With some experts asking whether we are witnessing a commodities bubble, Emma Oakman examines the factors driving commodities markets, including the recent surge in institutional demand
Isaac Newton famously discovered that what goes up must come down. After hitting a record high of US$146 per barrel in mid-July, the subsequent sharp correction in crude oil prices raised concerns the old adage was as true for commodity markets as for apples.
Commodities have certainly enjoyed a strong bull run with the price of crude up over 300% in five years, a performance few other asset classes could rival. Unsurprisingly, their success has attracted pension schemes' attention.
In the search for diversification, appetite for this asset class has continued to grow, with schemes making increasingly meaningful allocations, particularly as equity markets have foundered: Switzerland's CHF37bn AHV Ausgleichsfonds invested 5% of its assets (CHF1.85bn/$1.75bn) in commodities last year; Progress, Unilever's €4bn Dutch pension fund, said it was on target to double its commodities allocation to 4% of assets, approximately €160m ($2.5m), by the end of 2008; and the UK's Royal County of Berkshire Pension Fund recently said it was considering a £150m ($296m) investment, 10% of total assets.
"These kinds of inflation-linked assets are particularly useful to pension funds since obligations to our members can increase as inflation increases," said Clark McKinley at CalPERS, which has allocated $1.4bn to commodities since March 2007. "This is a long term programme aimed at diversifying our portfolio and giving us a hedge against inflation that doesn't move in tandem with the stock market."
Some experts, however, believed commodities would follow stock markets south. Alasdair Macdonald, senior investment consultant with Watson Wyatt said: "Commodities have been perfectly consistent with historical cycles where they lagged a fall in equity prices. As equity markets fell, commodity prices continued to rise for a while, but as the economic growth slowed, they corrected substantially.
"At $146 a barrel, airlines start shutting down, Americans start buying smaller cars and there is a huge impact on demand."
Strong parallels to the end of the 1970s commodities bull cycle existed, according to Andrew Marks, vice president at T. Rowe Price: the US was at war; the general bull market ended; and an energy crisis pushed oil to record highs creating inflationary pressures.
"However," he said, "it is not the simple black-and-white long commodities/short equities trade-off that made sense in the 1970s.
"Equity multiples are much more reasonable compared to the peak of the 1972 bull market and Central Bank policy has been much more attuned to combating inflation. The Federal Reserve stayed behind the inflationary curve in the 1970s by keeping real interest rates at zero or negative, which perpetuated inflationary problems and prolonged the bear market."
Marks also pointed to a key factor driving commodity price rises: increasing emerging market wealth. "Asia is currently going through a one-time industrial revolution making this cycle fundamentally different from the 1970s."
The strength of Chinese and emerging market demand meant commodity prices would continue to outperform, according to Nicholas Brooks, ETF Securities' head of research and investment strategy. "China has reached critical mass as a major force for commodity demand, which has created a snowball effect for continuous growth."
China, now the largest importer of a large range of commodities, would be affected at the margins by a Western slowdown, but, Brooks said: "Growth is unlikely to drop below 7% to 9% and China sustained steady growth in previous slowdowns. They have huge infrastructure spending plans and a high savings rate, particularly among corporates. Consumption is not credit based, which means more demand for basic items. Consumption and investment will therefore remain strong despite a slowing export environment."
Supply constraints also underpinned high prices and were not easily corrected. "There has been significant underinvestment in the commodities area as prices were so low until a few years ago," Brooks said. "It takes a long time to convert new investment into real supply, so we are still in an environment where demand is strong and increased supply is not coming through."
Investment levels were expected to rise as companies had been justifying capital expenditure budgets on oil prices of between $55 and $85 per barrel. Jonathan Waghorn, co-portfolio manager of the Investec Global Energy Fund, said: "With the July spot price around $135, we expect to see further capital expenditure increases going forward."
The real question, T. Rowe Price's Marks believed, was the extent to which emerging market demand was off-setting a slowdown in the West. "The supply/demand imbalance caused by the Asian industrial revolution will perpetuate a long term cycle for commodities."
"However," he added, "it is fair to say the widespread deterioration of the world economy will increase pressure in the near term and investors should expect some volatility."
Alternative energy and water
High prices and limited supplies of natural resources have fuelled a boom in alternative energy. "It is a physical fact that oil supplies are finite," Macdonald stated. "The world is having to look for substitutes."
"Nothing draws attention to the need for alternative energy faster than oil breaking $100 a barrel," Brooks added. "We have seen a really significant mindset shift over the last year. Few investors used to put their money where their mouths were, but there is no question that [pension] schemes are becoming much more interested in this area now."
He pointed to biofuels as evidence of the growing importance of alternative energy. "Increased ethanol demand has had a significant impact on corn prices as a third of corn is now going to ethanol production," he said, adding: "More corn also means less soy and wheat, pushing their prices up too."
This has also linked natural resources and agriculture. "Usually, the correlation between hard and soft commodities was quite low," he said, "but recently it has been increasing."
The focus on natural resources has drawn investors in new directions.
Water, in particular, has attracted growing attention, according to Eric Kolts, who is responsible for S&P's GSCI index. "The main way to play this theme has been the equity markets by focusing on production, delivery and usage," he said.
Brooks added to this: "It is difficult to invest in water directly, but there has been a move towards companies that are in the business of using water more efficiently and those who de-salinate sea water."
"Capacity has been an issue," Frank Nielsen, executive director at MSCI Barra, said. "Many market players are still very small and larger companies derive only a small portion of revenues from alternative energy sources like water."
Over the longer term, he believed this market would develop as companies grew and large players increased operations. "It is likely that the large index players will eventually move into this space," he said.
As water becomes more scarce, wastage will become increasingly important. The Sustainability Forum in Zurich raised the question of how long it would be before water-related externalities would be managed through financial instruments, citing the success of the carbon trading market as an example.
"We could see something similar evolve in water," Nielsen said, "where certificates are created and wasteful companies have to buy rights from those who are more efficient."
Kolts questioned whether this would ever become reality, but agreed there was a growth market in playing natural resources themes from an equity perspective. "We have seen more interest in 2008 than ever before," he said. Last year, S&P launched two such indices tracking clean energy, both of which have attracted over $500m already.
Inflows into commodities from institutional investors have prompted concerns in some quarters that speculation was responsible for driving up prices and exacerbating inflationary pressures.
The US Senate has proposed legislation to ban institutional investment in commodities as a result.
Investec believed short term speculative activity had had a short term impact, but was not responsible for the current high price environment. They cited a 32% oil price increase in April, while speculative activity dropped in the same month.
Watson Wyatt's Macdonald believed legislatory measures would have limited effect: "Even that wouldn't bring oil back down to $20 a barrel. It would have a marginal impact by making around $250bn of commodities available to other buyers, but regulating against investment would likely also create market distortions."
Brooks agreed a ban would be negative for the markets and said there were too many vested interests for any significant policy change to go through. Speculation aside, Kolts believed this commodity bull run was fundamentally different from previous cycles.
"The main difference is that commodity producing countries have become huge consumers, which is creating a global structural shift and transferring wealth from developed to developing nations," he said.
"The situation has been exacerbated by fundamentals like weather and supply constraints, which meant small hiccups had a more significant impact on prices than they previously would have. This is a true bull cycle that is going to continue."
In contrast, Watson Wyatt's Macdonald leaned towards Isaac Newton's view: "It's natural to want to invest in something that is going up rather than the thing that is going down. Ultimately, high prices will have a significant impact on demand and things will normalise again. People have forgotten that what goes up, can't go up forever."
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