Why Commodities - Types of Commodities - Benefits of Investing in Commodities

Why Commodities ?

Global Institutional investor interest in commodity trading has increased significantly over the past few years. This, in part, reflects powerful cyclical and structural forces working in favor of commodity markets, while, also the realization of the need to diversify personal investments into upcoming and popular financial products.

But what are these commodities?

Commodities are goods that are typically used as inputs in the production of other goods and services. Commodity prices are determined largely by supply and demand interactions in the global marketplace. Supply and demand conditions may be influenced by factors like the weather, Geo-political events, and supply-side shocks (e.g., wars, hurricanes).

Some examples of commonly traded commodities are energy products like oil and natural gas, metals like gold, copper and nickel, and agricultural products like sugar, coffee, and soybean.

Commodities exhibit interesting risk-return profile. Commodities not only offer a good way to diversify a portfolio of stocks and bonds, they often offer better returns. According to a Yale Study,

• Since 1959, commodities futures have produced better annual returns than stocks returns and outperformed bond returns even more.
• During the 1970s, commodities futures outperformed stocks; during the 1980s the exact opposite was true - evidence of the  "negative correlation" between stocks and commodities that many of us have noticed.
• The returns on commodities futures "positively correlate" with inflation. Higher commodity prices were leading a wave of high prices in general (i.e., inflation), and that's why commodity returns do better in inflationary times, while stocks and bonds perform poorly.
• The returns on commodities futures were "triple" the returns on stocks in companies that produced the same commodities.

Types of Commodities
 
Broadly speaking commodities can be divided in two categories: Soft and Hard

Soft commodities are typically grown. Corn, wheat, soybean, Soybean oil, sugar are all examples of "soft" commodities. Many soft commodities are subject to spoilage, which can create huge volatility in the short term. Weather plays a huge role in the softs market, which makes predicting supply especially difficult.

On the other Hard" commodities are typically mined from the ground or taken from other natural resources: gold, oil, aluminum. In many cases, initial products are refined into further commodities, as oil is refined into gasoline. Because "hard" commodities are easier to handle than "softs," and because they are more integrated into the industrial process, most investors focus on these products

•     Agriculture commodities

•     Non- Agriculture commodities 

Agriculture commodities

Agriculture provides the principal means of livelihood for over 58.4% of India's population. It contributes approximately one-fifth of total gross domestic product (GDP). Agriculture accounts for about 10 per cent of the total export earnings and provides raw material to a large number of industries. Being the third largest land mass in world it is number top producer of many agriculture commodities. And yet Indian agriculture has one of the lowest yields in most commodities, nearly 55.7% of area sown is dependent on rainfall. Clearly while there are challenges there are huge potentials as well.

Edible Oil Complex

Edible oil complex include actively traded commodities like soy beans, refined soy oil, soy meal, Mustard seed and Crude palm oil. These commodities contribute to more than 50% of the exchange volume. Out of the various Agri- commodities traded at the domestic bourses Edible oil complex have global appeal and therefore their prices move in tandem with the international markets. Prices in domestic exchanges enjoy high correlation with their global counterparts. Chicago Board of Trade (CBOT) is considered to be benchmark for Soy complex pricing and Bursa Malaysia Exchange is considered to be benchmark for Crude Palm oil pricing.

Soya Complex

Mustard seed

Crude Palm Oil

Castor Seed

Cottonseed Oil Cake

Pulses

India is the world's largest producer, consumer of pulses. Chana, Tur, Urad, Moong are some of the major pulses grown in the country. Of the total pulses production in India Chana contributes more than 40%. Chana is also the only commodity traded in the pulses segment and India being the lone platform for the trade globally. The commodity is highly liquid due to its high correlation with the physical market prices. This has attracted large volume of trade in this counter. Also Chana trading has been attracted by large corporates as well as retail traders due to its growing usage in food industry making it very attractive for hedging and arbitrage perspective.

•   Chana

·        

Grains

India has moved rapidly from being an importer of food grains to becoming an exporter. Today, it is the second largest rice producer after China, with a share of 20% of world in production, and is ranked tenth amongst the world's wheat growers. Currently India is one of the largest producers of cereals and grains. India produced more than 200 million tonnes of different food grains every year. The country is self-sufficient in grain production. Grain processing is the biggest component in the food sector, sharing over 40% of the total value. Grains can emerge as a major foreign exchange earner for India in the coming years. India's food grains production is now at around 230-240 million tonnes. These include rice, jawar, bajra, maize, wheat, gram and pulses.

Wheat

Barley

Maze

Spices

India is known as the 'The home of spices'. India is the leading producer, consumer and exporter of spices in the world. India contributes about 48% to the world spices demand. At present, India produces around 2.75 million tons of different spices valued at approximately 4.2 billion US $, and holds the premier position in the world spices market. In India, spices are important commercial crops from the point of view of both domestic consumption and export. Spices export from India has registered an all-time high both in terms of quantity and value during 2010-11.

Chilli, Coriander, Jeera, Pepper, Turmeric and cardamom constitute spice complex for derivatives trading in India. The performance of these contracts illustrates the success of efficient price discovery in the Indian domestic market through derivatives trading. Albeit the fact is that no other futures contracts of spices are actively traded on any of leading international exchanges.

Jeera

Pepper

Turmeric

Dhanya

Chilli

Cardamom

Others

India plays a crucial role in both the commodities Cotton and Sugar. India is the second largest producer consumer and exporter of Cotton. While production and global trade of sugar is very volatile because India is the largest consumer of sugar in the world, surplus or deficit in India tilts the global prices in the one or the other direction. Effectively both these commodities are very broad commodities has large economies of their own in India are an important price influencing factor in world. Within India both the commodities provide very important source of income to millions of farmers, traders and exporters, and because of its importance are highly politically sensitive commodities. Derivative segment for both the commodities is in nascent stage and does not justify the wide economic base it has in the country.

Cotton

Sugar

Mentha Oil

Potato

Non- Agriculture commodities

Broadly speaking commodities can be divided in two categories: Soft and Hard

Soft commodities are typically grown. Corn, wheat, soybean, Soybean oil, sugar are all examples of "soft" commodities. Many soft commodities are subject to spoilage, which can create huge volatility in the short term. Weather plays a huge role in the softs market, which makes predicting supply especially difficult.

On the other Hard" commodities are typically mined from the ground or taken from other natural resources: gold, oil, aluminum. In many cases, initial products are refined into further commodities, as oil is refined into gasoline. Because "hard" commodities are easier to handle than "softs," and because they are more integrated into the industrial process, most investors focus on these products

• Non- Agriculture commodities

While Nonagricultural commodities can include everything that is not agriculture, the derivative segment has evolved in Industrial Metals, Energy and Precious Metals.

India has huge deposits of natural resources in form of minerals like copper, iron ore, bauxite, and gold. Even on demand front India is one the major consumer of industrial metals and largest consumer of Gold. India is one of the few high growth economies. With growing focus on infrastructure the demand for these metals will continue to rise. India's energy consumption has been increasing at one of the fastest rates in the world due to population growth and economic development.

Precious Metals

A precious metal is a rare, naturally occurring metal of high economic value. The best-known precious metals are gold and silver. Other precious metals include the platinum group metals: ruthenium, rhodium, palladium, osmium, iridium, and platinum. The demand for precious metals is driven not only by their practical use but also by their role as investments and a store of value.

Gold is known for its role of an alternative asset in case of economic or political uncertainty. India being the biggest gold consumer also plays a key role in gold market. Silver is the cheapest precious metal but has close correlation with gold and rightly called poor man's gold. Platinum group metals are mostly used for industrial purposes.

Gold and silver are few of the highly liquid commodities on Indian and global commodity exchanges. Physical market for these metals is equally developed.

Gold

Silver

Base Metals Complex

Base metal complex is alternatively known as Non-Ferrous complex and includes metals like - Copper, Aluminium, Lead, Nickel and Zinc. They are used extensively in industrial applications. Availability is region specific while the usage is worldwide. As a result the price discovery is global. This complex has attracted the attention of the investment community giving different dimension to their importance. London Metal Exchange (LME) is considered to be benchmark for base metals pricing.

Copper

Aluminium

Steel

Nickel

Led

Zinc

Energy

Energy sources can be divided into two major groups- renewable (an energy source that can be easily replenished) and nonrenewable (an energy source that we are using up and cannot recreate). We get most of our energy from nonrenewable energy sources, which include the fossil fuels - crude oil, natural gas, and coal.

Crude oil is a vital source of energy for the world and will likely remain so for many decades to come. It is used to produce fuel for transportation, for power generation and to produce many other industrial fuels. Most countries are significantly affected by developments in the oil market, either as producers, consumers, or both. India being a growing economy and a major consumer plays an important role in crude oil market.

Natural gas is also used for transportation, electricity generation or residential/industrial heating but is a much cleaner source of energy than oil or gas. Natural gas is gaining a significant share in India's energy mix to reduce dependence on oil and coal.

Crude oil is one of the most liquid commodities on domestic and international exchange.

Crude Oil

Natural Gas

Benefits of Investing in Commodities

Diversification - Commodity returns have historically had low or negative correlations with the returns of other major asset classes, and may be used to diversify a portfolio. Other factors remaining same, diversified portfolios with low aggregate correlation tend to have lower volatility of returns. Therefore, diversification may improve risk-adjusted returns. Commodities may react differently from stocks and bonds in various economic and Geo-political situations, enhancing risk-adjusted returns and reducing the overall volatility of a portfolio.

Inflation protection - Changing macroeconomic factors (like inflation) tend to impact commodities differently from other financial products. Prices of goods and services rise in tandem with input prices, while prices of stocks and bonds tend to decline because of rising commodity input prices which put pressure on the economy and lower the value of future cash flows.

Hedge against event risk - Geo-political events like wars and supply disruptions due to natural disasters like hurricanes, droughts and floods may impact the supply of, and increase the demand for, certain commodities. Including commodities in a portfolio may act as a potential hedge against certain types of event risks.