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Investing In Commodities

Investing In Commodities

During recent market volatility, investors showed interest in gold as an investment. Gold prices tend to go up during periods of uncertainty and then subside during periods of stability. Gold is also priced in dollars, which means that it provides protection against a depreciating rand exchange rate.

Oil also received quite a bit of attention as a potential investment after falling to near two-decade lows in the first quarter. Oil prices are linked to economic activity and are also a function of the supply of oil – the prospect of weak economic growth and continued high levels of supply resulted in unsustainably low oil prices at the time.

Gold and oil form part of a wider set of investable commodities. Different commodities have different underlying drivers and understanding these drivers will offer investors the clarity required to successfully invest in this space –be it directly or indirectly.

What are commodities?

A commodity is a basic good used in commerce that is interchangeable with other goods of the same type. Commodities are used as a key ingredient in the production of other goods and services or, in the case of gold, as a store of value. The quality of the commodity can differ slightly; however, it is essentially uniform across producers resulting in a standard value.

Commodities are broken down into two categories: hard and soft. Hard commodities require drilling activities, such as mining. These include gold, copper, platinum group metals (PGMs) and oil to name a few. Soft commodities refer to raw materials that do not require drilling and are grown or farmed. Some examples include wheat, maize and coffee beans.

What causes commodity price changes?

Supply and demand trends of the commodity causes prices to change. When there is an oversupply relative to demand, prices will decrease. This is what was seen in the oil market recently. A shortage of a commodity or high demand will push the price up. This can happen on account of a drought reducing the supply of soft commodities and buyers increasing demand on fears of losing production inputs. The basic concept when trying to understand commodity prices fundamentally is to evaluate global trends.

What products are in high demand or short supply and how is this expected to change?

The simple commodity formula when evaluating trends:

  • Expected Supply > Expected Demand = Price Decrease
  • Expected Demand > Expected Supply = Price Increase

Megatrends and commodity demand

Understanding global trends is key when looking to invest in commodities. Megatrends are powerful, transformativeforces that can change the trajectory of the global economy by shifting the priorities of societies, driving innovationand redefining business models. Identifying the potential for structural change and investing in expectedtransformations early can be a key driver of successful commodity investing.

Megatrends are long-term structural forces that evolve over time. In 2016, the “emerging global wealth” megatrendprimarily focused on China’s rise. But since then, it has broadened to incorporate the emerging middle class in India,southeast Asia, and other developing economies.“Rapid urbanisation” has similarly incorporated the advent of smart cities and on-demand business models along withthe infrastructure needed to support emerging megacities.

Example: Urbanisation as a megatrend

Cities have been hubs for talent and job opportunities. In the past decade there has been a huge increase incity developments in emerging economies requiring significant infrastructure. As cities develop, they requiretelecommunication networks. This requires twisted copper wire as copper is generally the most common mode oftransmission used today.

Emerging cities account for a significant percentage of a country’s population as jobs and opportunities attractcitizens. Transportation needs to evolve, which means increased demand for cars, trains, and buses as well as fuel.Raw inputs into the production of cars include platinum, steel, rubber and aluminium. Higher fuel usage pushesup demand for oil while a shift to electric-powered vehicles means batteries that utilise lithium and cobalt in theproduction process will be in high demand.

When analysing megatrends, investors need to link the demand to raw products that are required in themanufacturing process. If there is an increased demand in electric vehicles, this might mean a decrease in demand foroil and PGMs (used in catalytic converters) and an increase in demand for cobalt and lithium.

Looking at long-term investment opportunities in the commodity market means fundamentally understanding theevolving megatrends within the global economy. It is also important to take note of short-term factors such as supplydisruptions or supply gluts, or sudden declines in demand when considering an investment in commodities.

Investing in commodities

There are several ways for long-term investors to gain exposure to commodities:

  1. Investing directly in the commodity: Investors have the option of purchasing and storing the physicalcommodity itself. This requires identifying a seller of the commodity, storing and insuring the physical rawmaterial as well as then locating a buyer. Acquirers of the actual raw commodity are more often manufacturerslooking to secure supply chain, as investors do not want the burden of buying, collecting, storing and sellingthe goods. Precious metals are bought and sold in their raw form such as Krugerrands; however, receiving andstoring barrels of oil might not be as practical for an investor. Fortunately for long-term investors there arealternative ways of gaining exposure.
  1. Commodity exchange-traded funds: A commodity ETF allows investors to gain exposure to commoditiesthrough an exchange-traded fund invested in physical commodities. JSE-listed commodity ETFs includeplatinum, palladium and rhodium ETFs, which track the price of these PGMs in ZAR terms. Other JSE-listedcommodity ETFs include gold ETFs (NewGold or FirstRand Krugerrand Custodial Certificates).
  1. Commodity exchange-traded notes: A commodity ETN allows investors to gain exposure to commodityprices through a structure that invests in derivative contracts. It is quite complicated but, most of thetime, these notes will track the underlying price of the commodity quite closely. In addition to some of thecommodities tracked by ETF providers, JSE-listed commodity ETNs include trackers of oil and silver ETNs alongwith soft commodity ETNs tracking corn or wheat.
  1. Buying commodity company shares: The last option allows investors to gain exposure to the commoditymarket by purchasing shares in a company that produces the raw material. Mining companies such as AngloAmerican Platinum or AngloGold Ashanti mines for precious metals while Anglo American and BHP are exposedto a variety of commodities. Anglo American’s main commodities mined are copper, platinum, iron ore anddiamonds. BHP has substantial exposure to iron ore, oil, copper and coal. A key consideration is that companyshare performance will not be based solely on commodity price changes. There will be internal performancemeasures that must be considered such as the management team, producer country currency changes, andregulatory and political factors.

Of course, there are also many companies that are indirectly impacted by commodity price changes –for exampleretailers tend to do well when oil prices are low because lower fuel prices place more cash in consumers’ pockets.The reach is endless but as you move along the supply chain, the impact of major trend changes will be diluted.