A bubble in the making?

Commodity prices have risen dramatically as institutional investors seek security and diversification. Joseph Mariathasan questions the rationale for investing in commodities now

 "The stone age did not end for lack of stone, and the oil age will end long before the world runs out of oil" is an oft quoted comment of Sheikh Ahmed Zaki Yamani, the former Saudi oil minister. With many commentators speculating that oil prices may reach $200 (€129) a barrel, from the $20 a barrel range seen earlier this decade, should Yamani be seen as a visionary or as a fantasist? The attitude that an institutional investor has towards this view may well be the key factor that determines whether they diversify their portfolios into commodities.

The last few years have certainly seen a tremendous bull run in both energy and agricultural commodities, and the credit crisis provided a boost to precious metals. But are institutional investors being led astray by commodities now after they have already seen spectacular price rises over the past few years? More worryingly, there is strong evidence that the actions of institutional investors themselves may be contributing to the prices rises that they are hoping to benefit from, a classic case of a bubble in the making.

George Soros in his latest book, "The New Paradigm for Financial Markets", explains how financial bubbles always start with some genuine economic transformation - the invention of the internet, the deregulation of credit or the rise of China as a commodity consumer.

The problem is that the existence of a new paradigm gives no indication as to the new equilibrium level for prices. Will Chinese demand drive oil prices to from around $20 a barrel to $50 or $100 or $1,000? What price level represents the equilibrium price for wheat given the increasing wealth of emerging markets combined with increasing urbanisation, leading to a more carnivorous diet? The perception of a new paradigm can produce a self-fulfilling momentum of rising prices that investors interpret as evidence of fundamental shifts. These misconceptions can drive prices to levels that have little relevance to the balance between supply and demand.

Institutional investors have tended to favour investment via commodity indices, of which the most favoured has been the S&P GSCI index (formerly the Goldman Sachs Commodity Index), with some interest also seen in the Dow Jones AIG indices and smaller amounts in the Deutsche Bank index and a variety of others. Generally, this implies a very high energy component. "We have energy-capped versions of the index, which have been popular over the past 18 months but more recently, interest has switched back to the headline GSCI index, which has an energy component of around 75%," says Eric Kolts, vice president for commodities indices at S&P.

Laura Ambroseno, portfolio specialist at Morgan Stanley Investment Management's quantitative and structured solutions division, estimates that the volume of investment via indices has risen from less than $10bn in 2000 to around $250bn in 2008,with the S&P GSCI amounting to over $90bn of this. More recently, assets in Schroders' Agriculture fund grew to $5.4bn this February when it closed to new investment.

But do these trends mean institutional investors are benefiting from long-term structural price changes that are sufficient to warrant a long term significant allocation to the asset class, particularly at current price levels?

Institutional investors who have made major investments into commodities, particularly energy, either exclusively, or through tracking indices such as the S&P GSCI or Dow Jones, may need to think deeply about the exact role commodities play in their portfolios. Phil Collins, who runs the Pheonix fund, a multi-asset portfolio at Newton, has a long-term allocation to commodities of just 2%.

As  Collins puts it: "For every other asset, if you have a long enough time horizon you will make money out of them. In a real asset, capitalism will work for you. Directors of firms look to increase profitability and hence the value of ownership goes up. Bonds pay interest and capital. But looking at a chart of wheat over 50 years you don't make any money. With gold, you can make or lose 50%. There is no reason why the price of a barrel of oil has to be worth more in 50 years time. It is just supply and demand."

The Dutch pension fund Pensioenfonds Zorg en Welzijn (PFZW), the pension fund for the care and welfare sector, has been invested in commodities since 2000, and was the first European pension fund to make a sizeable allocation. PGGM is now the asset management entity of PFZW.

The rationale for this is exactly the same as for Collins, who maintains a strategic allocation, albeit very small. Frans de Wit, who runs PGGM's commodities allocation, explains: "The decision to allocate to commodities has always been one of diversification rather than from a return perspective. We value commodities for their negative to zero correlation to equities and bonds, and to a lesser extent for their positive correlation to inflation. What we do not do is look at the asset class in isolation. The allocation is based on the fact that it will make the overall portfolio less volatile without necessarily sacrificing the expected return."

PGGM managed to benefit from both the diversification effects of commodities and also the recent price rises. Its current allocation is 7%, benchmarked to sub-indices of the S&P GSCI.

While over the long-term, commodities as an asset class may be seen to have too high a volatility for the expected returns, it is the volatility that is attractive in terms of diversification. As De Wit argues: "Although the asset class is volatile in itself, it is in fact the combination with the negative to zero correlation that makes it an attractive asset class to include in the overall portfolio. Given the negative to zero correlation with equities and bonds, the added volatility actually works in our favour in the total portfolio."

But producing diversification benefits requires returns that have the potential to be highly positive as well as negative when other assets classes are booming. There is a major problem with commodity investment that exists currently and is often glossed over by intermediaries. Investment in commodities via the futures markets either directly or indirectly through use of indices based on futures contracts such as the GSCI, generates returns through three different sources.

The first is the changes in the headline spot prices of the commodities; the second is the return on the collateral used to back up investment in futures by an institutional investor who typically would not be leveraging their investment, so a $100m investment in commodities via futures contracts would typically generate a Treasury bill rate of interest on the $100m of capital; and finally, the so called roll yield obtained through switching from a maturing futures contract to one of longer maturity.

In the case of energy futures, the longer dated contracts have often stood at a lower price than maturing contracts giving rise to a backwardation in prices, in contrast to the situation seen in financial futures markets and also precious metals such as gold where the longer dated contracts are in contango - priced above maturing contracts, reflecting interest rates, storage and borrowing costs. What this has meant is that a major source of returns for investors in energy contracts has been obtained through rolling the futures contracts. But when oil went up from $35 to $50 a barrel, the S&P GSCI index had a negative return of 14% because the energy markets were in contango whilst in 2007, with the markets in backwardation, the return was 32% when oil prices shifted from $50 to $80 a barrel.

The disappearance of the roll yield in 2006, many would argue, is intimately related to the influx of institutional investment into commodities. As Collins explains: "We are still positive on oil, and think the price will go higher. But it is driven by investors and the risk is that it will turn. Fundamentally and structurally, the trend is upward, but maybe from $60 a barrel and not $120." Similarly with agricultural commodities Collins argues: "We are in a multi-year bull market in agriculture. There is food price inflation driven by the increased wealth of emerging markets and the move to a more urban society - trends giving rise to more meat consumption. But we don't know the equilibrium position, so we don't know the timing. Our focus is just on direction."

The danger for institutional investors is that while commodities can act as a powerful diversifier for those that really need to reduce volatility even by small amounts, the prospects for extraordinary gains are more suspect. Moreover, the timing even for diversification benefits may be unattractive if the lack of backwardation driven by the influx of investment by the institutions themselves in the energy markets means that the opportunity for positive returns is greatly diminished.