Alex Brummer

INVESTMENT SPECIAL: Nature’s risks and rewards

A beginner’s guide to investing in commodities

INVESTMENT SPECIAL: Nature’s risks and rewards
Text settings

A beginner’s guide to investing in commodities

The arrival on the London Stock Exchange of the Swiss-based mining and commodities behemoth Glencore, valued at £40 billion, has provided a rare insight into the mysteries of the natural resources world.

This remains a relatively little understood sector even though the first commodities trades can be traced back to biblical times (there are whole Talmudic tractates on the subject) and the modern world of trading financial futures owes its origins to pork- belly and corn trading at the Chicago Board of Trade.

What we have learned from Glencore’s initial public offering is that many transactions in physical commodities, natural resources and precious metals take place away from recognised exchanges, and involve traders taking controlling positions. Disclosures in Glencore’s prospectus revealed for the first time what a dominant player this hitherto very private company is in vital metals — with a global share of 60 per cent in zinc trading, 50 per cent in copper and 45 per cent in lead. It is also a huge player in thermal coal, with a 28 per cent share, and a significant force in grain markets with 9 per cent.

The lack of transparency and regulation in commodity and natural resource markets, together with the dominance of a few key traders, makes them a very difficult place to invest directly. Trades are more risky, market moves tend to be very lumpy rather than gradual and smooth, and liquidity can be difficult. Yet in the last year or so, as inflation has reared its head again and the dollar has come under attack, commodities have come into sharp focus.

There is a tendency in some quarters to see commodities as one seamless trade from gold to coffee. But that would be a mistake. There are different drivers for each sector of the market. At the very top of the pile are the ‘monetary’ commodities, gold and silver. Demand for these is largely driven by economic factors, with the gold price (like oil) tending to move in the opposite direction to the dollar and inflation in the advanced economies.

The next group includes the industrial commodities, notably copper, zinc and to a lesser extent platinum (used widely in catalytic converters in cars) and iron ore. Fossil fuels — coal, oil and natural gas — are part of this group and their prices are generally demand-driven, although in the case of oil, Middle East politics and the uncertainties of the ‘Arab Spring’ have also been a factor.

Finally, there are the soft commodities. These are largely grains and other agricultural produce. Demand is a big factor here, too, with emerging countries, most notably China, sucking in ever larger quantities as they move up the food chain. But supply factors also play a big role. The boom in prices in the last year has much to do with the failure of the grain harvest in former Soviet Union countries.

Investors from within the highly regulated financial sector find themselves up against major trading firms such as Glencore (strongest in metals), and Cargill and Archer Daniels Midland, the two big American players in the soft commodity and grain markets. Nevertheless, despite the dominance of the hidden hands of the likes of Glencore and Cargill, financial players have become increasingly interested in this space. Among those making a big splash is JPMorgan Chase, led by Jamie Dimon, one of the few big winners on Wall Street from the financial crisis. Morgan’s interest in commodities began in 2007 when Dimon and his team decided that they could become a major source of future revenues. A star derivatives trader, Blythe Masters, was placed in charge of the unit, with the task of building it into a substantial business. The fire-sale of investment bank Bear Stearns, which Morgan picked up for a song, brought in the Bear Energy business, based in Houston with a strong knowledge of the oil, gas and power sectors. The next purchase was carbon trading firm ClimateCare, based in London, followed by UBS’s Canadian commodities arm. The biggest buy of all was Royal Bank of Scotland’s Sempra energy operations for a hefty $1.7 billion.

The fashion for commodity investment has been encouraged in part by distrust of financial products in the aftermath of the collapse of the US subprime market and the toxic debt that was built upon it. Professional investors have searched for something more tangible — and commodities, driven higher in price by demand from the BRIC countries (Brazil, Russia, Indian and China), have looked a good bet. But because of the illiquidity in these markets, prices can also be highly volatile and so when oil and other commodities suffered a setback in May — on fears that global output was faltering — a number of hedge funds including the London-based Clive Capital took a big hit.

Traditionally, the best way to gain exposure to natural resources is by buying mining stocks. In gold, the big pure plays are Randgold Resources and African Barrick Gold. There are also gold-backed exchange traded funds (ETFs). Similarly, platinum exposure can be acquired through miners Lonmin, Braemore Resources and Jubilee, but ETFs offer an easy dealing alternative. The mining groups Xstrata, BHP Billiton and Rio Tinto (all London quoted) offer a bigger basket of natural resources investment.

For those (including this writer) who favour collective investment, there is no shortage of commodity investment trusts. Among the big names are BlackRock Commodities Income which trades at a slight premium to net asset value, and BlackRock World Mining which doesn’t. I personally own Geiger Counter, which specialises in nuclear-related resources such as uranium, but it has been a singularly unimpressive performer. A bigger winner has been City Natural Resources.

As attractive as commodities may seem in an era of rising inflation and strong distrust of financial instruments, the volatility can be quite scary. A combination of markets dominated by a few big players and lack of liquidity means that prices can move very suddenly. A recent correction in some commodities, including oil, left even the most skilled hedge funds nursing large losses. Natural resources may look like a sure-fire winner in an age of uncertainty, but this is not an investment for widows or orphans.

Alex Brummer is City editor of the Daily Mail.