ItÆs hard to see why. For several years, pundits, such as the commodity market guru Jim Rogers, have been spelling out the case for buying precious metals as a store of value against a debased US dollar; for base metals because of ChinaÆs march towards industrialisation; and, for at least the past two years, soft commodities because of supply blockages and a secular shift in demand patterns.
Recent price movements and dramatic newspaper headlines certainly seem to have vindicated the commodity bulls. During the last three months, the agricultural staples of wheat, corn, soybeans, rice and oats have hit all-time highs. In the past year, the price of rice has risen by 118%, wheat by 95%, soybeans by 88%, corn by 66% and cotton and oats by just under 50%.
On the supply side, the investment argument was that after the green revolution in the 1970s and 1980s, agricultural productivity has made modest gains, while rapid urbanisation and the use of arable land for biofuel crops has reduced the amount of land for food crops. Also there have been recent supply shocks û pork in China and rice in Vietnam, both as a result of disease and the longer term decline of the Australian wheat and rice harvests during six years of drought.
Investment rationale and causation are also congruent on the demand side. Newly wealthy urbanites in the emerging world have shifted to a more high protein diet, which has meant greater demand for meat and dairy products, placing more pressure on cereal production because feeding humans via animals is a lot less efficient û seven kilos of grain is needed to produce one kilo of beef, for example. The impact on prices is more immediate for chicken because chickens have a short life-cycle, but consumers can expect higher beef prices because many farmers thinned their herds by slaughtering their cattle early rather than to pay the higher feed costs last year.
There are other factors driving prices higher too. It is important to view the rise in commodity prices with ôcurrency lensesö, says John Reeve, a senior member of UBSÆs agricultural commodities marketing team for Asia Pacific, pointing out that the decline in the US dollar has had a significant impact on nominal prices.
The Brazilian real has doubled against the greenback in the last two years, affecting soybean prices, and the Thai baht has appreciated by 30%, which has had an impact on sugar prices. The strong oil price has raised transportation costs and, perhaps more significantly, the cost of fertilisers. The price of diammonium phosphate, a key input for growing several agricultural products, has increased six-fold in the past six years, with most of that rise happening in the past nine months.
Let them eat cake
But why this explosion in agricultural commodity prices now? It is suddenly attracting headline news, prompting panic buying and incentives for hoarding in countries that can least afford either. ItÆs almost too easy to blame the fallout from the subprime crisis and the usual bogeymen of hedge funds, institutional investors and their fee-earning facilitators, the investment banks, but equally hard to avoid. Investors have scurried away from credit markets, while concerns about a world economic slowdown precipitated by a US recession have taken the shine off equity markets. As Amanda Lee, commodities analyst with Deutsche Bank points out, commodities returned 24.3% up to April 18, compared with 1.3% for bonds and -4.6% for equities.
ôCommodity prices have a near zero to negative correlation to the traditional asset classes of equities and bonds and hence can help significantly reduce the risk of an investment portfolio,ö said Matthew Wong, ABN AMROÆs head of private investor products in Asia, at the launch of his bankÆs new structured investment notes linked to the Rogers International Commodity Enhanced Indices in April.
But, of course, there needs to be a compelling underlying story for this huge re-allocation of assets to take place. And there is, but it is hardly new. It had been prepared by Rogers and others for the past two, or even five, years. At the beginning of the decade, passive investment in commodity indices amounted to about $2 billion notional; now it is between $160 billion and $180 billion. Yet, even this number understates the level of investment because many transactions take place over-the-counter and so are unreported. Pimco, one of the worldÆs largest fund managers, recently disclosed that it had allocated $16 billion to commodities.
This all suggests a major shift away from treating commodities as a small component of a portfolioÆs overall allocation to alternative assets, which itself traditionally makes up only 5% of a fundÆs total investments. UBS, for example, is currently advising institutional investors to make a 12% allocation to commodities, while a major US investment bank has suggested 20%.
Trading volumes on futures exchanges have also grown markedly, with the Futures Industry Association reporting a 28% increase in written contracts in 2007 from the year before. A head of Asia-Pacific commodities at one investment bank notes that so far this year, his nine-man agricultural commodities team has handled three to four times as many soft commodity transactions as in the whole of 2007. Market turbulence has alarmed the US Commodity Futures Trading Commission, which is concerned that the integrity of the Chicago Mercantile Exchange and its subsidiary, the Chicago Board of Trade (CBOT) û the benchmark for world grain prices and hedging for more than a century - might be damaged by speculative money pouring into the market.
Several US agricultural exchanges have already increased (cash) margin requirements on futures trading for wheat, while the CBOT have raised them for corn, soybean and soy oil futures in an attempt to curb market volatility. As David Wyss, chief economist at Standard & PoorÆs, pointed out in a recent paper there is, ôa deep suspicionàthat itÆs not the traditional commercial end-users [farmers, food manufacturers and retailers] of commodity futures contracts, options and other derivatives that are pushing prices higherö.
They have been joined by hedge funds and other large investors pursuing better returns than other more conventional financial instruments. And according to a Bloomberg report in April, traditional commodity index funds now control around 50% of the futures markets.
New structures
But the returns from traditional passive commodity funds have often been damaged by the high premiums paid when rolling over futures contracts. For example, between January 2005 and March 2008, the benchmark S&P Goldman Sachs Commodity Total Return Index only captured half of the commodity bull-run in the spot market due to those high roll-over costs.
Many banks have subsequently devised funds or notes deploying quantitative models that signal when to switch into a more distant contract and into which particular contract one should switch to avoid this problem. In April, for instance, ABN AMRO launched the aforementioned investment products in Asia linked to the Rogers International Commodity Enhanced Indices to allow retail investors to tap into the high growth potential of commodities. The first batch will be linked to the main RICI Enhanced Index and its agriculture sub-index (made up of 21 agricultural commodities, including wheat, corn and cotton) and already a series of structured notes is available for rich people in key Asian countries. Two exchange-traded certificates were listed on the Singapore Stock Exchange on April 11, and certificates linked to the RICI Enhanced Agriculture sub-index were launched on the Hong Kong exchange at the beginning of May.
The original RICI indices were created back in 1998 by Jim Rogers, former Quantum Fund colleague of George Soros, and self-styled ôinvestment bikerö. Between July 31, 1998, and April 1, 2008, the RICI Total Return Index delivered a 380.2% return, yet based on back-tested results, ABN AMRO claims that its enhanced version, comprising 37 listed commodities across energy, agriculture and metals, made an even more staggering 479.5% gain during the same period.
Samuel Ng, head of Asian product development, private investor products at ABN AMRO, estimates that commodity-linked structures made up between 5% and 10% of his business last year, with equity-linked products still attracting the biggest interest. This year, itÆs different. Commodity structures account for more than half of the products heÆs sold, as Asian private clients, hungry to join the food investment queue, have snapped up more than $500 million worth of commodity products since October. The well-established Schroder Agricultural Commodity Fund had an asset value of between $1.3 billion and $1.5 billion in October, but by February it had grown to $6.4 billion, with only 30% of that increase due to the higher value of its investments.
Of course, most leading banks are offering products to tap into this glut of demand. Lehman Brothers, for instance, markets a gimmicky ôbreakfast basketö of cereals, and recently a ôlunch basketö offering exposure to rice, pork and chicken. The four key investable soft commodities are sugar, soybean, corn and wheat, says Stuart Fox, head of Asian-Pacific commodities for UBS. So, what will be the next commodity to enjoy a bull run? Livestock, says Reeve at UBS. First hogs, then live cattle because there will be a shortage of both.
Ng, who has been marketing commodity products since 2004, reckons the bull story has further to go as investors, following a rather circular logic, buy commodities as a natural hedge against inflation. This year ôthere has been a staggering amount of demand from customers specifically for agricultural commoditiesö, enthuses Fox. High-net-worth-individuals, attracted by news headlines, want them for the potential of big returns, while passive investors seek diversification.
But as Martin Bertsch, head of capital markets structuring for Asia ex-Japan at Lehman Brothers, points out, the size of the commodity-linked structured product market is not big enough to have a significant impact on spot or futures prices. ôThe drivers are institutional and hedge fund investors,ö he says, and their presence is felt in the major commodity indices and through direct purchases of futures contracts.
And they are likely to continue buying. Despite the dramatic recent price hikes in agricultural commodities, they are still well below their all-time highs in real or inflation-adjusted terms, reached during the 1970s, a decade of stagflation throughout most of the world. But if speculators and investment funds continue to get rich on higher food prices while empty stomachs rumble, then this, even more than the collapse of housing markets and credit, might force regulators to control the allocation of capital.
This article was first published in the May issue of FinanceAsia magazine.
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