Commodities: the assets the world utilises daily

Overview

Given the importance of commodities in daily life, commodity trading began long before modern financial markets evolved as ancient empires developed trade routes for exchanging their goods. Today, commodity markets are highly sophisticated. While hard commodities, such as metals and minerals, are generally well-known, what are the opportunities offered by investing in soft commodities?

A commodity is generally defined as a tangible, unprocessed good with intrinsic value that can be processed further and traded.

Commodities can be classified into two groups:

HARD COMMODITIES

Hard commodities

Non-perishable, non-renewable products that are extracted from mining activities. Examples of these commodities include gold, iron, copper, coal and oil.

SOFT COMMODITIES

Soft commodities

Renewable (and often perishable) plant or animal resources that can be grown, such as maize, wheat, tea, beef and wool.

Commodities are classified as alternative investments and exposure to them provides investors with an inflation hedge and portfolio diversification, as commodities generally have a low correlation with traditional asset classes, such as equities and bonds. Because commodity prices typically rise when inflation is accelerating, they offer protection from the effects of inflation. Few assets benefit from rising inflation, particularly unexpected inflation, but commodities usually do. As the demand for goods and services increases, the price of goods and services rises as does the price of the commodities used to produce those goods and services.

Investing in commodities

There are typically four ways to invest in commodities:

1. Investing directly in the commodity (spot market)

2. Using commodity futures contracts to invest

3. Buying shares of exchange-traded funds (ETFs) that specialise in commodities

4. Buying shares of stock in companies that produce commodities

What makes soft commodities appealing?

No matter the state of the world economy, the basic need for soft commodities will always be there. Humans need to eat, for example, so there will always be a demand for food. The price will be determined by that need, but not economic growth per se. While a very weak economic environment will affect equities, soft commodity prices are subject to their own supply and demand factors. From that perspective, soft commodities can buffer an investment portfolio from economic cycles.

At the same time, when investing in soft commodities, it is worth noting that they are subject to mean reversion.

Commodity trading is the exchange of different assets, typically futures contracts, that are based on the price of an underlying physical commodity. With the buying or selling of these futures contracts, investors make bets on the expected future value of a given commodity. If they think the price of a commodity will go up, they buy certain futures—or go long—and if they think the price of the commodity will fall, they would sell the futures — or go short.

Mean reversion is a financial theory which suggests that, after an extreme price move, asset prices tend to return back to normal or average levels. So, while soft commodities can be subject to large price swings, these prices will “settle.” From an investor perspective, the risk associated with soft commodities is viewed through a market-neutral lens. In other words, investment returns can be made both when a soft commodity's price goes up or down.

Soft commodities can be a powerful portfolio diversifier, but investing in them requires specialised knowledge. A fund manager should not only have financial expertise, but needs a practical understanding of the soft commodities markets, their commercial use and interchangeable characteristics.

Commodity-focused hedge funds invest largely, but not exclusively, in financial products that have commodity equities and commodity derivatives as underlying assets. So, investors are not buying the physical asset – but a representative of it. An example being an agricultural derivative.

Risks

Due to the nature of soft commodities prices being subject to supply and demand forces, the market can be volatile. Soft commodities prices are subject to seasonality and weather conditions. Furthermore, geopolitical risk can also have a significant impact on the supply and demand of soft commodities – as can be seen with war in Ukraine, which has caused a lack of grain exports.

Before the start of the war, Ukraine was steadily increasing its production and export of grain. In 2021, Ukraine produced 107 million tonnes of grain, of which it planned to export 70 million tonnes. Prior to the Russian invasion, Ukraine exported 43 million tonnes of grain and oilseed. Another 4 million tonnes were loaded onto ships, but not taken out. Thus, at the beginning of the war, 27 million tonnes of grain were ‘stuck’ in Ukraine.”

SOURCE: Successful Farming

Climate change

The supply of most agricultural products is very sensitive to weather conditions in production areas, especially during the crucial phases in the development of the harvest. Holdover stock of previous seasons could have a significant effect on new-season prices too. The production of livestock and meat products depends much on weather conditions, the price of feed inputs and consumer preferences.

Given the current climate crisis, it is likely that the soft commodity market will be more volatile in the future. Seasons have become more unpredictable, which will certainly have an effect on soft commodity production cycles. While this unpredictability can catch the market off guard, in the scenario where the market does become more volatile, fund managers will be able to adjust investment exposures in order to mitigate this.

Food scarcity is also a concern – as has been evidenced in the supply chain issues due to the situation in Ukraine, for example. While this is a concern, the market will quickly highlight this and flag the future shortage of, for example, wheat. This will incentivise farmers to start planting crops aggressively to address this market shortfall.

Commodity trading in SA

Pre-1995

Agricultural commodities were traded solely by state-controlled agricultural marketing boards. Consequently, prices were not transparent and prices were not sufficiently determined by market forces.

1995

Deregulation led to the disbanding of the agricultural boards and the start of a proper commodities trading platform in South Africa. This was accomplished with the establishment of the Agricultural Markets Division of the South African Futures Exchange (Safex). The first two futures contracts listed were a beef and a potato contract, both of which did not survive.

1996

White and yellow maize contracts were listed and became immediately successful. Thus, an era dawned on the maize market in which local producers were provided with the necessary market tools for facilitating effective price discovery and price risk management due to the transparent prices generated in the futures market.

1997

A wheat contract was introduced.

1999

A sunflower seed contract was introduced.

2001

Safex was taken over by the JSE.

SOURCE: Understanding South African Markets

What are agricultural derivatives?

• A derivative which has agricultural produce (an agricultural commodity) as the underlying asset.

• Unlike financial assets, agricultural commodities are valued based on their future expected spot prices rather than future expected cash flows.

• For example, the value of a futures contract on wheat is based mainly on expected future spot prices of wheat and the storage costs of holding this commodity.

SOURCE: : IAS Parliament

REFERENCES

• Corporate Finance Institute. Available online: https://tinyurl.com/4try9w67

• IAS Parliament. Available online: https://tinyurl.com/mrxj5w59

• IG. Available online: https://tinyurl.com/anjru3dh

• Successful Farming. Export problems plague Ukranian Farmers. Available online: https://tinyurl.com/2jkuw87m

• The Balance. What is a market-neutral investment strategy? Available online: https://tinyurl.com/3eyffuu2

LEARN MORE

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