Natural resources gain stature as a permanent asset class

Commodities now appeal to a growing number of investors who in the past might have been put off by their reputation for volatility. These investors recognize that exposure to commodities can help steer a diversified portfolio toward higher returns and at the same time offer a hedge against the inflationary effects of a falling U.S. dollar.

Institutional investors in particular are taking a hard look at an asset class once deemed too risky. Goldman Sachs estimates that more than $90 billion was invested in commodities last year, up from less than $10 billion in 2000.

Source: Goldman Sachs

The California Public Employees’ Retirement System, the nation’s largest pension fund, set aside $500 million last year for a pilot investment program to help it decide whether to create a natural resources and commodities asset class within its holdings.

Those who venture into commodities investing will find that price swings, while sometimes
substantial, are not entirely unpredictable. When foreseen, a price swing can provide an opportunity to strengthen a position or seek out previously overlooked alternatives.

The growth of global population and economic development has driven up demand for commodities, so there is now an abundance of opportunities. This rapid growth is most notable in China and India, the world’s two largest countries. At the same time, the supply of certain commodities has been restricted by production constraints and environmental regulations, and threatened by political conflicts. These factors increase the likelihood that prices will rise.

An investor need not build an oil tank farm or store bullion in the basement to get exposure to commodities. Alternatives include buying indices that track commodity futures, or stock in mining companies or other resource producers.

2006 offers a good illustration of how investors can succeed in the commodities markets. While iconic pillars of the sector like gold and oil stalled in late spring, overall sector growth was sustained by the strength of base metals like copper, nickel and zinc, and agriculture products.

The best-performing industry within the sector last year was metals and mining. The Toronto Stock Exchange Metals and Mining Index finished the year up 69 percent, with industrial metals leading the way. Nickel was up 150 percent for the year and zinc rose 120 percent.

Strong global industrial production, primarily in Asia, drove the S&P’s Steel Index up 80 percent. Despite negative movement in heating oil, gasoline and natural gas, the S&P Energy Index managed to finish the year up 24 percent.

Knowledge of the historical patterns within commodities markets also can help investors make good selections and offset some of the volatility inherent in these sectors.

For example, history shows that per-capita oil consumption grows rapidly in industrializing nations before eventually leveling off. The United States consumed roughly 25 barrels of oil per capita In 2006, while South Korea used about 16 barrels per capital and Japan’s consumption was about 15 barrels per capita.

Despite massive growth over the past quarter-century, China’s per-capita oil consumption in 2006 was just two barrels and India's was less than one barrel. This suggests that China and India are still in the initial stages of the industrialization and urbanization cycles.

Also, historical data shows the nominal peak for crude oil was set back in December 1979 at $38 per barrel. Adjusted for inflation, this per-barrel price equated to $100 in June 2006, when actual oil prices were at $62.85. This means oil prices are still well below the inflation peak price, which could signal the possibility of higher prices going forward.

Crude prices follow defined annual cycles. During the summer months, from July to September, they tend to head upward. Heading into winter, from October to December, prices experience a pretty strong down trend. This knowledge can help investors decide when to buy and sell oil-focused holdings.

Another pattern that can prove useful to investors is the relationship between the dollar, gold and oil. It is important for commodities investors to recognize that gold and oil have a positive correlation - that is, they move in the same direction - 90 percent of the time. Meanwhile, gold and the dollar typically show a negative correlation - they move in opposite directions 70 percent of the time.

When investing in commodities, it is important to understand that everything from war to weather to world politics can dictate, drive or suffocate their growth.

Geopolitical events can restrict supply of commodities, which tends to drive up prices. For two centuries, prices have spiked in times of war and conflict: the War of 1812, the Civil War, the two world wars, the Cold War and, most recently, the ongoing wars in Iraq and Afghanistan.

The world’s most productive oil-producing region lies in a triangle of countries with political challenges: Saudi Arabia, Iraq and Iran. Iran is the only nation with an overwhelming Shiite Muslim majority, while Iraq has a slight Shiite majority and Saudi Arabia is a majority Sunni Muslim country contending with a growing threat of Islamist extremism.

The U.S.-led war that toppled Saddam Hussein’s government in 2003 has increasingly become a sectarian conflict between Shiites and Sunnis. The potential for destabilization in these oil producing countries is a risk for crude production and, because of that risk, a premium is built into oil prices.

Low oil prices during the 1990s led to cuts in exploration, creating an imbalance between rising global demand and available supply. On top of that, stiffer environmental and governmental regulations have curbed oil supply by making it more costly to produce.

Even as factors like these have suppressed supply of oil and other commodities, demand continues to rise as the global economy expands. Asia has particularly strong rates of growth in its gross domestic product and industrial production.

In the past five years, China and India have become two of the largest oil-consuming countries. Despite its low per-capita use, China accounts for just over a third of the new demand for oil worldwide. An increase in consumption has spurred China to seek oil from outside its own borders. On the other hand, India has entered this marketplace more recently, creating a competitive marketplace as it competes with China for the same supplies.

Source: Barry Bannister, Stifel Nicolaus Courtesy: Marc Faber; Gloom, Boom, and Doom; www.gloomboomdoom.com

Perhaps the largest driver for commodities demand is the exponential growth of the world’s population.

According to the U.S. Census Bureau, global population broke the 6 billion mark in 1999, double the population in 1960. The bureau projects world population will hit 7 billion in 2013.
Every day these people eat, drive, shop and otherwise consume commodities and, with the emergence of China, India and other large developing countries, it’s hard to see that trend changing any time soon.

 

by Frank Holmes

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