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Demand for natural resources has rocketed as emerging economies - especially China and India - develop and living standards improve. Frances Hughes examines a diverse sector, which includes gold, live cattle and coffee.
Natural resources is becoming a prominent investment area. New funds include the IAF Natural Resources fund, launched in August, Eclectica Asset Management's Agriculture fund launched in June, and the Schroder AS Agriculture fund, which was launched in October last year and is now $1 billion (£500m) in size. Furthermore, DWS announced last month [September] it is applying for UK distributor status for its Agribusiness fund. However, there are funds that have invested in natural resources for much longer. The JPM Natural Resources fund, for example, was launched in 1965.
The increasing demand for natural resources is a result of the rapid rate of global economic growth. The economic development of emerging markets in particular, especially China and India, is the most important component of this surge in demand.
China's rapid industrialisation is a key factor in rising consumption of raw materials. Indeed, increased demand caused the International Energy Agency to revise its forecast in July for growth in oil demand, from 2% a year, to 2.2%.
China is already the world's biggest consumer of copper, nickel and zinc. In short, demand for commodities is increasing at a rapid rate and supply is not keeping up.
Whereas countries like China would previously receive raw materials to produce goods cheaply largely for the Western world, now they are producing them for domestic consumption. "The dynamic is changing," says Richard Raymar, senior UK and Ireland analyst, quantitative asset management research, at Lipper, "Some of the goods are staying there. They are not just going in and coming out. It is about developing countries becoming developed. [These countries] are keeping resources, using them and enjoying them. It's not just for our enjoyment anymore."
The shipping industry is a good indicator of trade in natural resources. Last month's Merril Lynch Global Commodities report says, the dry bulk freight market "continues to hit new highs". Despite a substantial growth in dry bulk ships, which has seen an increase of 20.5% since 2004, the freight index has spiked again, it says.
"Shipping is most clearly related in the trade of natural resources," says Raymar. "The shipping markets have gone crazy over the past year. The demand is driven by both China, where raw materials go in and products go out, [but also because] shipping is an area where the derivatives market is growing."
Furthermore, the Merrill Lynch report says the strength in demand for shipping has contributed to push up bunker fuel demand, particularly outside the Organisation for Economic Cooperation and Development (OECD) countries. Increased shipping therefore, is both a result of increased commodity demand, and also a contributor to it.
Ian Henderson, manager of the JPM Natural Resources fund, says China and India are by far the most important consumers of commodities in emerging markets. Henderson has increased his exposure to gold, iron ore, coal and minor metals and reduced his base metal exposure. "The gold price was likely to go up because of demand from India and weak supply," he explains. "Almost all demand comes from India and China. The rest of the world is almost irrelevant. It's still going up by 10% per annum. There's a huge shortage of commodities. China's infrastructure spend is the biggest. They are building 20 million houses a year and building 20 new airports. It is also coming from the Middle East."
The JPM Natural Resources fund invests in quoted companies in mainstream London Metal Exchange traded commodities and traditional gold and precious metals. The position is 26 different commodities. The biggest sector exposure within the portfolio is the energy sector, with 22% in oil and gas. Gold is 21.3%. Base metals, from mining companies, like BHP Billiton and Rio Tinto is 12%. Alternative energy is 0.3%. "Alternative energy is part of our remit," says Henderson. "There is a role to be played through alternative energy. But it is not a big part of the portfolio. It is a small part of the total market [because] It is expensive and in its initial stages."
Evy Hambro, manager of the MLIIF World Gold & Mining fund at BlackRock, agrees that China's increasing influence is decreasing that of the rest of the world, in particular America. "There are massive changes taking place in the demand landscape," says Hambro. "In the past it was the US and Japan. Now the biggest part of the equation is China, not the US. It is a massive transformation."
China now represents 25-30% of copper demand, according to Hambro, while America is the second largest consumer of copper.
"India, Chile, Brazil, Russia and the Middle East are a powerful group of countries driving demand for commodities on their own," adds Hambro. "That's what's keeping prices as high as they are. They are all important now. Economies that are small in terms of overall consumption are growing fast now. India, for example, will become very important."
Indeed, the Merrill Lynch Global Commodities report says commodities have "to some extent" de-coupled from America. Split into major regions, world energy demand growth now hardly depends on America, according to the report
There are different underlying reasons for demand increasing across various regions: urbanisation, growing populations, increased affluence and building construction are all examples. The demand for mining-related commoditiesin the Middle East for example, is about construction. "That is about the development of a city," says Hambro. "In Moscow it is modernising. In China it's about massive infrastructure projects, power generation, increasing quality of life and urbanisation."
The demand for agricultural resources reflects improvements to living standards and urbanisation. One of the main drivers is the inclusion of meat in the diet of emerging market populations. Livestock need a diet of corn. As people become wealthier they eat more animal protein, and hence require more livestock. This is especially the case in China and India.
Patrick Armstrong, fund of funds manager at Insight, has increased his exposure to agriculture over the past two months. He holds the CF Eclectica Agriculture fund and the DWS Agribusiness fund across Insight's Wealthbuilder Growth, Wealthbuilder Balanced and DTR funds.
"The next wave of the commodities bull cycle will be agricultural commodities," says Armstrong. "Wheat hit an all-time high in August. Growing populations and an urbanisation of China are driving demand for agricultural commodities."
"The two biggest incremental drivers for demand are governments imposing targets for ethanol for bio-diesel usage, and the emerging middle classes in India and China, which are adding meat to their diet."
Armstrong points out that it takes eight kilograms of grain to produce one kilogram of chicken. "Agricultural commodities are attractive," he says. "Demand is outstripping supply now, and inventories are at 20-year lows."
Hugh Hendry, manager of the Eclectica Agriculture fund in which Armstrong invests, agrees that changing diets in emerging markets and the demand for more environmentally friendly fuel is driving agricultural commodity demand. He says these two factors could create a commodity price cycle. "The twin forces of biodiesel and the rising prosperity of China and India are likely to create a super-cycle," he says.
Hendry points out that corn is particularly cheap, trading at just under $4 per bushel at the moment. "You can buy a lot of it for not much money," he says. "For instance, you would require a convoy of 400 large trucks to take delivery of $1m of this year's harvest. That is because it is the same price today as it was 33 years ago."
"In real terms, corn has probably lost over 90% of its value," adds Hendry. "It feels like we are five years behind what has played out in copper. Five years ago copper was 50 cents per pound. Last year it closed at $4. That's the biggest move we've seen in copper's 167-year history. Copper has gone up eight times."
Rodolphe Roche, portfolio manager of the Schroder AS Agriculture fund, also points to agricultural commodities being cheap. "Historically speaking, agricultural prices have never been so low," he says. "The upside is largely higher than the downside."
Roche says there are three main reasons to be bullish on agriculture. "Firstly," he says, "the best way to hedge inflation is through commodities. Secondly, we are entering an environment where agricultural production increases but not in line with demand, [because] emerging countries are increasing demand. Thirdly, there is a new source of demand for biofuels."
Indeed, the demand for biofuels puts more strain on agricultural land, while urbanisation threatens to reduce the amount of land available to be farmed.
"There is only so much agricultural land," says Hendry at Eclectica Asset Management. "It has always been there for agricultural consumption. This is the first time in history that land use does not involve humans. The space given over [to food] is competed away for ethanol. It is a perfect storm. Yet it is still really early in the day."
Roche agrees that prices are likely to increase and says they will continue to do so over the long term. He predicts an eight to 15-year trend. The farmer's challenge, he says, is both how to feed the planet and how to produce more biofuels.
"In emerging countries there is more and more consumption of livestock," says Roche. "We need much more feed. [But] farmers [also] need to produce more biofuels. We don't have a solution how to meet this growing demand. Prices will be higher in the next few years. It is a long term movement."
The need to farm more land to produce enough food and the required amount of biofuels also means that companies linked to the production of these crops are likely to benefit from increased demand as well. This is why Armstrong invests in the Eclectica and DWS funds, he says.
"For demand to meet supply, there will need to be an increase in land farmed," says Armstrong. "Themost fertile land is already being farmed, and new land will likely require more fertilisers and irrigation. We expect companies involved in farm equipment, pesticides and fertilisers will be beneficiaries of this, and we have bought into the Eclectica and DWS funds [for that reason]."
Armstrong holds 1% in Eclectica Agriculture and 2.2% in the DWS Agribusiness funds. He adds that global warming also has the potential to disrupt the supply of grain, which can be seen by droughts in Australia and the mid-west of America.
According to Roche, efforts are being made to increase the availability of agricultural land. "Farmers don't have the possibility to extend this planting area," he says. "In China all land is being used and urbanisation means they extend their towns at the expense of agricultural land, so they have to import more and more. Increasingly they are trying to extend the agricultural land in Argentina, Canada, Brazil and the Black Sea regions. But it is not enough. In the long-term the biggest challenge is how to boost the yield in order to produce enough food."
Roche says subsidies for farmers would help to increase food production. But the World Trade Organisation policy is to decrease subsidies rather than increase it, he says. "We should help subsidise the farmers. Now we have a big deficit. We have a lot of investors and a lot of volatility. It will attract more speculators. We can expect more volatility, like in the metals," says Roche.
The supply of mining commodities is also feeling the strain of increased demand. Some argue a big factor in terms of a supply constraint is under-investment.
"You have to highlight the under-investment story in natural resources in the 1980s, 1990s and early 2000s," says Francisco Blanch, commodities strategist at Merrill Lynch Research. "Only now we are seeing re-investment back into the sector. In the 1980s and 1990s returns were low."
Hambro says under-investment in commodities is a theme BlackRock has talked about for about five years. "In the past capital has not been readily available." he says. "But over the past 10 years or so there has been a lot of consolidation. Companies are tending to build projects that are robust. [But] The rate of supply growth has slowed as they are only bringing them [projects] to the market when the market needs them. There is slower rate of expansion."
"With mining companies there is reluctance to re-invest in new capacity [because of] the capital cost of building these plants," Hambro explains. "All the M&A taking place in this sector means companies have more choice as to how they grow their businesses. They are becoming big diversified mining companies that produce a range of commodities. These larger companies [are] having big positions in overall supply."
Hambro also points out there are severe shortages of mining equipment. "The waiting time for new equipment has extended massively," he says, "and there is a shortage of highly-skilled employees. There is tight supply in markets," he adds. "In the mining sector we are in a stronger-for-longer environment with regards to pricing."
"The same factors affect the gold industry," he says. "You still need mining engineers for example. There have been low gold prices for many years. That has lead to under-investment. There has been a major shortage of projects."
Furthermore, Hambro says there are decreasing levels of supply in gold. "Now we have a declining production profile," he says. "Many other commodities are growing supply. With gold there is strong demand, but falling supply."
Volatility in prices, especially in agricultural commodities, is something to be expected, according to Hendry and Roche. They say agricultural commodities are at the beginning of their cycle and will be affected by speculation.
"The stocks we invest in are small companies no one has heard of," says Hendry of Eclectica. "When everyone has heard of them and is discussing their favourite fertiliser stock, the cycle is near the end. [but] Because it is early it is volatile.
In August the Eclectica Agribusiness fund lost 5 to 6%, says Hendry. But he does warn clients they must expect volatility. "It is volatile," says Hendry. "You can't put all your money into it. It has everything to do with speculation. It is like a call option. It is hard to own something when you are early."
"Agricultural commodities is a virgin bull market. It makes it hard for professional portfolio managers. It is speculation before the confirmation. Five years ago [metals] was volatile. Now it is not very volatile. They are more mature in their advance."
Roche, at Schroders, agrees there will be setbacks in agricultural commodity prices. "It will not be regular," he says. "With agriculture we are in a long-term trend. Energy prices began its bullish trend in 1998. Agriculture just began in 2006. Agriculture commodities are always delayed to energy products. We always have a lag."
Although some investors are cautious about volatile markets, the fact commodities are a good diversification tool works in their favour.
Agricultural commodities especially, show little correlation to equities and bonds. The Merrill Lynch Global Commodities report reinforces this view. It says: "Agriculture and precious metals are the best defensive plays in the market environment".
The report says that commodities "bear very little, or even negative, correlation with other asset classes", and adds that the negative correlation has been particularly high since January 2006. "Commodities," it says, "are one of the best macro hedges against a sharp drop in bond or equity prices." Therefore, commodities, offer good diversification opportunities to investors.
Although natural resources is a diverse sector, there are key themes within it that can be generally applied. That commodities are a good diversification tool is one. That demand is being driven by global population and GDP growth, is another.
Whether it is oil, precious metals or corn, the rise of the middle classes and increased urbanisation in emerging markets is a key driver in the demand for natural resources. The final common denominator is that the supply of natural resources is constrained. Many commodities will be increasing in supply, but none of them are keeping up with the increasing rate to which people want them.
