Commodities 101

Commodities have become a popular topic of discussion as a way to potentially hedge inflation.  What does investing in commodities actually look like?



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Investments involve the risk of loss. Diversification does not eliminate the risk of experiencing investment loss.  Commodity trading is highly speculative and involves a high degree of risk. Commodities and futures generally are volatile and are not suitable for all investors. 

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Transcript

Welcome to the Real Spiel with Ryan and Kurt.  This is Ryan Katz with USCF Investments. And this is Kurt Nelson with SummerHaven. 

KATZ:  Let’s talk about commodities 101.  We hear about commodities all the time as an asset class and as a way to potentially hedge inflation.  But what does investing in commodities actually mean and how do they differ from traditional asset classes?   

 NELSON:   These are good questions Ryan.  I really wanted to use this opportunity to take us not only back to basics but what does it mean if you are going to invest in commodities.  Commodities are not new.  They have been around for thousands of years in the global economy.  Even as futures markets, they have been around for roughly 400-500 years.  Starting in Japan when rice was essentially a currency and used as a matter of payment between feudal lords and lay people in Japan.  And they created a futures exchange with standardized contract specifications, delivery, expiration and they even had an exchange called the Dojima rice exchange which probably set up the stage for the CME and the ICE and all the exchanges that we know today.  I think investing in commodities is confusing and I think many people wonder like where do you store the cows or where do you store the corn.  That’s not what we do.  When we are investing into commodities what we are really doing is investing into commodity futures.   And so, for an investor what that means is we are trading in an instrument on an exchange, a regulated exchange with daily trading volume, price discoveries, settlement prices that are official and there is a well-worn process but there is confusion among investors about what that actually means.  

 KATZ:  Right.  And speaking about commodity futures, do you feel like that is critical for commodities exposure – I mean you can also invest in commodity equities so don’t you have your bases covered with commodity equities?  What are the differences between the two? 

 NELSON:   That’s a question we get a lot.  Which is like “I’m an RIA or I’m an advisor and I own ETFs and I own equities and I own bonds but why do I have to own commodities?”  How is that different?  I think commodity futures are unique because when you think about futures that trade in financial assets – currency futures, index futures on equities, interest rate futures, these are all arbitrage-able.  The commodity futures are actually a mechanism for hedgers to transfer price risk to the speculator.  I think of them as price insurance marketplaces.  And I think it’s a big driver of the long-term risk premium or compensation that investors get in commodity markets.  So, if you invest in corn for example, and you buy corn futures, there’s very possibly a farmer who is on the other side of that who is selling his future production and trying to lock in a price.  For you to come to that market, you could take your capital and you could invest into stocks or bonds or real estate or hedge funds or other things.  For you to be brought into the commodity markets and use your risk capital to ensure the farmer from their corn price risk you need to do two things.  You need to understand you are going to wear the beta risk of corn prices over the next two, three, five months.  But second of all, you have to be enticed to the market, so you are going to be able to come into a natural discount and we think that is one of the real sources of risk premium.  Why is it as compensation from hedgers to speculators when you go long commodity futures.  I mentioned these are not arbitrage-able and what I mean by that is if you were trading Japanese yen/US dollar futures, you could buy yen in the cash market you could sell yen in the cash market.  You could do the same thing with US dollars.  And if the kind of futures arbitrage of futures prices to interest rates and cash exchange prices deviated you would be able to take advantage of that and they correct very quickly.  There isn’t an arbitrage mechanism in commodities markets.  So, there is actual real price/risk transfer to a speculator.  What I mean by that is if you thought that futures were expensive and said I’m going to sell a future and buy corn cash and run a long/short.  Well, how do you but cash corn?  What are you going to do, buy a silo?  Buy a farm?  And if you flip it the other way and say if futures look cheap and so what you want to do is buy the future but short cash corn, you can’t really borrow and short sell corn.  So, what happens when you are a speculator in commodities markets, and this is true for any of these physical markets, whether its corn, wheat, soy beans, copper, gold, etc. the speculator is taking a position where they will wear the price risk for a period of time.  The duration of the futures contract – 2 months, 3 months, 5 months, whatever it is.  To entice that speculator, speculative capital to the market you need to come in at a slight discount to go long.  Now I think that discount can vary over time, and we will talk on another podcase about backwardation, contango, scarcity and what can make that bigger or smaller.  But you also, in addition to getting that sort of discounted long price, you are also wearing the risk of the commodity which is volatile. And so, one of the best ways to mitigate that is through diversification.  So rather than just taking a position in corn, or copper, or gold, you can take a position in a bunch of commodities where you trade more than twenty commodities markets and by taking small positions in a number of different markets it allows you to diversify your risk.  And because corn tends to be uncorrelated with cocoa, which is uncorrelated with copper, which is uncorrelated with other commodities.  So, by spreading your bets across a number of markets it allows you to mitigate that spot price risk and still collect that insurance premium.  

 KATZ:  And increase your correlation to inflation as well.  

 NELSON:  Yes.

 KATZ:  So just an add on to that question, how would these commodity futures investments differ from commodity equities?  

 NELSON:  Yeah, so I didn’t really answer that question.  The reality is we think commodity equity investments are interesting, but we think they are exactly what their name says.  They are sort of half commodities half equities.  So, an illustration would be if you were to buy British petroleum rather than buying an energy commodity you might say well, I’m in the energy exploration and extraction market.  I’m more comfortable buying an equity than trading an actual organic commodity on the futures market.  The problem is you are thinking that you are buying an energy product but in essence what you are doing is buying an actual enterprise that is running equipment and has labor costs and insurance cost and everything else.   What we saw a decade ago is that rather than getting exposure to energy markets what you got was an energy spill.  And BP prices fell by 50% in a very short period of time when energy markets were otherwise stable.  I think we see the same thing in mining companies.  A lot of investors have traded precious metals, gold mining stocks or other industrial metals mining companies but what you are doing is getting exposure to the base metal, base commodity, but you are also taking on enterprise risk of those companies that are profit generating enterprises.  So, if I was operating a mining company one of the natural things, I might do is hedge my risk.  So, if I’m extracting for example copper from the earth, and I have a forecast for the amount of ore that I’m going to extract and refine and sell it might be very prudent for me to go into the futures market and actually sell that production forward and lock in that price.  So, I can manage my cash flows, manage my cost structure.  But if you are buying a mining company which is hedging the core price risk of that underlying commodity you are getting a lot of noise in the system.   You are not getting a pure play on the underlying commodity.  So I think that in that way commodities are one of the most diversified commodities through the futures markets or one of the most clean ways to play the asset class without bringing in the other extraneous noise.  

 KATZ:  Great.  So that’s something for us to think about as to we are investing in commodity equities but a lot of that price exposure on what you are actually trying to do when you are investing in commodities of hedging inflation has already been somewhat – that the price risk has been sold off in the futures markets already, so you are taking the other side of that trade.  

 NELSON:  Well, it could be but you just don’t know.  Because a lot of gold mining companies have chosen not to hedge because they know that people are investing into their company to get gold exposure.  But they can. So, if you are a mining company, agricultural company, energy company, you may be selling production forward, you don’t know as an investor.  I think the futures markets are much more straightforward in that regard. You are not taking on the operating enterprise risk.  Companies have to deal with labor costs, input costs, cost of production, hedging price volatility – all of those things can impact your investment and that’s why I think commodity equity investments tend to be kind of commodities but kind of equities.  Whereas a commodities futures investment is a pure play on the underlying asset.  

 KATZ:  Absolutely.  This has been the Real Spiel with Ryan and Kurt.  We will talk to you next week.