What You Should Know About Investing In Commodities
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What You Should Know About Investing In Commodities

Recent strong performance has attracted a lot of neophytes. They may have much to learn.

By Simon Constable
Thu, Mar 10, 2022 3:51pmGrey Clock 5 min

After years in the investing wilderness, commodities are hot again. And it looks as if the rally may continue for at least the foreseeable future, some analysts say.

The speed of the rally has been striking. The Refinitiv/CoreCommodity CRB Index, which tracks a basket of commodities selected to represent prices of futures contracts across the whole sector, doubled from April 2020 through mid-February.

That performance follows a yearslong period when the index trended lower. And the surge is now attracting investors of all types—from veterans to neophytes.

The latter would do well to understand some of the basics in how commodity investing works. Commodities typically get grouped into three broad buckets: energy, foodstuffs and materials. Each has endemic risks, including weather, local and geopolitics.

Each also offers the possibility of direct investment, in the commodities themselves, or indirect investment, through vehicles such as mutual funds and exchange-traded funds. For the relatively inexperienced, direct investing in commodities can be particularly challenging, in part because of additional costs and risks generally not found in other types of investing. We’ll get to those details in a moment.

What follows is a look at some of the basics of commodity investing.

Complicated economics

The price of each commodity gets determined by the supply and demand dynamics for that item. For instance, last year bad weather in Brazil hurt the coffee crop and pushed up the cost of beans. Likewise, an attack on an oil-refining plant in the Middle East will tend to disrupt supplies and spark an energy-market rally.

Commodity markets are global. What happens in one country can have an impact on commodity prices world-wide. Therefore, all commodity investors should keep an eye on what’s happening not just in the U.S. but around the world.

While even just the risk of war can send prices higher for commodities, particularly those that originate in the countries directly involved, actual invasion tends to send those prices even higher. That is exactly what happened with the conflict between Ukraine and Russia as both countries are leading exporters of foodstuffs. Although the invasion began on Feb. 24, prices were rising long before. A bushel of wheat is fetching $13.48, up 77% from $7.61 at the beginning of February on fears that global supplies would be disrupted. Likewise, corn prices have rallied 21% over the same period. Such surges added to those already happening in the commodity markets. Even before the war, unfavourable weather- and pandemic-related disruptions across the world were reducing supplies and sending prices higher when production couldn’t keep up with demand.

Sometimes a price change in one commodity causes the cost of another one to move as well. One typical example is in livestock farming. Farmers sometimes switch from feeding hogs or cattle with costly grain to less-pricey alternatives. They might decide to buy corn from arable farmers instead of wheat or vice versa depending on the relative prices. In turn, those prices change to reflect the new demand for each product. This phenomenon shouldn’t be too surprising. Imagine if the cost of aged blue Stilton increases at the supermarket; at least some people will likely switch to a less-expensive cheese.

Price swings

Unlike commodity traders and other professionals whose direct positions in oil or grain might change from second to second, average investors in commodities will have longer time frames in mind for their commodity-related holdings. But a simple buy-and-hold strategy here won’t help you accumulate wealth as it would in the stock market.

Commodity prices can frequently trend lower for decades. New technologies, such as better farming techniques or methods of mineral extraction, have allowed supplies to increase over time, depressing prices.

For instance, oil hit a record high of around $147 a barrel in 2008 versus the current price of $115.68. Likewise, Arabica coffee prices peaked at $3.35 a pound in 1977 versus $2.24 now. When these prices get adjusted for inflation, the declines look starker.

Thus, even for individual investors in commodity-related investments, timing in these markets can be critical. Whether you think of your investment as short term or long term, investors need to pay attention to buy at the right moment and sell at an auspicious one. Lean-hog prices tripled from 37 cents a pound in April 2020 to $1.20 in June 2021 before collapsing to 72 cents in October. Anyone not ready for such swings will be in for a shock and an emotional roller coaster.

Adding commodities to a larger balanced portfolio can also help reduce risks as commodity prices tend to have low correlation to other assets such as stocks and bonds. That means when the S&P 500 falls, commodity prices may go up, or down, or not move at all.

One more advantage to investing directly in commodities rather than commodity companies is that a layer of risk is removed. When investing in stock there is always the possibility that management may make mistakes even when the underlying sector economics are favorable.

The futures market

Commodity investors typically don’t operate in the cash market, meaning they don’t purchase physical materials such as metals, oil, or foodstuffs. Instead, traders mostly buy or sell futures contracts in the hope of benefiting from the increase or decrease in prices. These contracts are legally binding agreements to buy or sell a specific volume of a commodity on a specific date in the future.

Ultimately, the prices in the futures market and those in the cash market will tend to converge. That’s why commodity producers and consumers use futures to hedge the risks of market price movements.

 

 

No dividends

Most stocks pay dividends to investors, meaning you can make money even if the share prices don’t move. Pretty much the opposite is true for commodity investors. It costs money to own commodities. For example, a buyer of 100 ounces of gold bullion will need to cover the costs of storage and insurance for the metal. While such expenses can be low for precious metals, they can stack up faster for crude oil and grains such as wheat and corn as more extensive facilities are needed to hold the stuff.

Mutual funds & ETFs

For fund investors, there are many choices. More than 150 mutual funds and ETFs cover the sector. Unfortunately, that means much due diligence is required. In short, it’s essential to understand what the fund owns and what its strategy is.

Just as with stocks, there are both passive funds (those that track a benchmark index) and active ones (those that follow a discretionary investing strategy).

In the passive category, some track the price of single commodities, such as SPDR Gold Shares ETF (GLD) and Invesco DB Gold Fund (DGL), which track slightly different benchmarks. Likewise, there is an ETF for wheat, Teucrium Wheat (WEAT). There are also passive funds that are designed to track groups of commodities, such as Invesco DB Base Metals (DBB), or the whole sector, such as iShares S&P GSCI Commodity-Indexed Trust (GSG).

Actively managed funds, such as the active ETF First Trust Global Tactical Commodity Strategy Fund (FTGC), make decisions on what commodities to buy or sell.

A warning on leveraged funds

There are a couple of wrinkles to watch out for with all types of funds. First, average investors should avoid any fund that uses leverage to enhance performance. Such funds often promise to deliver two or three times the performance of a given commodity. While that means such funds can deliver multiplied profits, they also magnify losses.

Other funds claim that they’ll mimic an inverse performance so that if a commodity’s price falls, the fund will increase in value by a similar amount. This isn’t the same as a hedge against losses unless the trade is made specifically to diversify risk within a larger portfolio. Another problem with these funds is that there can be significant tracking errors. These funds are best left to sophisticated investors.

It’s also worth being cautious about exchange-traded notes, or ETNs. This type of investment can expose investors to the risk that the fund company goes bust. ETFs and mutual funds protect investors against such events.

As with all investing, investors should find funds with low expense ratios. Annual fund expenses mainly range from 0.5% to 1%. Leveraged funds tend to have expenses of 1% and more. These compare with costs of 0.09% for SPDR S&P 500 ETF, which tracks the S&P 500.

Riches and rags

Investing guru Jim Rogers famously made a boatload of money during the 1970s investing in the commodity markets while material prices and food costs jumped. And there will likely be other people who do similarly again.

However, even the most sophisticated investors sometimes come unstuck, such as the Hunt brothers. In 1980 they accumulated major positions in the silver futures market using borrowed money. But a change in exchange rules led to a price drop, and quickly the brothers couldn’t cover their obligations. In other words, be careful in the commodity markets.



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Cocoa and Coffee Prices Have Surged. Climate Change Will Only Take Them Higher.

Some chocolatiers and coffee makers say they will have to pass on the extra cost to consumers

By JOSEPH HOPPE
Sat, Apr 13, 2024 5 min

Global prices for cocoa and coffee are surging as severe weather events hamper production in key regions, raising questions from farm to table over the long-term damage climate change could have on soft commodities.

Cultivating cocoa and coffee requires very specific temperature, water and soil conditions. Now, more frequent heat waves, heavy rainfalls and droughts are damaging harvests and crippling supplies amid ever growing demand from customers worldwide.

“Adverse weather conditions, mostly in the Southern Hemisphere, have played an important role in sending several food commodities sharply higher,” said Ole Hansen , head of commodity strategy at Saxo Bank.

The spikes in prices are a threat to coffee and chocolate makers across the globe.

Swiss consumer-goods giant Nestlé was able to pass only a fraction of the cocoa price increase to customers last year, and it may need to adjust pricing in the future due to persistently high prices, a spokesperson said.

Italian coffee maker Lavazza reported revenue of more than $3 billion for last year, but said profitability was hit by soaring coffee bean prices, particularly for green and Robusta coffee, and its decision to limit price increases.

Likewise, chocolatier Chocoladefabriken Lindt & Spruengli said in its 2023 results that weather and climate conditions played a major role in the global shortage of cocoa beans that led to historically high prices. The company had to lift the sales prices of its products and said it would need to further raise them this year and next if cocoa prices remain at current levels.

Hershey ’s chief executive, Michele Buck , said in February that historic cocoa prices are expected to limit earnings growth this year, and that the company plans to use “every tool in its toolbox,” including price hikes, to manage the impact on business.

In West Africa, where about 70% of global cocoa is produced, powerhouses Ivory Coast and Ghana are facing catastrophic harvests this season as El Niño—the pattern of above-average sea surface temperatures—led to unseasonal heavy rainfalls followed by strong heat waves.

Extreme heat has weakened cocoa trees already damaged from heavy rainfall at the end of last year, according to Morningstar DBRS’s Aarti Magan and Moritz Steinbauer. The rain also worsened road conditions, disrupting cocoa bean deliveries to export ports.

The International Cocoa Organization—a global body composed of cocoa producing and consuming member countries—said in its latest monthly report that it expects the global supply deficit to widen to 374,000 metric tons in the 2023-24 season, from 74,000 tons last season. Global cocoa supply is anticipated to decline by almost 11% to 4.449 million tons when compared with 2022-23.

“Significant declines in production are expected from the top producing countries as they are envisaged to feel the detrimental effect of unfavorable weather conditions and diseases,” the organization said.

While the effects of climate change are severe, other serious structural issues are also hitting West African cocoa production in the short- to medium-term. Illegal mining poses a significant threat to cocoa farms in Ghana, destroying arable land and poisoning water supplies, and the problem is becoming increasingly relevant in the Ivory Coast, according to BMI.

The issues are being magnified by deforestation carried out to increase cocoa production. Since 1950, Ivory Coast has lost around 90% of its forests, while Ghana has lost around 65% over the same period. This has driven farmers to areas less suited to cocoa cultivation like grasslands, increasing the amount of labor required and bringing further downside risks to the harvest, the research firm said.

The Ivory Coast’s cocoa mid-crop harvest—which officially starts in April and runs until September—is expected to fall to 400,000-500,000 tons from 600,000-620,000 tons last year, with weather expected to play a crucial role in shaping the market balance for the season, ING analysts said, citing estimates from the country’s cocoa regulator. Ghana’s cocoa board also forecasts a slump in the harvest for this season to as low as 422,500 tons, the poorest in more than 20 years, according to BMI.

Neither regulator responded to a request for comment.

Meanwhile, extreme droughts in Southeast Asia—particularly in Vietnam and Indonesia—are resulting in lower coffee bean harvests, hurting producers’ output and global exports. Coffee inventories have recovered somewhat in recent weeks but remain low in recent historical terms. Robusta coffee has seen a severe deterioration in export expectations, while Arabica coffee is expected to return to a relatively narrow surplus this year, said Charles Hart, senior commodities analyst at BMI.

The global coffee benchmark prices, London Robusta futures, are up by 15% on-month to $3,825 a ton. Arabica coffee prices have also surged 17% over the last month to $2.16 a pound in lockstep with Robusta—its highest level since October 2022. Cocoa prices have more than tripled on-year over these supply crunch fears, and risen 49% in the last month alone to $10,050 a ton.

“Cocoa trees are particularly sensitive to weather and require very specific conditions to grow, this means that cocoa prices are especially vulnerable to extreme weather events, such as drought and periods of intense heat, as well as the longer-term impact of climate change,” said Lucrezia Cogliati, associate commodities analyst at BMI.

Cogliati said global cocoa consumption is expected to outpace production for the third consecutive season, with intense seasonal West African winds and plant diseases contributing to significant declines.

Consumers hoping for a return to cheaper prices for life’s little luxuries in the midterm may also be in for a bitter surprise.

“There is no sugarcoating it—consumers will ultimately be faced with higher chocolate prices, products that contain less chocolate, and/or shrinking product sizes,” Morningstar’s Magan and Steinbauer said in a report.

“We anticipate consumers could respond by searching widely for promotional discounts, trading down to value-based chocolate and confectionary products from premium products, switching to private-label from branded products and/or reducing volumes altogether.”

The record-breaking rally for cocoa and coffee is likely more than just a flash in the pan, according to Citi analysts, as adverse weather conditions and strong demand trends are likely to support prices in the months ahead. The U.S. bank estimates Arabica coffee futures in a range of $1.88-$2.15 a pound for the current year, but said projections could be lifted if the outlook for 2024-25 tightens further.

At the heart of it all, climate change is set to play a major role, as the impact of extreme weather events could exacerbate the pressure on cocoa and coffee supplies, according to market watchers.

“I don’t expect prices to remain at these levels, but if we continue to see more unusual weather as a result of global warming then we certainly could see more volatility in terms of cocoa yields going forward, which could impact pricing,” said Paul Joules, commodities analyst at Rabobank.

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