Associate Professor of Finance Jaap Bos on October 17 delivered the fifth and final lecture of Studium Generale’s series on Sustainability and discussed the topic of responsible investing in commodities.
Investing in commodities is a controversial form of investment since trading in commodities can lead to an increase in prices of basic goods such as wheat and rice and endanger the livelihood of people in developing areas.
The price increase of a commodity through speculation not only affects consumers but also has an impact on farmers’ behaviour.
For example, farmers accept to take part in fair trade programmes in order to receive a higher price for their crops. If, however, they are able to achieve the same result through other means, the fair trade agreement might seem less beneficial to them.
Nevertheless, argued Bos, fair trade programmes come with additional benefits for farmers such as educating them on which fertilizers to use or how to enhance the quality of the crop.
Who buys commodities?
Originally, the only people purchasing commodities were those who needed them for consumption or production purposes.
Institutional investors started to get interested in the commodities market as a means to differentiate their portfolio.
Investors usually consider three main criteria before deciding to invest in an asset: the expected return, the level of stock risk or volatility and the possible gains in terms of diversification.
When constructing a portfolio, an investor seeks to maximize expected return while incurring the smallest risk possible. Diversification helps to manage assets that do not react to certain market shocks in the same way. If all stocks in a portfolio were to move exactly in the same direction, an investor would not be able to hedge his portfolio against a sudden crash. Commodities are seen to help this diversification since they tend to be more stable in price and more consistent over time.
As more investors start getting interested in commodities as a tool to diversify their portfolio, the demand market for commodities is growing. Nevertheless, as they are not genuinely interested in purchasing the products, the actual demand for the underlying products is effectively shrinking. Up to 60 percent of the futures market is held by investors who have no interest in buying the actual commodity. They keep the contract until close to the due date and sell it at the last moment. Then they replace it with a new contract.
Investing in commodities
The commodities market is made up of investments in assets such as coffee, rice, coal and oil. Out of all commodities, oil holds a majority of over 60 percent. This means that the price of oil dictates in great part how commodities indexes* move and how they are composed.
Investors can buy commodities futures contracts** or they can choose to invest in indexes. Buying a share in an index is less costly because of the size effect (investing in smaller parts of different commodities provides higher risk-adjusted returns) and also because of its dynamic structure (the weights of the different commodities change over time to reflect the price changes in the market and aim at maximizing return).
How does the futures market influence price the price of commodities?
After investors started trading in the commodities market, prices started rising as well. Did the investors’ demand for commodities increase their price?
“I can convince you that it’s not that simple,” said Bos. On the one hand, all investors are supposed to be atomistic, in the sense that they are just a grain of sand in the ocean and that their influence in the market is minimal. Nevertheless investors can also be big players in this market and their influence can become noticeable.
Bos presented research data showing that up to 80 percent of price fluctuation between 1990 and 2009 is not explained by supply and demand. Drought, labour productivity, price of fertilizers or other factors related to the production of commodities are the biggest influencers. Speculation does play a part in price variation but a very minimal one.
Furthermore, some investors say there is no spillover between the futures market and the actual spot market*** where the real goods are traded. This, according to Bos, is an even weaker argument because commodities are storable. This means that if there is a difference between the profit investors can make before the expiration date of the futures contract and afterward by actually selling the products in the spot market, they will wait until the contract expires and store the goods they purchased. This inventory model is a clear example of how the two markets meet.
Lastly, when looking at price development, Bos presented how speculation can actually move prices up. In years with bad harvest, the price of commodities will go up. Since most commodities are storable, if the harvest is good in the following year, farmers can choose to hold on to the stock and keep trading at the high price. The possibility of this to occur is much higher if the demand for the product is higher.
Speculation will move the price up, so the value of the commodity might rise even higher than the level attained during a bad harvest. If this is repeated, instead of having the price alternate in smaller peaks, the demand will ensure that price does not go down and just keeps increasing. However, , argued Bos, this will not be sustainable since price will not mirror the value of the product and the bubble will eventually burst. The commodity will go down to its original value and the cycle will be repeated.
How can the commodities market become more stable?
Since the futures market does appear to have an influence on the price of commodities, should investors be forbidden to gamble with food prices? In Bos’ opinion, taking out the futures market is not a good idea. Forbidding commodities indexes will not save the world, neither assuming away ties from futures to spot markets.
What is worth considering at this moment would be excluding oil or energy from the indexes. Price fluctuation in this sector influences the indices price and composition to a very high extent and excluding them will make for a more stable proportion of different commodities and less price fluctuation.
Prof. Jaap Bos on Responsible Investing in Commodities
Final notes and lessons on commodities
When investing in alternative asset classes, investors can have a non-atomistic impact. The futures and spot markets do influence each other and speculation does make the price of underlying goods go up.
Nevertheless, investing in commodities can also have a positive impact on the market, especially when investing in stocks to promote causes such as fair trade or sustainability.
Doing good can also be combined with financial gains if one puts enough research into which assets one should invest in.
By Ana Mihail
Ana Mihail is a student in International Business Economics at Maastricht University.
* A commodity index is made of a weighted average of a basket of commodities. The value of the index fluctuates based on the value of the underlying commodities.
** A futures contract is a contract that allows the holder to buy or sell a product at a certain price and a certain date.
*** The spot market or cash market is the financial market where financial instruments or commodities are traded for immediate delivery. In the futures market, delivery takes place at a later date.