Commodities are receiving global attention because of their ability to provide investors with good returns during times of crisis.
Although some commodities may fall in price as a result of geopolitical turmoil or natural disaster, others become more valuable.
Richard Davis, the manager of the BlackRock Commodities Income investment trust, says that natural resource portfolios should be correspondingly diversified to enable them to take advantage of gains and to minimise losses.
“Our fund is invested in 55% oil, and 45% mining. Oil is experiencing a very good period of growth, while gold and iron ore are also trading strongly. We like to have all the bases covered,” he says.
Political risk is possibly a more potent threat to returns than natural disasters. As commodity prices rise there is a tendency for governments to look for windfall tax benefits. To help guard against this danger the portfolio is diversified in terms of both geography and sector.
Australia announced a 40% mining profit tax in 2010 to be implemented next year. This had an immediate impact on Rio Tinto, one of the fund’s top 10 holdings. Several countries in South America such as Brazil, Chile and Peru have hinted at similar taxes.
Gold, which makes up 3% of the portfolio, provides another kind of diversification. Demand for the precious metal tends to rise when there is uncertainty with worldwide markets in general, as it is seen as a natural hedge.
The fund is further diversified through holdings in aluminium, copper, fertiliser, nickel, tin and zinc. For these commodities the key factor is demand rather than use as a hedge.
Two key events have tested the fund’s diversification strategy so far this year. When the Middle Eastern protests reached Libya, oil production halted as clashes turned violent. As a result, oil prices soared to over $100 a barrel.
Shortly afterwards the massive earthquake, measuring 9.0 on the Richter scale, hit northeastern Japan, to be followed by a devastating tsunami and a nuclear crisis. In the wake of the disaster many countries suspended their nuclear programme. Germany announced it would temporarily shut seven of its 17 nuclear reactors while China said it would suspend approval for new plants.
The price of uranium slumped more than 15% as a result. The ultimate fear for uranium investors is that development plans in the nuclear industry could be severely damaged.
Davis says that Japan’s disaster will reveal a need for other commodities to outweigh negativity towards nuclear production.
He adds: “Uranium prices fell dramatically in a short space of time, which undoubtedly affected commodities funds that hold it. However, Japan is going to need to import vast quantities of commodities such as concrete and steel when the reconstruction phase begins.”
Although reconstruction following the disaster will take time, a more immediate effect will be Japan’s need for fuel in the absence of nuclear power.
A carefully balanced commodities fund could benefit from the shift towards other fuels.
Another risk is that China, the largest global consumer of many commodities, could suffer an economic downturn.
If China were to fall into recession, or a bubble were to burst in its property market, this would have serious implications for commodities.
It would also be difficult to diversify against because China consumes the full range of natural resources.
On the upside, commodities are likely to remain strong as long as China maintains steady growth.
Davis says: “If China was to slip in to recession, or a bubble was to appear in its economy, this would definitely have an effect.”
“Otherwise, we believe it is a global bull market for commodities and demand will continue to outstrip supply.”
In the case of the BlackRock Commodities Income Investment Trust, the success of two of its major mining holdings, Vale and Rio Tinto, depend greatly on China’s ability to buy construction-related products.