Commodities: Getting real on risk and return

Back to the future with the old economy
Commodities have been an attractive investment so far this decade, far outperforming the major asset classes. The DJAIG^SM1 commodities index has risen by 119% since the beginning of 1999. ² Driving this impressive performance has been the combination of underinvestment in supply,low inventories and strong demand. Importantly, we continue to see an extremely constructive environment for commodities, with positive physical fundamentals being complemented by continuing growth in interest from the investment community.

Barclays Capital commodities conference
The high level of interest in commodities as an asset class was evidenced by the impressive attendance (more than 160 existing and potential clients, including institutional investors, private banks and hedge funds) at Barclays Capital’s inaugural commodities conference held in Barcelona in early February.

Jerry del Missier,head of rates,private equity and regional head of Europe for Barclays Capital, says:“We have been seeing an increasing demand for commodity linked structures. Institutional investors, including insurance companies, pension funds, asset managers and private banks, were coming to us looking for structured products to gain commodities exposure. It, therefore, seemed to be the right time to bring together experts from corporates, academia and financial institutions to look at how investors could be best served in what is, for them, a new asset class.” The title of the conference was “Commodities: getting real on risk and return”, and featured prominent speakers.

They included: professor Ken Rogoff; Thomas D Cabot, professor of public policy and professor of economics at Harvard University; Jim Rogers, the author of “Investment Biker,Adventure Capitalist” and the recently released “Hot Commodities”; Xu Feng,the vice-chairman of China Minmetals (the largest metals trading and producing company in China); and Gerard Picard, vice-president of Arcelor (one of the world’s largest steel producers), as well as Barclays Capital’s own commodities specialists.

The key theme that emerged from the conference was that of finding sophisticated approaches to investing in commodities to benefit from the high and volatile commodity price levels that are likely to persist. However, after the impressive performance in recent years, have commodities now factored an investor premium?

The time is still now
Fundamentally, we are of the opinion that the principal themes underlying the rally in commodity prices since 2002 are likely to persist over much of this decade at least.

Massive expansion and investment in technology, biotechnology, health care and web-based business models in the 1990s left little capital for the old economy. As a result, the 1990s was a period of significant underinvestment in the commodities sector and associated infrastructure.

Many elements across the value chain, from exploration to mining and refining, and all the associated services (such as transport and power) have not seen the appropriate level of maintenance and expansion. However, this under-investment may simply have provided support for weak commodity prices had it not been for an impressive acceleration in demand.The growth in the world economy and the emergence of China as an industrial base and location for mass urbanisation have resulted in a period of unexpectedly strong demand for raw materials.

Rising far-forward commodity prices are reflective of this structural change in the outlook for commodity prices, rather than simply a cyclical rally. As Kevin Norrish, head of commodities research at Barclays Capital,notes: “Big moves up in futures curves have been a feature of energy and metals markets this year.

It reflects the view of the many market participants that average long-term commodity prices have moved up due to rising demand growth rates and a constrained medium supply outlook”. ³ Critically, this trend is set to continue for the next few years. Some experts even suggest that the commodity rally will continue for at least another decade.

Not only do commodities provide a positive outlook on yield but they also provide diversification to a portfolio of financial assets. Equities and bonds can be negatively exposed to a rise in inflation and interest rates, whereas commodities tend to perform best in times of strong economic growth.

Given geopolitical instability, particularly in the Middle East, investing in commodities provides a natural hedge against politically caused supply disruptions.

How to invest
There are various ways for retail investors to gain exposure to the commodities markets. These include index and single-commodity trackers, commodity-linked notes, collateralised commodity obligations (using the same concept as collateralised debt obligations) and mutual funds (tracking a commodity index).⁴

The range of underlyings stretches from well-established commodities like energy, industrial metals, precious metals, agriculture and livestock to the newer traded markets like electricity, weather derivatives and freight. There is also a range of commodities indices available that reflect an investment in commodities as an asset class or its sub sectors.

As with equity structures, currency risks can be eliminated by creating quanto options hedging out the currency risk.

Last but not least, hybrid structures that combine various asset classes (e.g. the ‘rainbow’) have become popular strategies because they provide automatic asset allocation.

Structuring the products
In 2004, commodity-linked structured notes became as sophisticated as their equity- and rate-linked counterparts.The range of exotic optionalities increased steadily with robust secondary market making. Martin Woodhams, head of commodities structuring at Barclays Capital notes: “Throughout 2004, private banks looked to implement strategies that take advantage of Chinese growth. Commodity-linked strategies were received very well as they helped to express such a view in a straightforward manner.”

A buying opportunity
Years of under-investment and increased demand have driven up commodity prices. Barclays Capital believes that commodity prices will remain high for a number of years and that commodities will continue to be an attractive asset class for private banking and retail investors, providing both diversification and return. The challenge is to create structured products tailored to clients’ needs, taking into account the relative merits of basket options and index options given frequent backwardation in the commodities markets.

¹ DJ–AIGCI^SM is a service mark of Dow Jones & Company, Inc. and American International Group, Inc
² Jan 1, 1999 to Jan 31,2005
³The Commodity Refiner,Q1 2005
⁴ Collateralised commodity obligations (CCOs) are rated-fixed income investments that provide exposure to a static portfolio of commodity trigger swaps (CTSs). The CCO is collateralised by both highly rated senior debt obligations (the bond collateral) as agreed with the rating agency,and the CTS.

Repayment of the principal of the CCO is dependent on the prices of a basket of commodities over a short averaging period immediately prior to the five-year maturity of the CCO. Historically, commodity investors have been limited to receiving equity-like return profiles.

The CCO provides a unique opportunity for investors to access exposure to a basket of commodities in an established fixed-income format

Commodity basket versus index options

Should structured notes embed call options on a basket of commodities or options based on commodity indices? Options on indices generally relate to the rolling front-month contract, whereas baskets are based at the longer end of the forward curves. Hence, the performance of a commodity index is path-dependent, whereas the performance of a structure linked to a basket of commodities is path-independent. A key concept in determining how to structure these commodities investment products is the shape of the forward curve. Financial assets generally have an upward-sloping forward curve – i.e., the forward price is higher than the spot price. This typically reflects the cost of money (carry). In contrast, commodity prices can be lower in the longer-dated futures markets than they are in the spot market – a phenomenon called backwardation. Backwardation can be caused by supply bottlenecks, disruptions, spikes in short term demand, or structural constraints (e.g. difficulty in storage). Both strategies – choosing a commodity basket as well as a commodity index as underlyer – can take advantage of backwardation. In such an environment, basket options are cheaper than index options because of: 1) lower volatility at the long end versus the front end of the forward curve; and 2) the out-of-the moneyness of the optionality. An at-the-money spot option is in fact an out-of-the-money forward option because the long-dated forward point on which the option is priced is below the spot price. Since basket options are cheaper, they allow higher participation rates. However, index options allow the investor to participate in the roll yield. Neither of the strategies is superior when they are put on: depending upon what path the shapes commodities forward curves take until maturity, one strategy will perform better than the other. In 2004, basket options seemed better value than index options. This was because front-month contracts were more volatile than the historic average, and, therefore, long-dated contracts appeared even cheaper on a relative basis. Metals curves moved into backwardation throughout 2004, which cheapened options significantly. Another factor that reduces the cost of these options is favourable correlation conditions.

About Barclays Capital’s Commodities Group Barclays Capital is the investment banking division of Barclays Bank PLC. Barclays Capital’s Commodities Group delivers an integrated, global service for base and precious metals and energy products in all major currencies. Go to www.barcap.com/commodities or contact Torsten de Santos [phone] or via [e-mail] for more details. In January 2005, Risk magazine awarded Barclays Capital ‘Derivatives House of the Year’.

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