Level 1 CFA® Exam:
Categories of Commodities
Commodities include many categories, e.g.:
- energy: crude oil, natural gas, refined products, electricity, etc.
- agriculture: grains, livestock, coffee, etc.
- industrial (base) metals: copper, aluminum, nickel, etc.
- precious metals: gold, silver, platinum, etc.
- digital assets: digital tokens, virtual currencies, etc.
Here are the benefits of having commodities in a portfolio:
- First of all, investors benefit from the diversification of the portfolio because there is a low correlation between commodities and securities like stocks or bonds.
- What’s more, rates of return on investments in various assets differ depending on the economic cycle. Note that the rate of return on commodities is the greatest when the rate of return on stocks is the lowest (this usually happens in the late stage of economic recovery).
- Last but not least, since the prices of commodities rise in periods of growing inflation, the biggest advantage of commodity investing is this natural hedge against inflation.
Let's start with the following formula which describes a futures price.
If the futures price is not equal to the theoretical futures price, an arbitrage is possible.
It should be obvious what storage costs are and why the price of the futures contract increases as storage costs get higher. If storage costs are high, the long party (the one that holds the underlying asset) will want the price of the futures contract to be adjusted for the costs associated with storing the underlying.
But what is convenience yield and why do you subtract it?
The buyer of the futures contract does not have immediate access to the commodity. In other words, the buyer has given up the convenience of having physical possession of the commodity. In the futures price formula, the convenience yield is preceded by a minus sign, so the higher the convenience yield, the lower the futures price, and vice versa. The lower the convenience yield, the higher the futures price.
Because convenience yield is included in the futures price formula, a futures price may be either higher or lower than the spot price. These situations are respectively called:
- contango, and
Contango is a situation where the futures price is higher than the spot price. It occurs when the convenience yield is close to zero. This phenomenon is common in markets where investors expect a rise in spot prices in the future and which are dominated by investors buying futures contracts to hedge against price increases. We call these investors long hedgers.
Backwardation is the opposite of contango, so the futures price is lower than the spot price. It occurs when the convenience yield is high. This phenomenon is common in markets where investors expect a drop in spot prices in the future and which are dominated by investors selling futures contracts to hedge against price drops. We call such investors short hedgers. Typically, short hedgers are simply manufacturers.
- Commodities include many categories: energy, agriculture, industrial (base) metals, precious metals, and digital assets.
- Investors invest in commodities through investing in: derivatives on commodities, exchange-traded funds (ETFs), shares of companies with high exposure to the commodity markets, individual managed accounts, funds that specialize in commodity investing such as managed futures funds (aka. commodity trading advisors, CTA), private energy partnerships, private equity funds with exposure to a given commodity sector, etc.
- The biggest advantage of commodity investing is this natural hedge against inflation.
- The lower the convenience yield, the higher the futures price.
- Contango is a situation where the futures price is higher than the spot price. It occurs when the convenience yield is close to zero.
- Backwardation is the opposite of contango, so the futures price is lower than the spot price. It occurs when the convenience yield is high.
- The investment cycle in the case of timberland is much longer than in the case of agricultural land.
- Generally, farmland and timberland investments offer us 2 sources of return: income, which depends on harvest quantity and market prices, and appreciation of land.