure. This limiting exposure can be particularly important to commodities. This is because sudden shifts in demand, supply or

transportation conditions can affect the efficiency of the hedge

Commodity risk analysisEvent risk

This refers to significant events in individual commodity markets that have significantly affected prices. Examples of event risk affecting commodity prices include the Gulf War, Iraq War, the Hamanaka Copper scandal and the decision by Central Banks to halt gold sales

Commodity hedging

Corporations Financial risk management Commodity price risk management Commodity risk management Commodity derivatives Commodity hedging

Commodity hedging..

The awareness of commodity price risk management also coincides with increasing volatility in commodity markets. The volatility in commodity markets is at several levels

- Structural volatility

- Event risk

- Resource intensity

Commodity hedging.. Structural volatility

The declining purchasing power of monetary assets increase the demand for commodities, resulting in an increase in the prices of real goods (including commodities) relating to financial assets.

In the 1970s, basic commodity price rose sharply, reflecting high rates of inflation in the global economy. The major impact of this period was the massive transfer of wealth from commodity users to commodity producers, particularly oil producing countries.

High real interest rates in the late 1970s and the 1980s meant that the relationship between commodity prices and financial assets changed dramatically. As real interest rates rose, the opportunity costs of holding inventories of commodities increased, resulting in a shift out of commodities and into financial assets. The late 1980s and 1990s were characterized by high real but low nominal interest rates and low inflation. During this period, commodity prices fell in real terms.

Commodity hedging.. Event risk

This refers to significant events in individual commodity markets that have significantly affected prices. Examples of event risk affecting commodity prices include the Gulf war, Iraq war, the Hamanaka copper scandal and the decision taken by central banks to halt gold sales

Commodity hedging.. Resource intensity

This refers to changes in the fundamental level of demand. Commodity prices are affected by the increasingly lower resource intensity of certain industries. For example, the amount of metal used in cars have reduced dramatically over time, reducing demand. In contrast, the entry of certain communist countries into global trade has created demand for other commodities such as oil. It has also increased supply of other commodities, reflecting the participation of these countries in international trade

Commodity hedging.. Major drivers – Managing commodity price volatility

Commodity hedging offers both producers and users the ability to lock in the price of commodity purchases or sales. For the producer, the benefit of hedging is the guarantee of revenue. This is of particular importance to high cost producers that sacrifice potential windfall gains of higher prices in order to obtain protection against the risk of lower prices. For consumers hedging guarantees prices for the purchase of essential raw materials, allowing profit margins on end products to be determined. Commodity hedging can be used by processors to manage both input price and output price exposure

Commodity hedging.. Major drivers – Additional financing flexibility

Commodity hedging can ensure certainty of revenue cash flows o allow the organization to access finance. This is particularly important in the case of commodity producers seeking financing (typically non recourse) for resource and other projects. Commodity hedging can be integrated into natural resource project financing, particularly for the resource producers. The use of commodity hedging to manage the product price risk on resource projects is increasing. This reflects the requirement of project finance lenders that appropriate commodity price hedging action is implemented. A major factor facilitating the use of such commodity derivatives in the context of project financing is the increased involvement of supranational bodies. These entities act as the counter party to the commodity hedge. This is designed to allow entities of lower credit quality access to commodity derivatives markets.

Commodity hedging.. Structure

Key issues include

- Basis risk

- Value sources

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Commodity hedging.. Structure - Basis risk

The major types of basis risk include:

Quality / grade / size - involves specification. There are limited ranges of traded commodities on which derivatives are available. This requires the use of correlation relationships to hedge/trade exposures. This increases exposure to basis risk. Location – underlying commodity must be physically delivered at a specific location. Significant price differences can exist between locations reflecting supply demand condition and the cost of transportation between locations. The price differentials between delivery locations can change rapidly.

Time – liquidity conditions may dictate use of hedges with different maturity to the underlying exposure. This timing exposure can be particularly important in commodities. because sudden shifts in demand, supply or transportation conditions can affect the efficiency of the hedge.

Commodity hedging.. Structure - Value sources

Shape of forward curve – The forward curves frequently display backwardation and often change shape - from backwardation to contango. This allows one to extract additional value. Mean reversion / seasonality – the mean reverting and seasonal behaviour of commodity prices allows producers, processors and consumers with underlying positions to trade long run price cycles in commodity price cycles. High volatility – creates trading opportunities. It also creates opportunities for monetising volatility by the sale of options against natural underlying positions

Correlation – commodity users, processors or users often have embedded correlation positions that can be used to generate value. For example, Commodity users often have exposure to a range of commodities that are imperfectly correlated. Commodity producers have price exposures that are imperfectly correlated to exposures in other asset classes (interest rates and currency). This allows correlation-based hedges with lower costs.

Commodity indexes

Similar in concept to other indexes, including equity indexes, the ability to provide diversified exposure to commodity prices in general on a diversified basis has encouraged the advent of transactions where the linkage is to an index. The benchmarking of commodity portfolios to these indexes for the purpose of performance measurement has also encouraged transactions based on the index.

Commodity indexes Characteristics

A commodity index is essentially designed to represent and track price changes in a basket of commodities or commodity futures contracts. The underlying logic is that the returns on the index approximate the returns to an investor holding an un leveraged position in the assets underlying the basket.

Commodity indexes Drivers

The essential drivers of commodity indexes are: - Indexes allow diversified exposure to commodities to be

engineered - The index can be used as a performance benchmark for commodity investments

In practice, commodity indexes are important in commodity markets as derivative transactions (futures contracts as well as forwards and options) and structured notes based on the index rather than specific commodities have become increasingly popular.

Commodity indexes Differences between indexes

Composition – commodity indexes are either narrow or broad based. Narrowly based indexes typically cover major commodities, primarily energy and metals. Broad based indexes cover these commodities, but extend their coverage to a large variety of other commodities including ‘softs’ (grains, livestock and other agricultural products). Narrowly based indexes aim to be sector specific and focus on liquid commodities with a direct link to industrial production and GDP. Narrowly based indexes also seek to avoid exposure to factors such as weather conditions. Broad based indexes are focused on a widely based exposure to all commodities that are economically significant. Broad based indexes, while more difficult to replicate, will generally provide more accurate protection against inflation and exposure to the low cross correlations between commodities. The underlying assets in a commodity basket may also vary. Some indexes use physical commodities while others use futures contracts on the commodity. The difference is driven by the relative liquidity and price transparency of the relevant commodity markets


Weight

Index weight may be based on Economic weights – based on fundamental economic data (such

as world production quantities or values)

Equal weights – based on fixed weights

Market weights – based on relative trading volumes in futures markets (on futures contracts on the commodity)

Optimised weights – based on econometric models which seek to optimize nominated criteria (such as level of returns, volatility of returns, correlations to inflation etc) over the selected time period


Rebalancing – index rebalancing entails two separate factors – the mechanics of rolling futures contracts and rebalancing the portfolio weighting. Where the commodity index is based on commodity futures contracts, the futures contract will mature and must then be rolled into a more distant maturity. This rolling process is the mechanism that allows capture of the convenience yield in the commodity markets. The other element of index rebalancing necessitates adjusting the positions in individual commodities (for example, electricity or telecommunications capacity). There are two approaches:

fixed weights – consistent exposure is maintained based on fixed quantities of commodities in the basket

value weights – this requires constant rebalancing with investors effectively selling (buying) commodities that have risen (fallen) in value


Return calculations – return may be calculated on an arithmetic or geometric basis. The use of geometric returns prevents domination of index value changes by higher priced commodities.


Leveraged versus un leveraged returns – a leveraged commodity index is typically based on future contracts. This reflects the fact that trading in futures requires minimal commitment of capital (the initial and variation margin). This will have the effect of enhancing the returns, as price changes will be relative to low levels of employed investment capital. Un leveraged indexes assume either

Investment in cash or physical commodity assets

Investment in future contracts, but with fully matched cash investment equal to the underlying value of the contract (the cash earns risk free returns) .


Total return versus excess returns – the commodity index returns are calculated in two ways

total return – representing the total rate of

return of the index

excess return – representing the total returns minus the return on treasury bills

Commodity indexes Various indexes

CPCI - Chase Physical Commodity Index, CRBI - Commodity Research Bureau Index, DJ-AIGCI - Dow Jones AIG Commodity Index, GSCI - Goldman Sachs Commodity Index

Commodity indexes Comparison

Index CRBI CPCI GSCI DJ-AIGCI

Composition

Broad Broad Broad Broad

Major sectors

Energy, Live stock, grains, industrial metals, precious metals and softs




Weighting Equal Economic Economic Liquidity, economic

Rebalancing Value: static Value: dynamic

Quantity; dynamic

Value: dynamic

Returns Geometric Arithmetic Arithmetic Arithmetic

Commodity investment

The market has witnessed a rapid growth in demand for commodity linked investment instruments. The growth in this source of commodity demand is evidenced by the fact that a significant portion of commodity trading is now investor driven


Financial and portfolio investors face substantial difficulties in effecting commodity investments. These include storage and related (insurance, transport, etc) costs and difficulties in leasing or lending out the commodity holding. These factors have encouraged the development of a paper commodity market that strongly emphasizes commodity-linked notes (or pure off balance sheet structures) as the mechanism for creating the required exposure to commodity prices. The investment demand for commodity-linked products has been met from two sources: firstly, issue of commodity linked debt from commodity producers (and, less frequently, commodity users); and secondly, structured notes with commodity price linkages. In practice commodity linked structured notes are the principal method of providing commodity exposure for investors


Commodity investment by traditional financial investors has become a significant factor in commodity markets. Commodity investment is driven by different factors to that driving investment in other financial assets.


The demand for financial investment in commodities was originally driven by the following factors.Speculation: Investors seeking to speculate on future price movements of the underlying commodityInflation protection: Investors seeking inflation proof investments in an attempt to preserve the purchasing power of their monetary asset particularly under conditions of high inflationPure commodity exposure – Investors seeking pure commodity exposure that is not obtainable efficiently through equity investments (that filter the direct commodity exposure)Commodity as a separate asset class: Investors seeking exposure to commodities in a diversified portfolio where commodity assets are treated as a unique asset class

Commodity investment Speculative purposes

The demand for commodity investment for speculative purposes is a constant feature of commodity markets. This interest derives from both retail and institutional investors. Retail interest is widespread, in areas where commodities (precious) metals are seen as a type of savings. This is particularly evident in Asia, the Middle East and Latin America

Commodity investment Inflation protection

During the inflationary period of the 1970s and 1980s, a variety of commodity linked structures evolved in response to the demand for effectively priced inflation linked securities. These investments were designed to protect the value of investment capital in real terms. Interest in commodities as a mechanism for preservation of purchasing power has become less important as the price inflation pressures have reduced in the 1990s.

However, these pressures have resumed in the 2000s, with the oil taking its onward march very steeply; additionally the Chinese demand for more commodities have seen the prices of many metals going up to unheard levels so far. Moreover, the present economic predicament in which US economy is placed is also putting upward pressure

Commodity investment Pure commodity exposure

The traditional format for commodity investment is investment in the stocks of companies involved in resources (commodity producers and users). Increasingly direct investment in the commodity itself has emerged as the favoured form of creating the price exposure. This reflects increased awareness that resource based stock’s price movements are strongly correlated to movements in equity prices generally. This means that the commodity price exposures obtained through stock investment is imperfect. The fact that the commodity firm may have investments in a range of (unrelated) commodities may also make it difficult to obtain pure price exposure to a single commodity.

Commodity investment Separate asset class

The concept of an asset class relates to a set of investments that exhibit similar and distinctive investment characteristics (primarily return, volatility of return and relationship of return to returns from other investment assets)

The typical characteristics of an asset class includeYieldPrice returnVolatilityLiquidity

It is important to differentiate between physical commodity investments (investment in commodity assets) and paper commodities. In practice, all commodities, particularly paper commodity assets, display all of the requisite characteristics identified above