Monday, 3 December 2007

Commodities Investment

Hi it’s been a long time since I last updated my blog. I was busy preparing for my CFA examination. It’s over now and I'm back again :)

If you have flipped through the papers recently or have listen to the news, I guess the most commonly heard news beside the Cambodia tragedy was the rising prices of almost everything but not your salary :( If you have read about Dr Money column about inflation, he demonstrated a simple seven steps process of setting your own inflation rate to manage your expenses more efficiently. He mentioned in his step 6 that commodities and property do well in inflationary times. There are however many commodities related securities that one can invest in.

Investing in commodities gives an investor exposure to an economy's production and consumption growth. When the economy experiences growth, the demand for commodities increases, and price increases are likely. When housing starts to increase, the demand for sand, bricks, cement etc. increase; when automobile sales are high, the demand for steel is likely high as well. During recessions, commodity prices are likely to fall with decreased demand. Overall, swings in commodity prices are likely to be larger than changes in finished goods prices.

The motivation for investing in commodities may be as an inflation hedge as what Dr Money had mentioned or for hedging purposes or for speculation on the direction of commodity prices over the near term. Most investors do not invest directly in commodities that need to be transported and stored. Passive investors who hold commodities as an asset class for diversification or those who hold commodities as a long-term inflation hedge are more likely to invest in a collateralized futures position. A collateralized futures position or collateralized futures fund is a combination of an investment in commodity futures and an investment in Treasury securities equal in value to the value of the futures position. Active investors may invest in commodity futures in an attempt to profit from economic growth that is associated with higher commodity prices.

Commodity-linked equity investments also provide exposure to commodity price changes. Shares of commodity producing companies are likely to experience returns that are strongly tied to the prices of the commodities produced. This may be especially true for the shares of smaller, less diversified commodity producing firms.

Commodity-linked bonds provide income as well as exposure to commodity price changes since the overall return is based on the price of a single commodity such as gold or oil. Other commodity-linked bonds are linked to inflation through payments based on inflation or a commodity price index. These bonds may be attractive to a fixed-income portfolio manager who wants exposure to commodity price changes but cannot invest either directly in commodities or in derivative securities.

Having mentioned so much about commodities investment, some of you may be ready to seek out stock related to commodities and hope to profit from them when inflation kicks in. Inflation in 2005 was 0.5 per cent. It doubled to 1 per cent in 2006. This year, it will be about 2 per cent. Last month, the Government forecast 2008 inflation to be 2 to 3 per cent. Now, the official forecast is 3.5 to 4.5 per cent. These figures seem too good to let go of any investment opportunities in commodities.

Nevertheless remember that the short-term market is always irrational. For students from the WA08 class, remember what Conrad mentioned to us? In case you have forgotten, he told us to avoid oil, energy and utilities stocks as they move along with supply and demand of the economy and fluctuate with the prices of commodities. You should understand better why he said that now.


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