Keeping track of commodity cycles can help one pick up related stocks and diversify the portfolio.
Commodities are a separate asset class and an increasing number of investors are actively looking at this area for meeting their investment needs. Commodity investments help investors achieve diversification of their portfolio, as well as making use of the opportunities to earn a higher rate of return. There are a lot of investors who believe this type of investment is not for them and hence they avoid it. In many cases they do not even look at the area, thinking they have no exposure to it, so there is no impact they will face.
IMPACT
Avoiding commodities and the developments, here, can prove to be costly, because there are a number of ways in which the investor will find the movements or the changes in prices will impact them either directly or indirectly. Ignoring this area can lead to several implications that are not factored into the investments, as often there is no knowledge about what is going on. Investors might not buy commodities but most companies in which they invest are impacted due to the various commodity price movements, so their fate is somehow linked to commodities.
The first part of the process of recognising this involves looking at the various commodities and then checking which of these have some impact on companies in the portfolio. This can either be in the form of a raw material or a part of the product the company is involved in. Once that is done, there are additional factors that will need attention in gauging the exact impact of the developments in this space.
DEMAND
The demand for a commodity is the first factor that often impacts the price of the commodity and, consequently, the financial impact on the result of a company. A strong demand can lead to a situation where the prices often remain steady or move higher. If this is an input for the company, then the impact is not good, but if it is an output, then it can mean higher sales. The exact impact is decided by the pricing power of the company.
For example, if there is strong, rising demand for an agricultural commodity like coffee due to increasing consumption, then one aspect of the price determining factor will be strong.
Similarly, higher demand for steel could propel a higher demand for iron ore and this would lead to ore-mining companies being on a strong wicket on financial performance. This is the starting point of a financial impact and a weakening demand can lead to a fall in prices, like what happened to crude oil when it fell sharply following the economic crisis that led to lower demand across the world.
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SUPPLY
Often, it is not demand but supply that determines the extent to which prices of the commodity will go and this can have a serious disruptive impact down the line. A good example is tea, where the output is expected to be down this year both in India and the world market, as a result tea prices are already rising and consequently, tea companies will perform well.
A commodity like sugar, used on a daily basis, can have a lasting impact due to supply constraints. Poor monsoon in India, along with farmers less interested in planting cane, has led to a shortage of sugar. Coupled with the weather condition in Brazil, this supply is restrained, putting upward pressure on sugar prices. While sugar companies would do well, it is important to look at the other industries like biscuits or soft drinks which are using sugar as a raw material. They will be forced to buy at higher prices, resulting in an increase in their prices. Their ability to pass on prices will determine the end-impact for such companies.
INVENTORIES
There are situations when the inventories of various commodities across the world can take care of the immediate problems arising due to a demand-supply mismatch and this can be a saving grace. For example, adequate inventory of, say, crude oil present with various countries ensures that a short-term demand-supply mismatch can be prevented, with the drawing down of inventories. A similar situation can be witnessed in other spaces, including agricultural commodities and metals. Every industry from automotives to plastics uses some commodity as an input.
Adequate inventories raise expectation of a more stable outlook for prices, while a lower figure here can increase volatility. For example, if there are record inventories of copper that has piled up in the market, then this can be expected to control price movements leading to user-industries being marginally impacted.
SPECULATION
One unknown factor can trump all other items and is very difficult to predict for the investor. This is the role of speculation, especially by various hedge funds and other big players who take positions in various commodities. Liquidity and demand here can change the situation, leading to a position where the risk remains high. In such a situation, there could be a position in precious metals like gold or silver, where additional action by funds can push the price significantly higher, since supply is limited. Precious metals directly impact households and companies that use these for operations are affected indirectly.
The writer is a certified financial planner
