Exchange Traded Commodities
Commodities have received a lot of press over the past few years, and with this there have been
some spectacular returns in many commodity markets and indices. As a new investor to the sector,
it would be normal to question whether the run in commodity prices can continue and whether it is
too late to get involved? Given the wide range of commodities, indices and new products available
to investors today, it is never too late to enter the commodity markets.
By Nik Bienkowski
ONE INDICATOR OFTEN used to com- pay-back time for investment projects is long relative to other indus-
pare hard assets with financial assets is tries. As such, energy and mining companies are loathe to over-cap-
the Dow-Gold ratio which compares the italise on large development projects in the hope that demand will
Dow Jones Industrial Average (the be there in twenty years.
longest standing equity index) to the Other than the long-term cyclical nature of commodities, there are
price of one ounce of gold (the world’s a number of immediate factors driving the current commodities
oldest asset). Figure 1 shows that finan- boom. These include growing demand (especially China), stagnating
cial assets and hard assets (gold) have supply, increasing input costs, previously low expenditure on develop-
moved in long-term cycles of approxi- ment, and investment demand for alternative assets.
mately twenty years. Based on history,
and the fact that markets tend to over-
... many commodities are nearing exhaustion in
react (both up and down), it is possible
stable regions, increasing the risks in new projects
that the current commodities boom
and thus driving down commodity
has another fifteen years to run, rela-
company’s risk-adjusted returns
tive to equities. At the end of each
cycle, equities have managed to create Global commodities demand continues to grow as the world’s
a new high. However, the ratio always largest countries continue to modernise. Oil is expected to meet 35-
fallen to around 2x – at today’s prices, 40% of the world’s energy needs for the next thirty years or more,
that means (if history were to repeat yet it is becoming harder and more expensive to replace our natural
itself) the Dow could fall below 1,300 or resources every year. In addition, rapidly developing countries are
gold could rise to over US$6,750/oz! now using more commodities like oil, industrial metals and agricul-
One of the other main reasons that tural products to meet their growth needs.
commodity prices tend to move in Previously, low commodity prices had resulted in a lack of develop-
long-term cycles is that the commodity ment and falling exploration expenditures. Significant discoveries
cycle – from exploration to production have fallen and production facilities have not been upgraded. While
and particularly for extracted com- demand for commodities has increased, supply has either remained
modities – can take 10-20 years. The stagnant or grown at a slower pace than demand. Coupled with this,
extraction of commodities is a very many commodities are nearing exhaustion in stable regions, increas-
sophisticated, time consuming and ing the risks in new projects and thus driving down commodity com-
expensive business. As a result, the pany’s risk-adjusted returns.
extractive industries need to spend Finally, the end of the bear market in commodities and bull market
their budgets wisely given that the in equities around the turn of the century caused investors to recon-
sider their portfolio allocations and to look for non-cor-
Figure 1: Dow/Gold Ratio, 1920–2007 related sources of return as world equity markets
peaked and became more correlated. As a result,
investors reallocated parts of their portfolio from equi-
ties into alternative assets including real estate and
commodities.
In addition to the theoretical benefits of commodi-
ties in a diversified portfolio, new demand has come
from investment themes such as biofuels. The increase
in demand for corn also impacts other agricultural
commodities, as crop rotation into corn means reduced
plantings of substitute crops like wheat and soybeans.
Moreover, if crop yield enhancements don’t keep up
60
0 0
1
920
1930 1
940
1
9
5
0
19 197 1980 199 2
000
2007
with the demand and population growth, then supply
Source: Bloomberg
will be additionally squeezed.
58 SEPTEMBER 2007 COMMODITIES NOW
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