Forward Diary

How to Trade Commodities

In the simplest terms a commodity is any good which is supplied without qualitative differentiation across a market. So copper has a universal price which fluctuates on a daily basis in reaction to supply and demand while a manufactured product like a laptop will be priced according to a number of other criteria including the strength of the brand, specifications of the product and the market in which it is being sold.   Commodities can be separated into four main classes: energy; agricultural products; industrial metals and precious metals. All commodities are driven by a greater or lesser degree by the macro economy and most are traded through futures contracts which allow traders to speculate on the future direction of prices without receiving physical delivery of the resource in question.   A participant in an oil futures market for example will agree to purchase or sell a barrel of oil at a fixed price for delivery on a specified date – typically either one month, three months or six months out.   Very few futures contracts will be settled by delivery; most participants will seek to ‘roll’ their contracts forward (selling them and buying new ones) to avoid this. The ‘spot’ price, which is also quoted for many commodities, represents the price for immediate delivery.   The futures market phenomena contango and backwardation can have an impact on returns - particularly in the oil market. Contango refers to the market condition whereby the price of a futures contract in a commodity is trading above the spot price while backwardation describes the reverse. If a market is in contango then a trader will often have to pay a premium to retain the same exposure to a market.   Because oil is one of the key engines of economic growth its main pricing benchmarks, WTI and Brent, are perhaps the most closely aligned of all commodity prices, to the fortunes of the global economy. As a result it has been particularly volatile in the wake of the 2007/8 financial crisis – trading as low as $35 a barrel and as high as $147 a barrel.   Geo-political developments add a further layer of unpredictability - the Organisation of the Petroleum Exporting Countries (OPEC) controls around 77% of the world’s oil reserves and this gives the 12-member cartel at least a degree of control over the future direction of oil prices.   Traditionally natural gas prices followed oil but the link between the two has broken down as technological advances have facilitated the exploitation of unconventional or ‘shale’ gas in the US. This has created a supply glut and depressed the North American market in particular.   Of the industrial metals, which include aluminium, nickel and zinc, copper is often seen as the best barometer of the health of the global economy, earning the nickname ‘Dr Copper’. This is due to its ubiquity, with the metal forming a critical component in the manufacture of electronics, homes and infrastructure.   Precious metals like gold and silver are traditionally seen as ‘safe haven’ assets but investing in agriculture could also be seen as being consistent with a conservative investment approach. Demand for food is relatively inelastic, with most consumers likely to prioritise having enough to eat over spending on luxuries.   Energise your portfolio   The most heavily traded global commodity in terms of volumes is crude oil and its various derivatives such as heating oil and gasoline. These products are mostly traded in the New York Mercantile Exchange (NYMEX), ICE Futures, the Dubai Mercantile Exchange (DME) and the Central Japan Commodity Exchange (C-COM). Like the majority of commodities, oil is traded in futures contracts – with the purchase or sale of a barrel of oil agreed at a fixed price for delivery on a specified date – typically either one month, three months or six months out. This facilitates the buying and selling of a commodity without anyone having to take physical delivery - in fact only a tiny fraction of these contracts are settled through deliveries. As well as the price of the futures contract you may see reference to the ‘spot’ price of a commodity. This is the price quoted for immediate delivery. The two main benchmarks in the crude oil market are West Texas Intermediate (WTI) and Brent. US oil is priced off WTI while the latter is the yardstick for crude sold in Europe and Asia.   Over the last quarter of a century global energy consumption has increased by nearly 60% and it is expected to rise another 35% to 40% over the next 25 years. At present oil accounts for around 35% of the world’s energy needs. Demand is split fairly evenly between the developed and developing world but the US Department of Energy estimates emerging markets will represent 60% of oil consumption by 2030. While the world’s thirst for oil increases its supply of conventional crude is diminishing. Data from the International Energy Administration (IEA) records how conventional oil production peaked at 70 million barrels of oil per day in 2006. The Organisation of the Petroleum Exporting Countries (Opec) controls around 77% of the world’s oil reserves and this gives the 12-member cartel at least a degree of control over the future direction of oil prices. A further potential pressure on supply is leaders in the Middle East may seek to retain a greater proportion of their output for domestic consumption. A 2011 development plan from Saudi Arabia's Ministry of Economy and Planning revealed an aspiration to grow the economy at 5.2% a year with final consumption of commodities rising by 5.4% per annum. Oil is one of the key engines of economic growth and prices are closely linked to the fortunes of the global economy. As a result the commodity is particularly prone to volatility. The natural gas market has traditionally been closely associated with oil – although in the last few years the link between the two, at least in terms of pricing, has largely broken down. This is due to the increasing exploitation of unconventional gas in the US, which has opened up a new source of supply and put significant pressure on prices - in particular the main North American pricing benchmark Henry Hub. The development of liquefied natural gas (LNG) has also made it easier to transport gas and made an increasing number of gas developments commercially viable. Coal, the fossil fuel which facilitated the industrial revolution, remains an important contributor to the global energy mix. Despite significant environmental concerns, around 40% of the world’s electricity is generated by burning thermal coal. Asia is by far the biggest market and accounts for around 60% of global consumption. Unlike oil the future supply of coal is not a pressing issue with enough to meet current demand for several more centuries. Uranium, used to produce nuclear power, is also relatively abundant. A study from the International Atomic Energy Agency suggests there is enough of the metal to meet projected demand for at least the next 85 years. In any case plans for the expansion of nuclear power were either put on hold or abandoned in a number of countries in the wake of the devastating Japanese earthquake in February 2011 which caused a meltdown at the Fukushima nuclear plant.   Heavy metal The industrial metals complex is made up of aluminium, copper, lead, nickel, tin and zinc. These six metals are traded on several exchanges around the world but the benchmark contracts are listed on the London Metal Exchange (LME). Volume on the LME is dominated by the aluminium, copper and zinc contracts, which combined represent around 85% of total turnover. The annual production of aluminium, which reached 40.7 million tonnes in 2010, exceeds the output of all other industrial and precious metals combined, with the exception of steel. Around 50% of global output of the lightweight metal is used in construction and the manufacture of transportation equipment. High costs of production dictate that recovery from scrap is a major component of the aluminium industry. Copper is often seen as a good barometer of the health of the global economy, earning it the sobriquet ‘Dr Copper’. This is largely due to its ubiquity. The metal is a critical component in the manufacturing of electronics, homes and infrastructure. In 2010 China imported 39% of the globe’s refined copper. The main producer of the metal is Chile, accounting for more than 40% of the world’s exports. While copper is relatively abundant much of it cannot be extracted profitably using existing technologies and, as a result, the world faces a supply deficit. Supply pressures are less acute in the zinc market. More than half of the world’s annual zinc output is used to galvanise other metals in order to prevent corrosion and there are a number of alternatives capable of doing the same job. By definition precious metals are rare and have high economic value. The platinum group metals (PGM), which includes platinum as well as palladium, iridium and rhodium, do have industrial uses – principally in the construction of emissions limiting technology in cars. Silver is widely used by the electronics industry but like gold (see breakout below), which has limited industrial applications, a significant proportion of global output is used in the manufacture of jewellery.   Cream of the crop Both gold and silver are traditional ‘safe haven’ assets though anyone favouring a conservative investment approach could also consider gaining exposure to agriculture. This market has defensive qualities as demand for food is relatively inelastic.  Most consumers are likely to prioritise having enough to eat over spending on luxuries such as cars, expensive clothes and holidays. The world has a growing number of mouths to feed and the 2010-2019 World Agriculture Report, prepared jointly by the Organisation for Economic Co-operation and Development (OECD) and the Food and Agriculture Organisation of the United Nations (FAO), estimates a 70% increase in world food production is required by 2050 if global food demand is to be met. The capacity to meet this threshold is finite and under pressure. According to the FAO the world’s  arable land covers an area of around 41.4 million square kilometres out of a total global land mass of 148.9 million square kilometres. Every year more of this precious land is lost to urban sprawl, erosion from industrial activities and desertification. Beyond these long-term drivers, short-term moves in crop prices are dictated by factors such as changes in the weather and the planting decisions of farmers.   Taking action Assuming this run down of the major commodity classes is sparking some interest and you are thinking of researching your own investment ideas, we can now consider how to put theory into practice. There are a number of options available but the most accessible direct exposure can be gained by buying an exchange-traded commodity (ETC). In the past investing directly in commodity markets was left almost entirely to the professionals. They alone had the necessary time and resources to play the futures market and closely track their investments to ensure they were not forced to take physical delivery of the underlying commodity. The development of ETCs, offering exchange-traded exposure to a myriad of different commodities from oil, gold and copper to more esoteric markets such as live cattle and rhodium, has altered this dynamic.   Exchange-traded commodity funds (ETCs) offer exposure to a huge range of markets, including cattle   A specific risk facing an investor in an ETC is the significant impact that the futures market phenomena contango and backwardation can have on returns. This applies particularly to the oil market. Contango refers to the market condition whereby the price of a futures contract in a commodity is trading above] the spot price. The resulting futures ‘curve’ would be upward-sloping with prices for dates further in the future trading at even higher levels. Backwardation describes the reverse, where futures are trading below the spot price. This usually occurs because of short-term tightness in the underlying market, itself normally the result of unexpected disruption to supply. When an ETC rolls contracts (sells them and buys new ones) in order to avoid taking delivery of raw materials, returns are diminished, in the case of contango, or enhanced, in the case of backwardation. The impact of contango is more acute for investors in ETCs because, unlike other passive investors, the providers of these products do not pay a premium every month to cover the cost of the roll and maintain the same position. In effect the ETC is giving up a proportion of its position to cover the cost of the roll. Beyond these technical risks, investing in a single commodity involves putting all of your eggs in one basket and for investors seeking diversified exposure it may be more appropriate to buy an exchange-traded fund (ETF) which tracks a range of commodities. In addition to ETFs, ETCs and other passive instruments such as unit trusts and investment trusts, investors could consider buying a managed fund. Among the most popular and successful of these is Ian Henderson’s JP Morgan Natural Resources fund. While a newcomer to the commodity markets may be more comfortable putting their cash in the hands of a professional it is worth remembering you will pay handsomely for the expertise of the person managing the fund (for more detail see Chapter 8 – The funds option). Investors looking for leveraged exposure could consider trading commodities through covered warrants, contracts for difference (CFDs) or by opening a spread betting account. For further information on these options consult Chapter 13 – Leveraged Instruments.   Investing in companies Another choice available to a prospective investor in crude oil, natural gas, coal, uranium or metals is to buy shares in a company which is engaged in the exploration for and production of these resources. As well as tracking the price of the respective commodities they exploit, the share prices of these miners and oil companies will respond to operational performance. This offers the prospect of greater upside if a company performs well but also risks more significant downside if it encounters setbacks. Firm in the resources sector vary from behemoths like the Anglo-Dutch group Royal Dutch Shell and Aussie miner Rio Tinto to ‘blue sky’ exploration plays such as the Falkland Islands-focused company Rockhopper Exploration. Shell pays a dividend and could be considered a relatively safe investment but Rockhopper, while potentially offering greater reward, comes with a much more significant degree of risk attached as its fortunes could be dictated by the results from a single oil well. In the mid-1800s, during the California gold rush, thousands travelled West with the dream of making it rich. Few of them realised this ambition but those who sold them the picks and shovels made a killing in the meantime. Investors looking for an alternative play on the commodity markets could consider applying this principle in the twenty-first century and buying shares in the companies which provide the services and technology necessary for the effective exploitation of different commodities. These could include drilling contractors, rig construction firms like Dubai-based Lamprell, farm equipment makers such as US giant John Deere and even the UK-listed animal breeding specialist Genus. BHP Billiton's ultimately unsuccessful attempt in 2010 to buy Potash Corp of Saskatchewan also highlighted the importance of phosphates and fertiliser providers as farmers seek to maximise land productivity and keep the world fed.   Copper   Copper is a bellwether for global economic strength. It is therefore understandable why the base metal price has been so volatile amid growing concerns about Eurozone debt, a slowdown in China's economy and a potential renewed recession in the developed world. Yet efforts are being made to bolster economic growth and this means copper looks well underpinned. A fresh dash to $10,000 a tonne cannot be ruled out entirely.   Labour disputes at copper mines in Indonesia and Peru are giving support to the commodity price, amid market fears supplies will suffer disruption. This trend could reappear elsewhere in the world as mining workers seek appropriate remuneration from strong commodity prices.   The industry is already facing tight supplies and there are limited stockpiles, so there is a potential cushion to the copper price. The base metal's valuation will be dictated by the actions of the US and China in the near term. As long as China's growth outlook does not deteriorate significantly, then copper should not fall below its current trading range. Around 40% of copper demand comes from China. Half of this goes into electrical and electronic products and a further quarter into building and construction.   Stockbroker Numis expects the global market to be in deficit this year and stay that way until at least 2015. Production should rise by 5% in 2012 and 2% to 4% a year thereafter, although pressures on miners including higher costs, project delays and labour unrest could pull these figures down.   Silver   Silver is a dual-role asset which can benefit from both investor anxiety and market hopes for economic recovery. In 2010 fabrication demand rose 12.8% year-on-year to reach a ten-year high as global growth improved. Usage in industrial applications such semiconductors, solar panels, water treatment and medical applications in particular helped to power off-take. Meanwhile the grey metal has been boosted by safe-haven investment demand, as a cheap alternative to gold. Investment interest rocketed 563% year-on-year in 2009 as a hedge against risk, and surged a further 47.5% last year.   Prices have struck repeated multi-decade peaks over the past 12 months, although silver trades below the near- $50-an-ounce summit seen in late April, when inflationary and sovereign debt fears – combined with geopolitical unrest in the Middle East and North Africa (Mena) region – bolstered its flight-to-safety appeal.   Novice and experienced commodity investors alike therefore need to remember the silver market can be prone to volatility. Prices collapsed shortly after April's record highs, shedding 24% in the space of a fortnight, as fears a bubble had formed provoked intense profit- taking. The commodity has since steadied to trade around $42.50 per ounce. Further gains appear likely given the prospect of further unorthodox monetary policy in the US, UK, Japan and possibly Switzerland.   Investment in companies focussed solely on primary silver mining facilitates maximum leverage from a solid silver price. With around three-quarters of all silver  output coming as a by-product of other precious and base metals including gold, copper, lead and zinc, exposure to these producers also can come with the added benefit of diversification.   Platinum There is a forecast surplus of platinum in 2011 to the tune of 230,000 ounces. Although this drops to a mere 30,000 ounces next year and a 29,000 ounce deficit in 2013. This year’s surplus could be marked down if the large miners continue to experience supply problems.   Strike threats have given support to the platinum price over the summer as two companies which account for around two-thirds of the world’s platinum production found themselves under pressure to push up wages. Platinum is  trading around $1,840 per ounce (oz)(Oct 2011). It is forecast to average $1,900/oz this year, rising to $2,000/oz in 2012. There are two other key components within the Platinum Group Metals (PGMs)basket, a group of commodities which tend to be mined together. The first is palladium. It trades at $750/oz and is forecast to average $850/oz this year and hit $1,000/oz in 2012. The second is rhodium. It changes hands for $1,850/oz and is forecast to average $2,100 on average this year before rising to $2,500/oz in 2012. Palladium is in market deficit and demand for rhodium is expected to increase following the launch of an ETC on this commodity in May, which trades on the London Stock Exchange as DB Physical Rhodium (XRH0) .   The two main users of platinum are the car and jewellery industries. Chinese vehicle sales are increasing but the rate of growth is slowing. The US automotive industry is relatively stable at the moment with likely gains in truck sales in the second half of 2011. Global auto production is expected to be up by 3% or 4% this year.   Jewellery demand has remained strong and investment in platinum via ETCs has also stayed resilient against a weaker equity market. ‘As long as the supply side continues to struggle, even low global demand growth will be enough to keep the metal prices well supported,’ says RBC Capital Markets. Jewellery purchases in China increased by around 20% in the first half of 2011 compared with the same period in 2010. ETC platinum holdings increased by around 15% over the same period.   Market commentators are more bullish over palladium prices than platinum, because it is more tied into the automotive industry and because Russia’s palladium stockpiles are believed to be running out. Investment bank Natixis reckons platinum would benefit if gold keeps rising in value. A high gold price could encourage more people to consider platinum as a more affordable investment. Natixis also suggests the family of platinum group metals would benefit should the US Federal Reserve implement a third round of quantitative easing (QE-III) as this should boost gold prices and take the other PGMs along for the ride.     This ‘How to’ guide is produced by Shares Magazine and is only for general information and use, and is not intended to address particular requirements. The value of investments and the income derived from them can go down as well as up. Past performance is not necessarily a guide to future performance. You should get professional financial advice before making any investment decisions.

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