COMMODITIES Precious Metals Industrial (Base) Metals Commodities Grains and Oilseeds Softs affect supply curves Exotics Standardization Tradability

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1 COMMODITIES Commodities: real and tangible assets that are elements of food (agricultural products like wheat and corn), fuel (oil, gas), metals (ex: copper, aluminum, gold, tin, zinc), and natural resources (lumber, rubber, etc.) among others - These are not the final products consumers purchase, but inputs into products and production in general (affect supply curves) - They are standardized in each commodity class - Supplies are finite and limited - They require long lead times for production - Commodities are a hedge against inflation, as their prices tend to move in step with inflation - Generally traded in futures markets (see All commodities are defined by three characteristics: Standardization: they are not differentiated, thus interchangeable Tradability: have a marketplace with many buyers and sellers, as well as a specific futures market Deliverable: actual exchange of the commodity occurs between buyers and sellers Technically, commodities are classified as being in one of six categories: metals, energy fuels, agricultural, livestock, exotics, and financials These categories also have sub-categories. For example: - Metals are broken down into Precious Metals (gold, platinum, and silver), and Industrial (Base) Metals (aluminum, copper, lead, nickel, palladium, tin, and zinc) - Agriculturals are broken into Grains and Oilseeds (corn, soybeans, soybean oil, soybean meal, and wheat) and Softs (cocoa, coffee, cotton, orange juice, and sugar) One category, Exotics, is not an obvious one. These are commodities that do not have the same demand as other commodities. Many of these do not trade on US commodity exchanges Exotics consists of: - Ethanol - Lumber - Rubber - Wool In futures markets, commodity contracts have different sizes for the underlying (commodity). For example, copper has a contract unit of 25,000 pounds, while for corn, the size is 5,000 bushels. Not all contracts are expressed in the same units (some are in pennies, others in dollars, etc.)

2 Commodity exchanges are referred to a Designated Contract Markets (DCM s), which facilitate the trading of commodities and their underlying derivative products (futures, options, etc.) - At DCM s, standardized commodity contracts are listed and executed - As markets, these bring together producers, merchants, and speculators (ex: large institutions) DCM s, as the central figure in futures markets and commodities exchanges, provide many benefits - the interaction of buyers and sellers of contracts that occurs in these exchanges establishes global commodity prices - these exchanges provide transparency (no hidden information) - DCM s allow participants not involved in producer or merchant activities to speculate on commodity prices, taking risk and adding liquidity to these markets - DCM s establish clearing firms, legal corporations that are charged with protecting the financial integrity of commodity markets, which facilitates trade settlement and ensures deliverability Different exchanges emphasize specific commodities: Chicago Board of Trade (CBT) trades agricultural commodities New York Mercantile Exchange (Merc) trades energy and metals Chicago Mercantile Exchange (CME) trades livestock and some agricultural commodities - NO SINGLE EXCHANGE HAS EXCLUSIVE RIGHTS TO TRADING IN A SPECIFIC COMMODITY INVESTMENT CONSIDERATIONS Investing in commodities provides many benefits that are not available with traditional stock and bond trading - Commodities should be viewed as a separate asset class - Commodity prices are subject to fundamental (macroeconomic) and technical factors (ex: support/resistance, momentum) - As commodities do not move in exact step with stocks, they can be a diversification element that can reduces the risk of a portfolio. Their inclusion reduces price volatility of a portfolio, smoothing returns over time - Commodity prices are highly correlated with inflation, so commodities provide a hedge against inflation - Commodity demand in general is very inelastic (there are not many substitutes for each of these categories) - At times like the first half of 2008, commodities can provide substantial returns - There is no product obsolescence risk with commodities, unlike regular products - Issues concerning the management of firms, etc. do not exist with commodities

3 POTENTIAL RISKS - Market Risk: external (macroeconomic) factors can produce lower commodity prices - Volatility Risk: rapid and substantial price fluctuations can often add the element of price volatility (risk) - Weather Risk: in commodity markets, this is called force majeure, the effect of events out of the control of market participants that impact commodity prices. The major example of this is weather (rain, hurricanes) - Terrorism Risk: global supply and demand for a commodity is sometimes affected by geopolitical events, such as terrorist attacks on oil pipelines. If a large producer is affected (ex: Nigeria), this can have a significant and immediate impact on price - Liquidity Risk: widely and frequently traded commodities are very liquid. Some commodities, like emission credits and coal, are thinly traded, making them illiquid. So the actual price for a contract might be very different from that listed at a point in time - Speculation Risk: speculators do provide benefits to markets, like risk taking and liquidity. At times, speculators can move markets very abruptly, and away from prices based on fundamentals MORE GENERAL RISK (for a specific investment) SYSTEMATIC RISK: risk that emerges based on conditions, events, etc., that are outside (external) of the scope of a specific investment. There are four types of systematic risk: 1) Exchange Rate Risk: exchange rate fluctuations can adversely affect commodity prices 2) Interest Rate Risk: as interest rates rise, commodity prices often fall 3) Market Risk: sudden and dramatic swings in the overall market can adversely affect commodity prices 4) Purchasing Power Risk: inflation erodes the real value of investment income over time. Obviously, as inflation hedges, commodities help with this. NON-SYSTEMATIC RISK: elements of risk associated directly with a specific investment. For commodities these are: 1) Business-related risk: these are related to the firms that mine or produce different commodities, such as business risk (problems with sales and income for companies), and financial risk (financial instability of firms) 2) Liquidity Risk: the risk that a commodity investment can t be sold at or near the original current market prices 3) Regulation Risk: risk that new laws or regulations will adversely affect investments (ex: carbon credit proposal)

4 RISK vs. RETURN Modern portfolio theory emphasizes the overall risk and return profile of a portfolio. You should not evaluate each investment separately and independently of all others in your portfolio (entire set of investments). Risk is reduced by diversification. - Given two potential investments with identical risk and different expected returns, choose the investment with higher expected return (then pray like hell that your expectations are correct) - If there are two investments with identical expected return but different risks, select the investment with the lower risk - (statistical) correlation is a key element in gauging portfolio risk and thus diversification. CORRELATION: a measure of the linear association between a pair of variables (here, possible investments). - If two investments are positively correlated, they tend to move together (same direction). The higher the correlation coefficient (closer to +1), the stronger be will their pattern of association. - If two investments are negatively correlated, they will generally move in opposite directions, separately and (hopefully) independently. The closer negative correlation is to -1, the greater will their movement in opposite directions tend to be. DIVERSIFICATION (AND HEDGING) REQUIRES THAT INVESTMENTS IN A PORTFOLIO SHOULD HAVE NEGATIVE OR ZERO CORRELATIONS (and maybe small positive correlations). THIS REDUCES PORTFOLIO RISK BUT NOT NECESSARILY ITS RETURN. COMMODITY PRICE INDEXES - there are a number of commodity price indexes. Some pertain to specific commodities (ex: Gold or Precious Metals) while others attempt to summarize overall commodity prices (ex: CRB Index) CRB Index (now called the Reuters/Jefferies CRB Index) This was established in 1957 and now included 19 component commodities, which are in four tiers. - Tier 1 is Petroleum Products (WTI Crude Oil, Heating Oil, and Unleaded Gasoline) with a weighting of 33% of the total based on production value - Tier 2 is Highly Liquid Commodities (Aluminum, Copper, Corn, Gold, Live Cattle, Natural Gas, and Soybeans) with a weighting of 42% - Tier 3 is (Moderately) Liquid Commodities (Cocoa, Coffee, Cotton, and Sugar) with a weighting of 20% - Tier 4 is Diversified Commodities (Lean Hogs, Nickel, Orange Juice, Silver, and Wheat) with a weight of 5% - No exposure is given to exotic commodities - This index is rebalanced each month

5 The symbol for this in StockCharts.com is $CRB - The chart above looks at daily data. Note the run-up in commodity prices from late August 2007 through July of The relative strength of commodities (lower graph) rose sharply during this time period as well. - As rapid as this run-up was, the subsequent decline was stunning, moving from a high of 474 all the way down to 200. What has been long-term commodity price behavior? There was a long-term secular downtrend in commodity prices from , as shown by the resistance line above - Note that a double bottom signaled the end of the secular downtrend in commodities - As sharp as the uptrend in commodity prices was during , note how rapidly commodity prices rose from What about intermarket relationships here?

6 Dow-Jones-AIG Commodity Index Established in 1998, this follows 19 commodities. - The weights are 33% for energy, 30.1% for metals, 29.5% for agricultural commodities, and 7.4% for livestock. - Rebalancing occurs monthly - WTI Oil is the largest component, with a 13.2% weight - There is no exposure to exotics - Its symbol in StockCharts.com is $DJAIG The CRB Index and the Dow-Jones AIG Indexes tend to be highly correlated through time RELATIONSHIP OF COMMODITIES TO INFLATION This can be established using basic supply and demand analysis. Microeconomics: Commodities are inputs into production (ex: energy or metals), and as such these affect the marginal cost of production. Recall, supply curves (when they exist) are marginal cost curves. So: commodity prices MC of production S Given demand, this causes equilibrium price to rise and equilibrium quantity to fall. Q: How much will MC rise? A: Review the Supply and Demand notes for this. The increase in price will be greater, the larger is the increase in MC (how intensively firms or industries use the higher-priced commodities) and the more inelastic (i.e., steeper) is demand (shorter the time period) Macroeconomics: As commodity price inflation causes product prices to rise, we get a short-term rise in the rate of overall inflation (these changes are inflationary), not core inflation which excludes food and energy - This erodes real income as typically wage growth lags inflation during these periods. Lower real income causes individual demand curves to shift left at the micro level, and for aggregate demand to weaken at the macroeconomic level.

7 - This also raises the inflationary premium in interest rates, causing nominal interest rates to rise, which further retards aggregate demand growth, as interest-sensitive spending falls. The greater is the resulting commodity price inflation, and hence overall inflation (with a lag), the more demand will weaken. This, in turn, will feed back on commodity prices. - At times like 2008, when a recession occurs, the overall demand for commodities falls dramatically. But, we aren t necessarily sure if a recession is actually taking place as all of this is occurring. DRAMATIC WEAKENING OF COMMODITY PRICES IS A SIGNAL OF GROWING ECONOMIC WEAKNESS. TECHNICAL ANALYSIS OF COMMODITY PRICES CAN SIGNAL SUCH WEAKNESS FOR THE NEAR FUTURE. - The Fed uses CORE inflation as its guide, which excludes both food and energy. The only time they will react is for pass through, where food and/or energy prices are passed through to prices across the board, causing core price inflation to also rise.