Investment in Natural Resources

Commodities

While it is possible to invest directly in commodities such as grain and gold, the most commonly used instruments to gain exposure to commodity prices are derivatives. Commodities themselves are physical goods and thus incur costs for storage and transportation. Returns are based on price changes and not on income streams.

Futures, forwards, options, and swaps are all available forms of commodity derivatives. Futures trade on exchanges; some options trade on exchanges while others trade over the counter; and forwards and swaps are over-the-counter instruments originated by dealers. Futures and forwards are contractual obligations to buy or sell a commodity at a specified price and time. Options convey the right, but not the obligation, to buy or sell a commodity at a specified price and time.

Other methods of exposure to commodities include the following:

• Exchange-traded funds (commodity ETFs) ⇒ are suitable for investors who are limited to buying equity shares. ETFs can invest in commodities or commodity futures and can track prices or indexes.
• Managed futures funds, such as commodity trading advisers (CTAs), are actively managed. Some managers concentrate on specific sectors (e.g., agricultural commodities), while others are more diversified. Managed futures funds can be structured as limited partnerships with fees like those of hedge funds (e.g., 2 and 20) and restrictions on the number, net worth, and liquidity of the investors. They can also be structured like mutual funds with shares that are publicly traded so that retail investors can also benefit from professional management. Additionally, such a structure allows a lower minimum investment and greater liquidity compared with a limited partnership structure.
• Specialized funds in specific commodity sectors can be organized under any of the structures we have discussed and focus on certain commodities, such as oil and gas, grains, precious metals, or industrial metals.

Potential benefits and risks of commodities

Returns on commodities over time have been lower than returns on global stocks or bonds. As with other investments, speculators can earn high returns over short periods when their expectations about short-term commodity price movements are correct and they act on them.

Historically, correlations of commodity returns with those of global equities and global bonds have been low, typically less than 0.2, so adding commodities to a traditional portfolio can provide diversification benefits. Because commodity prices tend to move with inflation rates, holding commodities can act as a hedge of inflation risk. To the extent that commodity prices move with inflation, the real return over time would be zero, although futures contracts may offer positive real returns.

Commodity prices and investments

Spot prices for commodities are a function of supply and demand. Demand is affected by the value of the commodity to end-users and by global economic conditions and cycles. Supply is affected by production and storage costs and existing inventories. Both supply and demand are affected by the purchases and sales of nonhedging investors (speculators).

For many commodities, supply is inelastic in the short run because of long lead times to alter production levels (e.g., drill oil wells, plant crops or decide to plant less of them). As a result, commodity prices can be volatile when demand changes significantly over the economic cycle. Production of some commodities, especially agricultural commodities, can be significantly affected by the weather, leading to high prices when production is low and low prices when production is high. Costs of extracting oil and minerals increase as more expensive methods or more remote areas are used. To estimate future needs, commodity producers analyze economic events, government policy, and forecasts of future supply. Investors analyze inventory levels, forecasts of production, changes in government policy, and expectations of economic growth in order to forecast commodity prices.

Commodity valuation

Wheat today and wheat six months from today are different products. Purchasing the commodity today will give the buyer the use of it if needed, while contracting for wheat to be delivered six months from today avoids storage costs and having cash tied up. An equation that considers these aspects is:

futures price ≈ spot price × (1 + risk-free rate) + storage costs − convenience yield

Convenience yield⇒ is the value of having the physical commodity for use over the period of the futures contract. If there is little or no convenience yield, futures prices will be higher than spot prices, a situation termed contango. When the convenience yield is high, futures prices will be less than spot prices, a situation referred to as backwardation.

Farmland and Timberland

Two additional assets under the heading of natural resources are timberland and farmland, for which one component of returns comes from sales of timber or agricultural products. Timberland returns also include price changes on the land, which depend on expectations of lumber prices and how much timber has been harvested. Farmland returns are based on land price changes, changes in farm commodity prices, and the quality and quantity of the crops produced.

While most agricultural crops must be harvested within a short period, timber is different in that the choice of when to harvest is based on current prices and expected growth rates. Because agricultural crops (including trees) consume carbon, they are attractive to investors with an ESG focus on climate change.

Risks of investing in farmland and timberland include low liquidity, high fixed costs of production, variable cash flows that depend on weather, and potential losses from natural disasters such as wildfires.