Properly assessing commodities risks

In light of the recent falls in silver and oil prices, Ron Bewley considers the case for investing directly in commodities.

Commodity prices drive our dollar, our economy and the performance of our resource stocks. Gold prices recently hit record highs – as did silver – and many other commodity prices have also been booming. But silver and oil prices fell sharply at the beginning of May.

Is this the end of the commodity price cycle? Should investors get in or out of direct exposure to commodities? Should investors keep a weather eye on commodity prices to guide their equity exposure?

It is not just the metals and oil that have had surging prices. Coffee and cotton – and many other prices – have had steep trajectories.

The demand from China and other rapidly developing nations has a lot to do with price inflation. But supply conditions – which might change quickly – and speculation are also in the mix.

Australia is a major exporter of commodities, and the Reserve Bank of Australia (RBA) compiles indexes of the aggregate commodity prices relevant to our exports and they also break the index down into Rural Commodities and Non-rural Commodities indexes with a Base Metals index also being separated out from the latter.

I show these three indexes in figure 1, valued in $US.

The price of base metals – aluminium, copper, lead, zinc and nickel – have been volatile since the 1980s, but they have not yet regained the peak of 2007.

When valued in $A, the recent high falls further short of the 2007 peak, the Non-rural index, which includes the Base Metals as well as coal, iron ore, gold, oil, LNG and alumina, has reached new highs.

The RBA data are monthly and so the impact of the May sell-off cannot yet be shown in figure 1, which ends in April 2011.

Rural commodities had been reasonably flat for nearly 25 years.

The recent surges are causing pain for the people of poorer nations who spend proportionately much more than us on food from their household budgets.

It has been a widely held view by economists since the floating of our dollar in December 1983 that the terms of trade (ie, the ratio of export to import prices) is one of the major determinants of the dollar.

While a high dollar makes our imports cheaper, it has a detrimental impact on tourism, education and other sectors that must compete with imports.

If China, in particular, were to experience a hard landing from its tightening of monetary policy, there would be dramatic consequences for commodity prices and our economy.

While the ‘usual suspects’ are leaning towards the hard landing scenario, mainstream believes a controlled slowing to a sustainable growth path is the most likely outcome.

The China issue – as well as European debt and the growth in the US economy – has convinced some investors to turn to gold as a ‘safe haven’.

The problem with gold is that it has little use other than as a perceived store of value.

It produces no yield (or dividend) and the main reason to buy it is that the investor (or is it speculator?) thinks when the time comes to sell, someone else will be prepared to pay more than they did.

I show gold prices in $US in figure 2.

Clearly anyone who invested in gold in the mid 2000s would have done very well, but those who bought in 1979 or 1980 would have had to wait 25 years to get their money back.

The question this chart raises is whether we are now in a bubble (like in 1980) that will burst. When valued in $A, gold has already fallen from its December 2010 high.

Late in 2010, the surge in gold prices arguably tempted some investors to find a substitute investment that had not run so hard.

Silver prices started to permeate market chatter late in 2010.

Until May 2011, silver prices in figure 3 looked to some like the big bet. The peak in January 1980 was caused by the Hunt brothers trying to corner the global silver market.

What is now a peak in April 2011 is a harsh lesson for those who got on board too late.

A major portion of silver was/is bought ‘on margin’ (ie, only a deposit is paid). On May 1, the CME Group (the biggest derivatives market) increased the margin on silver and its price fell 12 per cent in just 11 minutes.

A few more margin increases and silver had fallen by 28 per cent in a few days.

Oil suffered a similar fate, falling from well above $110 a barrel to under $100 in the same time frame.

The silver story, and apparent greed, can best be seen in figure 4.

For a number of years, silver prices more or less kept pace with gold until the speculation bubble started in earnest in October 2010.

If and when the European debt problems are in hand, and the US seems strong again – and it is getting stronger – what will happen to gold prices?

If the price of gold rose dramatically because of the GFC and some geo-political events, why should the gold price stay high when the problems disappear?

How quickly can the gold price collapse if fear does dissipate? 

Nevertheless, there is increasing enthusiasm for creating products to satiate the demand from would-be commodities investors.

Of course, gold and silver bullion can be bought from the Perth Mint. However, investors should not only consider the cost of storage and insurance, there is the bid-ask spread (buying and selling prices) to contend with.

On May 13, 2011, the price at which the Mint would buy back the precious metal was about 5.2 per cent lower for a one-ounce bar of gold than an investor would buy at on the same day.

The comparable figures are 10 per cent lower for a one-ounce bar of silver and 7.5 per cent lower for a one-ounce gold coin. That is a big factor to account for when considering holding precious metals.

Exchange-traded funds (ETFs) and exchange-traded commodities (ETCs) have proliferated in recent times. While these vehicles allow investors to trade commodities and share indexes on the ASX, there are important differences – just as there are with BHP and RIO.

Since some time in 2010, some ETFs/ETCs were introduced that did not invest directly in the underlying asset. Instead, they use derivatives to gain exposure.

Introducing derivatives into the equation brings counterparty and leverage risk to the table. 

In much the same way that a credit default swap is simply an insurance payment against a company defaulting that the insurer does not necessarily own, the derivatives markets introduces risks that do not exist when the physical asset is owned.

Some blame counterparty risk as the vehicle that magnified the extent of the GFC. 

Another feature of ETFs/ETCs that should always be considered is the fee for service.

This may be as little as a fraction of one percent for an ETF replicating the ASX200 but there are reports of some charging no fees on capital growth but they take half the dividends – if you read the fine print.

The ASX currently lists seven ETCs: three for gold, and one each for silver, platinum, palladium and a basket of metals.

Often only two of these seven vehicles are traded on a given day: gold (ASX code: GOLD) and silver (ASX code: ETPMAG).

Thus, there is extreme liquidity risk for investors following this path for the other five ETCs. ETCs only attempt to follow the underlying prices.

The ASX even highlights the possibility of arbitrage opportunities arising.

There are, of course, futures markets for all of the main commodities but this form of investing is surely beyond the skill-base of most investors.

But even if it was ‘easy’ to invest in commodities, how can investors work out their appropriate exposures to a basket of commodities?

It does not seem reasonable to me for an investor to just pick a couple of commodities because there are ETCs giving exposure to them.

A lot of effort goes into an equity fund manager’s assembly of a stock portfolio and the same can be said of hedge funds that offer commodity-based funds.

Perhaps it is better for an investor to gain exposure to resources by investing in the big resource companies like BHP and RIO.

They are diversified and are constantly looking to manage risk – including currency risk. It is more difficult to gain exposure to the agricultural commodities in this country, but the likes of Incitec Pivot has indirect exposure through it fertiliser business.

But we all remember Incitec Pivot’s spectacular 80 per cent share price fall during the GFC.

As tempting as investing in commodities might seem for some, the risks seem much higher than with the companies that produce them.

Diversification is based on a balance of risks and returns.

So as high might be the expectations for some people for some commodities, a sensible estimate of risk probably means most people should settle for the old standard allocation – as boring as that might seem.

Those who have enough knowledge are probably industry professionals!

Dr Ron Bewley is an investment consultant with Infocus Money Management.