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Posted on April 15, 2011
By BEN LEVISOHN and JESSICA SILVER-GREENBERG
Anyone who has invested in commodities is watching the markets warily these days. After soaring for the past few months, oil and other basic materials have tanked in the past week.
But that doesn’t mean it is time to bail. Volatility is a given in the commodities markets. Investment strategists and money managers increasingly are suggesting that investors devote a bigger chunk of their portfolios to commodities that pass one crucial test: scarcity.
With the world’s population expected to hit 9.1 billion by 2050, up from 6.7 billion today, according to the World Bank, demand for many commodities is only expected to rise. That is especially true as emerging-market populations get richer. In countries with per-capita gross national incomes below $1,000, each 10% increase in income will result in a 10% increase in the use of metals, a 6% increase in the use of grains and a 4.25% increase in the use of energy, according to Nomura Holdings Inc. research.
Yet while demand for raw materials is growing steadily, supplies of crops, water, energy and industrial metals aren’t keeping up. The world now has enough corn to last only 54 days, the lowest since 1973 and well below the average of 120 days, according to Michael Lewis, head of commodity strategy at Deutsche Bank AG. Copper stores are about 10% lower than they were a year ago. While water supplies are sufficient for now, by 2030 they are expected to be 40% below demand, according to the 2030 Water Resources Group, an industry research group.
Another benefit to the scarcity trade: Investment strategists say commodities can reduce volatility in a portfolio. Adding a 5% position in a basket of commodities to a portfolio of 60% stocks and 40% bonds can reduce price swings by 0.1 percentage point while adding 0.1 point of return, according to J.P. Morgan Asset Management.
The trick for investors is to play these markets smartly. Profiting from scarcity isn’t as simple as buying barrel of oil or a bushel of cotton; investors need to consider multiple financial instruments, from exchange-traded commodity funds and individual stocks to private-equity plays and currencies. They also should have exposure to a broad swath of commodities, says Robert Weissenstein, a managing director at Credit Suisse Wealth Management.
“You don’t just want to diversify your commodities,” he says. “You want to diversify your investments as well.”
Here’s what you need to know.
Agriculture and Farmland
Some crops, such as soybeans and cotton, are fundamentally in short supply, because they can be produced only in certain soils and regions of the world. For instance, 95% of all soybean production comes from just four countries: the U.S., China, Brazil and Argentina. Last month, Chinese officials expressed concern that growing appetites for soybeans are outstripping supply. In 2010, China imported a record 54.8 million tons.
Other crops may not be in short supply now, but new pressures, such as a push toward ethanol production or shifts in diet, threaten to deplete supplies. As more people eschew chicken in favor of beef, for example, supplies of corn and wheat likely will dwindle. It takes four kilograms of feed to produce one kilogram of beef, versus just one kilogram of feed for poultry.
That doesn’t mean it is easy for investors to capitalize on rising prices. Crops are among the riskiest and most volatile of commodities. Rather than play the futures markets, investors should look for companies that focus on producing more food for every acre of land, such as makers of fertilizer, seed and machinery, says Dylan Grice, a research analyst at Societe Generale SA. Market Vectors Agribusiness, an ETF, includes some of the largest players in agribusiness, with fertilizer company Potash Corp. of Saskatchewan Inc. and seed maker Monsanto Co. among its largest holdings. The fund is up 23% over the past 12 months.
Earlier this month, ETF firm IndexIQ launched its Global Agribusiness Small Cap ETF. The portfolio holds companies involved in livestock operations, agricultural logistics and farm machinery.
“Emerging markets are experiencing huge bursts in their populations, and that creates a fundamental, long-term demand for food that will outstrip supply,” says Roger Nusbaum, a portfolio manager at wealth-management firm Your Source LLC in Phoenix, which owns shares of the Market Vectors Agribusiness ETF. “We want to be part of that story.”
Another way to invest in crops is via farmland. Across the U.S., prices have surged 58% over the past decade, according to the U.S. Department of Agriculture. Some farming hotbeds have seen big gains of late: In 2010 alone, prices in Iowa jumped 18%, according to the Federal Reserve Bank of Chicago.
Since farmland is difficult to buy and sell quickly, diversification is crucial. There are no publicly traded real-estate investment trusts dedicated to farmland, but strategists say some private-equity portfolios are worth consideringparticularly those focusing on Africa, Eastern Europe, South America, Australia and Canada, where prices haven’t run up as much as they have in the U.S.
For example, Canadian private-equity firm AgCapita Partners, with $150 million under management, focuses on Saskatchewan farmland, which for regulatory reasons is less than half the price of farmland in nearby Alberta. The fund saw an estimated 10% appreciation in portfolio land values in 2010.
Water supply is essentially finite. Yet global demand is expected to increase 53.3% by 2030, estimates the 2030 Water Resources Group.
“We think water might be the most important commodity story of the 21st century,” says Charles Reinhard, deputy chief investment officer at Morgan Stanley Smith Barney. “Scarcity of water in Africa and Western Asia, combined with other factors including increased urbanization globally, will likely cause demand to exceed supply.” The firm is overweight in its commodity positions.
The problem for investors is that there is no pure-play in water: Futures don’t exist, and many of the companies involved in water production are giant conglomerates, including Siemens AG and General Electric Co., of which water is only a small part.
Barnaby Levin, a financial adviser at the HighTower Advisors in Menlo Park, Calif., says he is looking to put clients into ETFs and funds that can deliver exposure to water through publicly traded companies.
There are four ETFs to choose from: PowerShares Water Resources Portfolio, First Trust ISE Water Index Fund, Guggenheim S&P Global Water Index and PowerShares Global Water. Water Resources Portfolio is the biggest, with assets of $1.2 billion. It holds stocks of smaller companies that focus on treating water for consumption and delivery. Since its 2005 debut, the fund is up 27%, compared with a 4% increase in the S&P 500. Abraham Bailin, an analyst at Morningstar Inc., likes the fund because it has the lowest fees.
There also are four small water-focused mutual funds: Calvert Global Water, Allianz RCM Global Water, PFW Water and Kinetics Water Infrastructure Advantaged. With just $71 million in assets, Allianz is the largest. The fund, which focuses on water utilities, has returned 15.4% over the past year, compared with 9.8% for the S&P 500.
Prices for energy, like food and water, are being driven largely by emerging markets. Demand there is expected to increase 27% by the end of the decade, versus 8% for developed nations, according to the U.S. Energy Information Administration.
At the same time, supply remains tight. Political turmoil in OPEN nations in North Africa and the Middle East has fueled an 18% rise in oil prices this yearso sharp a spike that some strategists are predicting a pullback.
Yet despite the short-term worries, some analysts say prices will move higher over the next several years as companies struggle to extract more oil from the earth. “Investors are buying the dips because the fundamentals are strong,” says Michael Marino, an analyst at investment bank Stephens Inc.
Much of the world’s oil is deep under the ocean, trapped in Canadian sand or in politically unstable countries. Risky deep-water drilling, for instance, now accounts for about 9% of world oil production, up from 2.5% in 2000.
“BP isn’t drilling in the deep water of the Gulf of Mexico for the intellectual challenge,” says Gary Flam, a portfolio manager at Bel Air Investment Advisors LLC in Los Angeles, which oversees $5 billion. “It’s because that’s where the oil is.” He is overweight energy in his portfolio.
Many advisers recommend against oil ETFs, which suffer from a market malady known as “contango.” Commodity ETFs typically buy futures contracts rather than the underlying physical substance. Contango kicks in when funds must replace expiring futures with longer-term contracts at higher prices, eating into returns. The U.S. Oil Fund, for example, has gained just 5.8% over the past 12 months, even as oil has jumped 29%.
A better bet, say strategists, is oil-sector stocks. Mr. Flam prefers oil-service and exploration companies, because their expertise will be needed to access hard-to-reach oil.
Buying opportunities could present themselves soon. Houston-based drilling company Baker Hughes Inc. warned in a March 3 filing that it would take a profit hit because of unseasonably cold weather and the turmoil in the Middle East and North Africa, which hampered its ability to deliver equipment to oil fields. Other service providers are expected to announce similar problems when they report earnings in the next several weeks, which could shave a few dollars from their stock prices.
Investors can also purchase ETFs or mutual funds holding shares of oil companies. The SPDR S&P Oil & Gas Equipment and Services ETF, for example, has returned 35% in the past year. PowerShares Dynamic Energy Exploration & Production Portfolio, which holds shares of Chevron Corp. and Exxon Mobil Corp., is up 42% over that span. iShares Dow Jones US Oil Equipment Index, with holdings like Halliburton Co., is up 39%.
Strategists caution against natural-gas and alternative-energy plays, however. The development of hydraulic-fracturing techniques in recent years has allowed access to previously unreachable supplies of natural gas, causing prices to plunge. That, in turn, has removed power producers’ incentives to develop alternative energy such as wind and solar. The Guggenheim Solar ETF has dropped 5% during the past year, while the iSharesS&P Global Clean Energy Index ETF is down 8.2%.
Precious metals such as gold and silver get most of the attention, but industrial metals are better suited for the scarcity trade. Gold, for instance, trades more as a hedge against inflation and geopolitical risk than on supply and demand considerations.
Copper, however, is a key component of wire, switches, electromagnets and other industrial wares. The metal has jumped 23% during the past 12 months, driven largely by growth in emerging-market nations. China now imports 40% of the world’s copper, up from less than 10% in 1996, according to Barclays Capital.
Supplies, meanwhile, have fallen well below their typical level of three weeks of consumption and will remain below that for at least the next five years, according to Andy Mohinta, director of Citigroup Inc.’s mining and steel research group. Other industrial metals facing shortages include lead and iron ore.
Paul Simon, chief investment officer of Tactical Allocation Group LLC, which has $1.1 billion under management, likes precious and base metals as a way to play scarcity. “There are supply constraints and seemingly insatiable demand in emerging markets,” he says.
There is one ETF that buys futures contractsPowerShares DB Base Metals, which purchases aluminum, zinc and copper and varies the contracts it buys to minimize contango.
Most industrial-metal products, however, are exchange-traded notesdebt instruments that track specific indices. These include iPath DJ-UBS Copper Total Return Sub-Index, iPath DJ-UBS Ind Metals TR Sub-Idx and UBS E-Tracs CMCI Industrial Metals TR. ETNs typically do a good job of tracking the underlying index, but can be less liquid than similar ETFs.
Other metals, like iron ore, don’t have futures contracts, so investors are limited to the stocks of companies that get a large portion of their profits from mining. Avy Hirshman, chief investment officer at Newgate Capital Managment LLC, prefers Brazilian iron-ore producer Vale SA and Cliffs Natural Resources Inc., which mines iron-ore and coal.
“Both substances are scarce,” Mr. Hirshman says, “and both are in demand.”