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# Commodities

Commodities are physical products such as precious and base metals, energy products, agricultural products, etc. Returns on commodity investments are based on price changes instead of income. Since holding physical commodities incurs significant storage costs, most investors trade in commodities using derivatives. Products and other participants in the supply chain participate in the derivative markets for the purpose of hedging while investors act as speculators. Commodities are further classified based on grade (quality) and location.

## Commodity derivatives and indexes

The majority of commodity investments are executed through derivatives, with commodity index futures being the most popular. Forward contracts are over-the-counter products that typically require physical delivery while futures contracts are exchange-traded cash-settled standardized contracts marked to market daily. An option provides a right but not the obligation to buy or sell a specific commodity. Swaps represent a series of cash flows in which one party pays a fixed amount and receives an amount based on a commodity or commodity index. Since most of the commodity indexes are based on derivative prices, their values may differ significantly from the values of the underlying commodities.

In addition to direct investment or investment in commodity derivatives, exposure to commodities can be obtained using the following alternative vehicles:

• Exchange-traded funds: They allow equity investment exposure to a commodity or a commodity index. They may use leverage and charge fees, which are typically lower than mutual fund fees.
• The common stock of companies exposed to a particular commodity, for example, oil: however, the extent of how well they track the performance of commodities is unclear.
• Managed futures funds are professionally managed hedge-fund-like (concentrated or diversified) investment vehicles that invest in futures (and more recently in other derivatives). Some offer their shares to the public just like mutual funds while others are restricted like hedge funds.
• Individually-managed accounts represent commodity investments of HNWIs managed by professional money managers, and
• Specialized funds also exist which allows investors to obtain exposure to a specific sector. For example, private energy partners are private-equity-like investment vehicles (they charge a fee in the range of 1-3% of committed capital) which specializes in the energy sector; public equity funds (with fees up to 1%) specialize in commodity investments. particularly oil and gas.

## Commodity performance and diversification benefits

Advantages of adding commodities to an investment portfolio include:

• Return potential: In the short or intermediate term, commodities can generate a positive return if prices increase. However, since commodity prices determine inflation index levels, they may generate zero real return over time. But commodity futures offer liquidity and other premiums.
• Diversification benefits: Commodities have diversification benefits because the correlation of their return is low with traditional investments.
• Inflation protection: They offer inflation protection because many indexes depend on it. CPI and commodities have a reasonably positive correlation.

## Commodity prices and investments

Commodity prices depend on supply and demand, costs of production and storage, value to users and global economic conditions. Actions of non-hedging investors also affect commodity prices. The supply of commodities cannot be changed much in the short-term because a significant lag exists between an increase or a decrease in demand and production. This causes a mismatch between demand and production, low production in the high demand phase and vice versa. In the case of many commodities, the weather also affects supplies. Further, there is a reluctance on the part of producers to create excess capacity due to increasingly higher cost of production. Demand levels depend on global manufacturing dynamics and economic growth.

## Pricing of commodity futures contracts

Commodity investments often involve the use of futures contracts in which the long position (buyer) receives the commodity or its cash equivalent based on the expiration spot price, from the short position (seller) and pays the settlement price. The value of a contract to the long position increases with an increase in the price of the underlying.

Futures contracts are often closed by entering into an offsetting contract i.e. long takes a short position and vice versa. If a contract is outstanding at expiration, it is settled through cash. Futures contracts are marked to market daily and any gains and losses are credited/debited to margin accounts maintained by each party with the clearinghouse.

Futures price can be given by the following equation:

$$Futures Price = Spot Price × (1 + r) + Storage Costs - Convenience Yield$$

Where r is the short-term risk-free interest rate. Future price increases due to storage costs because a long position in a futures contract can avoid these costs, hence it must pay a higher price, otherwise, an arbitrage opportunity would exist. Similarly, convenience yield is the value that a commodity-holder obtains from its possession, but a future-holder does not. Hence, it causes a decrease in the futures price.
When futures prices are higher than spot prices mostly when convenience yield is zero or very low, the commodity forward curve is upward sloping and the situation is called contango. But when futures prices are lower than spot prices, which is the case when convenience yield is high, it is called backwardation.

Return on a futures contract has three sources of return: roll yield, collateral yield and changes in spot prices. Roll yield is the return that corresponds to the difference between the spot price at which a futures contract converges and the futures price dictated by the futures contract. It is positive when the market is in backwardation i.e. when forward prices are lower than spot prices. This movement is referred to as the theory of storage. Collateral yield is the return earned on any collateral put up by the investor to cover his futures position. Changes in spot prices refer to changes in current prices.

by Obaidullah Jan, ACA, CFA on Tue Feb 11 2020