The Handbook of Commodity Investing

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Commodities are currently enjoying a renaissance due to institutional investors such as pension funds and traditional portfolio managers. Many market participants attribute the recent dramatic price increases in commodities to increased demand for consumer goods, particularly from the populous countries of India and China.

Demand from Brazil and Russia, two of the fastest-growing economies currently, has undoubtedly also played a part. (Collectively, these four countries are referred to as the BRIC countries.) Globalization and economic and political convergence have been behind the stimulated growth in these economies to a large extent. Besides increased investment on an enterprise level, increasing state investment in infrastructure in China has also led to enormous demand for commodities.

This has caused a shock to the worldwide supply and demand dynamics, leading to at least short-term price increases. Such dramatic increases in commodity prices are often explained by the commodity super cycle theory. According to Heap, a super cycle is a lasting boom in real commodity prices, usually brought on by urbanization and industrialization in a major economy.1 Hence, super cycles are driven by demand caused by an expansion of material-based production due to intense economic activity. The economic situation in China is of crucial importance to the commodity markets.

China has greatly increased its share of global commodity consumption over the past few years, and is seen as the major driver of the current commodity boom. For example, between 2001 and 2005, China’s demand for copper, aluminum, and iron increased by 78%, 85%, and 92%, respectively. This clearly shows China’s considerable influence on commodity pricing. This super cycle, however, is not characterized by a continuous growth phase, as the events of May 2006 show. Many commodities were under pressure during that time, and actually lost about one-fourth of their value.

Under market conditions like these, the question inevitably arises as to whether this is a temporary price correction or a general trend change. Following the super cycle theory, a long-lasting upward trend in commodities in the future is likely, as most remain far below their historic highs when adjusted for inflation. Compared to foreign exchange or equity markets, there is almost no way to intervene in commodity markets. Because the production side reacts very sluggishly to market distortions, short-term supply and demand shocks are compensated for only by price movements.2 These inherent asset class volatilities are the main reason many investors have refrained from investing in commodities, despite the fact they can provide valuable diversification.

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