Investing in Commodity

It is not as simple as you think and I see kind of air turbulence for commodity in next couple of months. Things do look a little bit too perky for my taste in the short term.

There has been rapid demand for commodities from financial investors to the point that commodities have become a mainstream asset class. According to Barclay Capital, total commodity linked asset under management 36% last year to US$257 billion, with ETF program growing even faster. Only a few years ago, commodity-linked ETFs were a rare phenomenon and it has grown to become the product of choice for many commodity investors. Commodities now are becoming more financial rather than real assets. Over the past 15 years, financial futures have grown from 2 times the size of physical markets to almost 12 times the size.

As commodity markets are tiny compared to the size of financial markets, prices are easily distorted. In this respect, China – the largest nation on earth, is intimately linked to the growth story of commodities and there is no doubt at present, a desire of the Chinese authority to cool down things a notch or two. Deutsche Bank now expects growth in Chinese infrastructure spending to be slashed from 120% last year to just 4-10% this year. Industrial metals such as lead, zinc, copper and nickel are particularly sensitive to such investments.

It is also a fact that China stockpiled commodities en-masse last year and Royal Bank of Scotland has found a ferocious appetite for industrial metals from Chinese buyers throughout 2009. By stock piling commodities on a large scale, China is effectively placing their excess dollars in hard assets rather than buying the more dubious paper assets – US treasuries. It is also helped to lower large trade surpluses - a point of contention that will set RMB to appreciation path.

One should also beware of contango effects i.e. when the future is priced higher than the spot price and the roll yield is negative. Most commodities are in contango more often than not, effectively costing investors the spread between the nearby future and the more distant future every time the position is rolled. The danger is that for passive investors to be taken out by professional and active traders every time they need to roll their positions.