5 Reasons Commodities Are Important for All Investors

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It is so important to save for the future. Pensions used to provide income to those who spent their lifetimes working to earn a living. However, today many working people will need to rely on their savings during their golden years. In the United States, social security is a troubled system. The system is susceptible to changes by politicians who have to deal with growing deficits and may decide to change benefits in the future.

Social security is not likely to provide significant and necessary income in the future. People are living longer these days, and that means that they will need more money to sustain themselves.

The advent of Individual Retirement Accounts and other tax advantageous savings plans has driven savings to the equity and fixed income markets. While there are many investment professionals out there to help people with their plans, it is important that we all not only understand markets but become active participants in our futures when it comes to our nest eggs. It has also become an imperative for those financial experts to comprehend a major asset class when advising on capital allocation decisions.

Commodities have long been alternative investment vehicles. They scare many financial experts and individual investors because of the volatility inherent in the raw material markets; they tend to have far more price variance over time than other asset classes.

However, some investors look at the volatility in commodities markets as an opportunity. These market participants tend to take a far more proactive approach to their savings plans. They tend to buy and sell much more than those invested in stock or bond markets that buy and hold for the long-term.

Whatever your orientation to savings, whether you take a proactive or a buy and hold approach, knowledge is power. Understanding of the inter-asset relationships between commodity markets and other asset classes can enhance returns and can at times, provide necessary signals that will serve to protect capital or increase returns. We all have innate knowledge about commodity markets; we buy gasoline to fill our automobiles, purchase food at the supermarket, heat and cool our homes, and buy homes that contain essential building materials. We are all commodity consumers on a daily basis, and we are sensitive to changes in the prices of raw materials on an individual basis. If we hold equity portfolios, the companies we invest in are also commodity consumers; price movements in these staples will influence earnings. When the price of a commodity moves higher, it often decreases profit margins for companies that require them, their cost of goods sold rises. Conversely, when commodity prices drop, costs of goods sold declines and profit margins and earnings increase. If our nest eggs hold bonds, inflationary or deflationary pressures cause fixed income prices to move in a volatile fashion.

Commodity prices are often the front line when it comes to price pressures on bonds signaling deflationary or inflationary pressures, and an investor who monitors raw material prices can identify shifting trends.

Therefore, an educated investor these days should understand the fundamentals of commodity markets even if they do not invest or trade directly in these staples. Commodity prices are an important variable when it comes to investment science. Accurate solutions to finance problems are dependent on understanding and explaining all inputs. Commodities have always played a critical role in the science of investing, but there are at least five reasons that they are becoming more important every day.

Reason One: Demographics

The impact of commodities on other asset classes is increasing on a daily basis because of demographic trends.

This trend manifests itself in two ways, population and wealth.

In 1959, there were 2.9 billion people on planet earth. At last check, that number now exceeds 7.33 billion. Commodities are finite assets; there can be only so much raw material production at a price. The increase in population around the world continues to stretch the fundamental supply and demand equation for commodities. Simply put, as the number of people around the world increases, so does the requirement for more food, energy, building materials and other staple goods. The other aspect of the demographic pressure on raw material prices is the increase in wealth around the world. China is a perfect example of the effects of the increase of wealth and its effect on commodity prices. With over 1.3 billion people, almost 19% of the world’s population, together with an increasing standard of living in the Asian nation, the demand for commodities has grown to a point where China has become the demand side of the equation for many raw material markets over recent years. Growth slowed in China starting in around 2014; this caused the prices of many commodities to move lower illustrating the direct effect of the Asian nation on all asset sectors. China’s economic slowdown then generated fewer revenues in many producing countries like Australia, Canada, Brazil and others and the value of their currencies moved lower. The contagious effects of slowing demand for raw materials reverberated across all asset classes around the world.

Demographic changes have caused the flow of commodity staples all over the world to change. Increasing population and wealth will mean that more people will compete for finite goods. The ramifications for other asset classes are dramatic. The prices and availabilities of raw materials will have an ever increasing influence over other markets across all asset classes in the years to come.

An excellent example of how demographics have had a tremendous impact on a commodity is in the cocoa market. While the prices of many commodities moved lower from 2012 through 2015, cocoa made a series of higher lows and higher highs over the period. The strength in cocoa was because of increasing demand for chocolate confectionery products in Asia. The Chinese discovered the joy of chocolate and became chocoholics along with the rest of the world. Demographics caused price strength in the cocoa market.

Reason Two: Technology

Technology has made the world a smaller place. Advances in communications and transparency have created the environment where an event in one corner of the earth influences asset prices around the world in a flash.

When I began my career in the commodity markets in the early 1980’s price dissemination was poor. The advent of computer technology has caused dramatic changes in all markets but particularly in the world of commodities. Today, commodity prices are available to everyone around the world who has a computer or smartphone via the futures markets. The exchanges provide delayed data with a ten minute lag for free via their websites. However, real-time prices are available to anyone willing to pay the exchange for the privilege of viewing live price action.

Additionally, when I began trading commodities, pit traders bought and sold futures contracts at the exchanges of the world. Today, electronic trading allows futures prices to move around the clock during the business week. Buyers and sellers have the ability to transact in an open and transparent environment increasing information flow and reducing the time needed to transact fostering the transference of risk from buyers to sellers and vice versa.

Reason Three: Liquidity

Before 2004, anyone wishing to trade or invest in commodities had only two options; physical or the futures markets. The volatility of raw material prices scared many investors away from the asset class. Additionally, futures are highly leveraged instruments. The initial margin for futures positions often amounts to far less than 10% of the full contract value. That means margin calls are the norm rather than the exception. Furthermore, leverage acts to enhance both profits and losses. Therefore, the risk component of futures trading is only appropriate for a select group of traders and investors.

The advent of Exchange Traded Funds and Exchange Traded Notes has brought instruments that seek to replicate the price action of commodities to any investor holding an equity account as these products trade on traditional stock exchanges. These products have increased liquidity as they bring new market participants to the world of commodities. ETF and EFN products are not investments in the underlying commodity products themselves but instruments that attempt to replicate the price action in raw material markets. The administrators and issuers of ETF and ETN products often use other derivatives such as futures, options and in some cases positions in the commodities themselves to help correlate the vehicles to actual prices.

Investors can use ETF and ETN products to position for moves higher or lower, and they can choose from an array of leveraged vehicles as well adding a tremendous amount of liquidity to commodity markets. ETF and ETN products provide a new method for market participation without the traditional risks as well as a way to monitor raw material prices.  

Reason Four: The production-consumption dynamic

In the world of commodities, the producer-consumer dynamic has changed over recent years. On the producer side, boom and bust markets have caused only the strongest and lowest cost producers to have the ability to survive volatile markets. The most influential producers have built market share and increased their reserves of commodities as high-cost producers leave the market during periods of price declines.

One of the best examples of this trend has been in the oil market. When the price of crude oil was over $100 per barrel, North American production increased as high-cost shale oil became economic. However, one of the results of the price decline from triple digits in June 2014 to lows of $26.05 in February 2016 was that North American production fell dramatically as the cost of producing the energy commodity became higher than the market price. Traditional, low-cost producers saw their market share rise as rig counts in North America fell from over 2000 oil rigs in operation to under 400.

On the consumer-side of the fundamental equation, there have been vast changes over recent years. As China is the largest commodity consumer on earth because of their population and increasing wealth, Chinese investment in commodity production around the world has taken the form of joint ventures and direct investments in commodity producing properties and businesses. The Chinese desire to ensure the flow of raw materials to the nation has resulted in ownership of metal and mineral producing properties around the globe.

In 2013, a Chinese entity purchased the largest pork producing company in the world; Smithfield Foods the U.S. based hog processing company. The trend of direct investment to guaranty raw material flows is likely to continue in the years to come.

Reason Five: Politics

There is an important political element to commodity markets around the world. Over the course of history, the price and availability of food have sparked revolutions and political change. Bread prices and shortages were one of the main reasons for the French Revolution. More recently, bread riots in Tunisia and Egypt were a cause of the Arab Spring that commenced in 2010 and swept political change across North Africa and the Middle East. Wheat is the main ingredient in bread, shortages or higher prices for the commodity can have significant political ramifications for the world.

Oil is also a traditionally critical political commodity; gasoline lines in the United States in the 1970s caused a shift towards energy independence. Furthermore, commodities can have significant political consequences for producing nations. As an example, more than 60% of the world’s cocoa bean production comes from the West African countries of the Ivory Coast and Ghana. Many jobs in these two nations are the result of cocoa production and logistics to bring the main ingredient in chocolate to market. Therefore, the price and availability of cocoa have political ramifications for these two nations.

There are so many reasons that knowledge of commodity markets is an imperative for all investors around the world. Commodities not only impact the prices you pay for goods every day but the value of each and every one of your investments. Take the time to watch commodity prices, awareness of this piece of the global financial puzzle could enhance your returns and signal changes in markets that could save your capital at times.