Comment: Commodities: They're not boring anymore

Kathy Graham outlines a number of key issues that are being driven by the steady rise of global demand for commodities.


A first has occurred - all commodity prices are up at the same time.


 Most understand that this demand for commodities, i.e., all agricultural products, both natural and refined (like cocoa and sugar, which are called "soft" commodities), metals, and energy - is due in part to China's growth coupled with the US hunger for such products in an environment where global resources are more readily and affordably accessible.


What isn't commonly understood is how pervasive commodities financing and investment decisions wrap around all of our lives and some of our careers.


The producers' impacts
Economics 101 says that when demand increases to the point that the current supply cannot cover it on a short-term basis, prices rise and, in response to the increased prices, supply swells to meet the demand, thus recreating equilibrium again.


The problem with commodities is that supply can't easily be increased until a new crop is grown, a new mine and/or refinery is built once new ore or oil/gas/etc. is discovered … and then more railways, roads, and ships to handle the extra loads need to be added.


Time, for most commodity supply increases to occur, is minimally a year and often as long as five to ten years.


Further exacerbating the time issue is the fact that most commodities are not items that store well because, as discussed in Hilary Till and Joseph Eagleeye's chapter "Commodities - Active Strategies for Enhanced Return," in the forthcoming book 'The Handbook of Inflation Hedging Investments', the storage costs are too high so commodities lack the inventory safety net.


Therefore, when supply/demand imbalances occur, prices of commodities tend to rise for longer time periods than experienced by other products.


The producers, most all but one notable exception, are racing to fulfil their expected role of increasing supply. According to Rebecca Bream, Christopher Brown-Humes, and Kevin Morrison in their Financial Times article on 4/11/05 "On the climb: a natural resources boom is unearthing both profits and perils", mining is up, heavy machinery makers for agribusiness are having record sales years, plus port operations and ship owners are expanding their capacities so over time supply will again meet demand.


To meet these new goals, producers are cautiously adding staff, especially in the risk management areas as commodity firms, quite familiar with the volatile "boom or bust" nature of their business, want to ensure that they don't expand themselves into a downdraft.


The one notable exception to producers increasing supply in response to higher prices are the oil companies. With their increased profits they don't appear to be increasing exploration or ways to grow supply. Instead, it seems that they're mostly buying back their own shares and acquiring other companies. Neither of these activities increase supply so the question remains: given increasing prices, why aren't oil companies investing more in exploration and growing supply?


One final thought: a nice feature not often mentioned is that because many of these commodity producers are in third world or emerging market countries, all this building, mining, and growing is creating jobs. The jobs are moving people from the country to the cities and providing those individuals with the resources to buy new goods and services they couldn't afford before, thus strengthening the virtuous circle towards better living conditions slowly on a global basis.


The financiers' impacts
Already consumer banking systems where none or only primitive facilities existed are being established in these countries according to international monetary standards proven to increase liquidity via creating structures that people can trust with their funds. Stronger local banks built on regional monies are now vying for business that the major international banks once owned. The cost of capital is falling in these areas due to the increased competition, again fortifying that virtuous circle.


The international banks' original supplying of capital to these regions at rates lower than their country's rate helped set the stage for corporate development. This type of financing is called structured financing because it's based not on the quality of the firm's balance sheet (which, in many countries where their accounting standards aren't up to acceptable levels, is questionable to begin with) but on the profitability of the transaction. Because these banks are global, they have the resources to minimize the multiple risks inherent in such deals via the way they structure the contracts.


Structured commodity trade finance and traditional commodity trade finance are the financing tools that primarily a handful of international banks offer to commodity producers and the commodity trading houses worldwide. These tools are the vehicles that enable potential locked in the form of oil or gold in the ground or plantations capable of growing coffee or oranges to be transformed into ready capital.
The price increases that are driving producers to supply more product are also driving bankers to provide more credit lines and innovative structures to meet the producers' demands.


Because much of commodity trade finance is in illiquid higher risk countries dispersed over a wide geographic region, there is a significant reputation and commitment barrier to entry for new financiers interested in entering this lucrative field.


Commodity trade finance consists of a small group of professionals - a much smaller niche than even hedge funds - working for banks that have been in this niche for a long time. In fact, some of these banks have been doing this type of financing going back to the first trading ships that went to India and China.
Commodity trade finance professionals are smart and creative because they need to be able to structure financing around unique company and country conditions.


They are adept at managing all sorts of risk for commodities are one of the most volatile product lines (i.e., think just about agricultural products: slight variations in weather can result in bumper crops that send prices crashing with their oversupply or wipe out an entire season's production…and we're not even considering country risk, delivery risk, etc…).


The demand for commodity trade financiers' services is creating the need to hire more credit, risk managers, and marketing professionals. Because the supply pool of qualified individuals is small and widely dispersed globally, this demand is escalating base and bonus compensations.


The investors' impacts
In addition to the usual producers and some financiers who use the commodity futures markets to manage their forward price risk, big money investment funds, pension funds and insurance firms are all increasing their stake in commodities. Some are even actually taking physical delivery of goods!


Trade & Forfating Review's 4/22/05 article entitled "Pushing beyond the lines" says that about USD 1 trillion commodities futures contracts are trading each month, making them more attractive to investors than private equity or hedge funds because of the ease of purchase and sale. Many of the top performing mutual funds are in the commodity sectors. Macro hedge funds are gearing their portfolios towards more of an energy-related emphasis.


Hedge funds are one of the largest holders of energy debt and are major players in the emerging field of the "green" products, which are organic agriculture and renewable energy sources.
The "greens" could also stand for green as in money. Consider organic agriculture; although not a large segment, it's one of the most profitable sectors for its producers and retailers.


Although the renewable energy sources aren't yet as profitable, they are attracting a lot of money. Goldman Sachs, with its recent purchase of a wind power projects developer, is now one of the US major wind developers. Morgan Stanley is one of the largest emissions trader in the global sulphur dioxide market. BP, formerly known as British Petroleum but today refers to itself as Beyond Petroleum, is one of the largest alternative energy producers. There are now many dedicated "green" hedge funds, mutual funds, money management, and private equity firms.


Who knows - perhaps the "greens" will be the soft landing to the current commodities demand/supply imbalance? Goldman Sachs, in its 3/30/05 controversial U.S. energy oil research report where it mentioned $105/bbl oil prices, says that oil demand in China and India plus US gasoline consumption are the two major components fuelling demand in this sector.


They continue by saying that they expect steel prices and drilling rig rate hikes to increase in the short run but in the long run they forecast return to equilibrium as either demand is destroyed or "material new investments" are made. Citigroup in its 3/31/05 equity research global commodities report concurs that equilibrium will be restored by declining demand.


Declining demand can come from a recession, a shock to the system like a disease epidemic or terrorist attack, or through innovation. Let's hope it's an innovative equilibrium restoration.


Kathy Graham
Principal
HQ Search, Inc.

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