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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.
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.
