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Commodity markets may provide the clearest insights into the short-term risks that global investors now face. Civil uprisings across the Middle East, sparking the type of geopolitical “event risk” that can benefit commodity prices, have driven up the price of oil and incited fears among investors that it could undermine the global recovery, said Colin O’Shea, head of commodities at Hermes Fund Managers. Throughout February and into mid-March, when Investment Magazine went to press, the price of oil surged by more than US$20 a barrel to beyond US$100 as investors feared the people of Saudi Arabia would, like those of Egypt and Libya, openly protest against their authoritarian rulers. Investors’ uncertainty was obvious as equity markets sold off and gold was bought for more than US$1,400 an ounce.


This “supply shock” raised questions about how much spare capacity the world’s oil producers have, O’Shea said. And for good reason: some producers have had to slow or “shutter-down” production, while companies further down the supply chain face higher operational costs. This price improvement is beneficial for Hermes, which sources close to $2 billion of its $38 billion under management from commodities mandates. But the manager does not want to see the barrel price of oil go beyond US$130, “because if it goes to this level it could de-rail the recovery,” O’Shea said. The potential for another oil shock is ever-present because large producers, such as Saudi Arabia, Nigeria and Venezuela, lay on geopolitical fault lines. Investors are now watching Saudi Arabia closely, given its proximity to the so-called Arab Spring.

O’Shea said there is no clear evidence that protestors will soon take to the streets of Riyadh, “but it’s difficult to forecast what will happen”. In 2010, Hermes forecasted that existing oil supplies will last until 2014 before they are severely depleted. But now that Libya’s production has slowed, the world is drawing up to 4.5 billion barrels each day from its reserve supplies, “we might be looking at a 2012 or 2013 limit”, O’Shea said. Fears of an oil shock have compelled investors to sell equities. But in a break from past behaviour, they have not looked for safety in the US dollar, said Matthew Kaleel, CIO at H3 Global Advisors. During equity sell-offs, the US dollar usually rallies alongside bond markets and the prices of gold and oil. But not this time, as investors express wariness towards the US economy’s debt problems, Kaleel said. Excessive money-printing doesn’t boost the dollar’s strength, either.

feeding the masses a major theme Jacked-up oil and gold prices are key contributors to the strong run commodities are making, Kaleel said. But the long-running industrialisation within emerging markets countries is as an ongoing theme. “In every country where this has happened – Western countries, Singapore, Korea and Japan – people eat more meat, they buy air conditioners, cars and refrigerators.” In its revised World Population Prospects for 2005, the United Nations predicted that by 2015, half of the global population will live in cities, and these urban dwellers will outnumber the entire world population of 1965. This will exacerbate an already apparent scarcity of harvested land and will put pressure on food prices.

Drawing on data from the US Department of Agriculture and Bank of America Merrill Lynch, O’Shea said the world’s supply of farmland has increased by 26 per cent since 1970, while the number of people to be fed has risen by 80 per cent. Barring great advances in food productivity, through genetic engineering or other scientific methods, this trend is “unsustainable”, O’Shea said. However, in the short-term, H3 will reduce its exposure to food commodities because it expects a “supply response” in which primary producers will endeavour to rapidly increase crop yields to meet rising demand for food. He says this summer’s disastrous flooding in Queensland, northern NSW and Victoria would bring some benefits to Australia – and commodities investors. “There is so much water in the soil now, it has created the best growing conditions in 30 years,” Kaleel said, adding that commodity markets were expecting bumper crops from next year’s harvests.

Producers aim to secure agreeable prices on the commodities market in case valuations fluctuate dramatically by the time their goods reach the market. Investors provide this price guarantee, and receive payments for doing so. “It’s really seen as an insurance premium. That’s where a lot of the excess return in commodities comes from,” O’Shea said. Counting on commodities Driven by the dynamics of global supply and demand, and unaffected by the corporate management or any position in the capital structure of companies, commodities tread a different “return path” to equities, said O’Shea. But in doing so, they are more volatile. In the 30 years to December 2010, the S&P Goldman Sachs Commodities Index (S&P GSCI) returned 10 per cent at a volatility level of 20 per cent. In contrast, the MSCI World delivered 9.6 per cent with 15.1 per cent volatility. But O’Shea reckoned the diversification benefit compensates for this higher volatility. This is primarily because commodities outperform equities in periods of high inflation. Hermes pointed to the track record of the S&P GSCI in the 30 years to December 2010, in which it greatly outperformed the MSCI World Equity Index, and also global bonds and cash, in periods of high inflation. But the asset class underperformed when inflation ran low, irrespective of GDP growth.

 

Lowly correlated with equities This contributes to the low correlation between commodities and equities returns. For example, the oil price has a correlation between 0.26 and 0.33 with major producers Shell, Chevron and Exxon Mobil, according to Hermes. But in 2008, when investors would have treasured anything uncorrelated with global equity markets, commodities simply “didn’t work”, O’Shea said, because inflation fell dramatically. Also, since commodities are a direct input cost for businesses, they were bought in smaller volumes as “demand destruction” set in among consumers. The trend, however, is that commodities usually perform well when equities don’t, and vice versa. In the 10 negative years of equity returns since 1970, in which the MSCI World underperformed by an average return of -16.2 per cent, the S&P GSCI posted an average return of 7.7 per cent. And in the 20 positive years, when the MSCI World posted an average 19.8 per cent return annualised, commodities underperformed, bringing in 10.8 per cent.

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Commodity markets may

provide the clearest insights into

the short-term risks that global

investors now face.

Civil uprisings across the

Middle East, sparking the type of

geopolitical “event risk” that can

benefit commodity prices, have

driven up the price of oil and

incited fears among investors that

it could undermine the global

recovery, said Colin O’Shea, head

of commodities at Hermes Fund

Managers.

Throughout February and

into mid-March, when Investment

Magazine went to press, the price

of oil surged by more than US$20

a barrel to beyond US$100 as

investors feared the people of Saudi

Arabia would, like those of Egypt

and Libya, openly protest against

their authoritarian rulers. Investors’

uncertainty was obvious as equity

markets sold off and gold was

bought for more than US$1,400 an

ounce.

This “supply shock” raised

questions about how much spare

capacity the world’s oil producers

have, O’Shea said. And for good

reason: some producers have had to

slow or “shutter-down” production,

while companies further down the

supply chain face higher operational

costs.

This price improvement is

beneficial for Hermes, which

sources close to $2 billion of its

$38 billion under management

from commodities mandates. But

the manager does not want to see

the barrel price of oil go beyond

US$130, “because if it goes to this

level it could de-rail the recovery,”

O’Shea said.

The potential for another oil

shock is ever-present because large

producers, such as Saudi Arabia,

Nigeria and Venezuela, lay on

geopolitical fault lines. Investors are

now watching Saudi Arabia closely,

given its proximity to the so-called

Arab Spring. O’Shea said there is

no clear evidence that protestors

will soon take to the streets of

Riyadh, “but it’s difficult to forecast

what will happen”.

In 2010, Hermes forecasted

that existing oil supplies will last

until 2014 before they are severely

depleted. But now that Libya’s

production has slowed, the world

is drawing up to 4.5 billion barrels

each day from its reserve supplies,

“we might be looking at a 2012 or

2013 limit”, O’Shea said.

Fears of an oil shock have

compelled investors to sell equities.

But in a break from past behaviour,

they have not looked for safety in

the US dollar, said Matthew Kaleel,

CIO at H3 Global Advisors.

During equity sell-offs, the US

dollar usually rallies alongside bond

markets and the prices of gold and

oil. But not this time, as investors

express wariness towards the US

economy’s debt problems, Kaleel

said. Excessive money-printing

doesn’t boost the dollar’s strength,

either.

feeding the masses

a major theme

Jacked-up oil and gold prices

are key contributors to the strong

run commodities are making,

Kaleel said. But the long-running

industrialisation within emerging

markets countries is as an ongoing

theme.

“In every country where this

has happened – Western countries,

Singapore, Korea and Japan –

people eat more meat, they buy air

conditioners, cars and refrigerators.”

In its revised World Population

Prospects for 2005, the United

Nations predicted that by 2015,

half of the global population will

live in cities, and these urban

dwellers will outnumber the entire

world population of 1965.

This will exacerbate an already

apparent scarcity of harvested

land and will put pressure on food

prices. Drawing on data from the

US Department of Agriculture and

Bank of America Merrill Lynch,

O’Shea said the world’s supply of

farmland has increased by 26 per

cent since 1970, while the number

of people to be fed has risen by 80

per cent. Barring great advances

in food productivity, through

genetic engineering or other

scientific methods, this trend is

“unsustainable”, O’Shea said.

However, in the short-term,

H3 will reduce its exposure to food

commodities because it expects a

“supply response” in which primary

producers will endeavour to rapidly

increase crop yields to meet rising

demand for food.

He says this summer’s

disastrous flooding in Queensland,

northern NSW and Victoria would

bring some benefits to Australia –

and commodities investors.

“There is so much water in the

soil now, it has created the best

growing conditions in 30 years,”

Kaleel said, adding that commodity

markets were expecting bumper

crops from next year’s harvests.

Producers aim to secure

agreeable prices on the commodities

market in case valuations fluctuate

dramatically by the time their goods

reach the market. Investors provide

this price guarantee, and receive

payments for doing so.

“It’s really seen as an insurance

premium. That’s where a lot of the

excess return in commodities comes

from,” O’Shea said.

Counting on

commodities

Driven by the dynamics of

global supply and demand, and

unaffected by the corporate

management or any position in

the capital structure of companies,

commodities tread a different

“return path” to equities, said

O’Shea.

But in doing so, they are

more volatile. In the 30 years

to December 2010, the S&P

Goldman Sachs Commodities

Index (S&P GSCI) returned 10

per cent at a volatility level of 20

per cent. In contrast, the MSCI

World delivered 9.6 per cent

with 15.1 per cent volatility. But

O’Shea reckoned the diversification

benefit compensates for this higher

volatility.

This is primarily because

commodities outperform equities

in periods of high inflation. Hermes

pointed to the track record of

the S&P GSCI in the 30 years

to December 2010, in which it

greatly outperformed the MSCI

World Equity Index, and also

global bonds and cash, in periods

of high inflation. But the asset class

underperformed when inflation ran

low, irrespective of GDP growth.

Lowly correlated

with equities

This contributes to the low

correlation between commodities

and equities returns. For example,

the oil price has a correlation

between 0.26 and 0.33 with major

producers Shell, Chevron and

Exxon Mobil, according to Hermes.

But in 2008, when investors

would have treasured anything

uncorrelated with global equity

markets, commodities simply

“didn’t work”, O’Shea said, because

inflation fell dramatically. Also,

since commodities are a direct

input cost for businesses, they

were bought in smaller volumes as

“demand destruction” set in among

consumers.

The trend, however, is that

commodities usually perform well

when equities don’t, and vice versa.

In the 10 negative years of

equity returns since 1970, in which

the MSCI World underperformed

by an average return of -16.2 per

cent, the S&P GSCI posted an

average return of 7.7 per cent.

And in the 20 positive

years, when the MSCI World

posted an average 19.8 per cent

return annualised, commodities

underperformed, bringing in 10.8

per cent.

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