Topic 8: Natural resources & commodities

What two broad categories make up natural resources as an asset class?

Commodities and raw land used for agricultural purposes (farmland and timberland).

What are the five commodity sectors?

(1) Energy — oil, natural gas, electricity, coal; (2) Base metals — copper, aluminium, zinc, lead, tin, nickel; (3) Precious metals — gold, silver, platinum; (4) Agriculture — grains, livestock, coffee; (5) Other — carbon credits, freight, forest products.

What is meant by the "financialisation of commodities"?

The process by which commodities are increasingly treated and used as financial investments rather than purely as physical goods.

Why do commodities themselves not generate cash flows?

Commodities are physical assets that produce no income stream. Instead, they incur costs (storage, transportation, insurance) and investors seek returns purely from price appreciation.

Why do most investors gain commodity exposure through derivatives rather than physical ownership?

Physical ownership creates tax obligations and costs (storage, insurance, brokerage, transportation), and physical markets can lack transparency. Futures/forwards are standardised, exchange-traded, marked-to-market daily, and highly liquid.

 

What four terms does a commodity derivative contract standardise?

Quantity, quality, maturity date, and delivery location.

What are the three main benefits of exchange-traded commodity derivatives?

Minimised counterparty risk, daily mark-to-market, and high liquidity facilitating price discovery.

What is a CTA (Commodity Trading Adviser)?

A managed futures fund that makes directional investments primarily in futures markets using technical and fundamental strategies. CTAs may focus on a single commodity or be diversified across many.

What is the cost of carry in commodity futures pricing, and what does it consist of?

The cost of carry reflects the opportunity cost of holding a commodity. It consists of the risk-free interest rate (r) and the cost of storing, transporting, and insuring the commodity (c). It is positive and increases the futures price.

What is the convenience yield in commodity futures pricing?

The non-cash benefit from holding the physical commodity — e.g., ensuring continuous access when inventory levels are low. It accrues only to the physical holder, so it reduces the futures price.

Write the continuous-time commodity futures pricing formula and define all terms.

F₀(T) = S₀ · e^((r + c − i)T)

Where: S₀ = current spot price, r = risk-free rate, c = cost of storage, i = convenience yield, T = time to expiration.

What is contango and what condition causes it?

Contango is when futures price > spot price (upward-sloping futures curve). It occurs when r + c > i (cost of carry exceeds convenience yield).

What is backwardation and what condition causes it?

Backwardation is when futures price < spot price (downward-sloping/inverted futures curve). It occurs when r + c < i (convenience yield exceeds cost of carry).

In January 2020, was the NYMEX oil futures curve in contango or backwardation? Why is this economically intuitive?

Backwardation. The market had ample supply and strong convenience yield — holders valued immediate physical access, driving spot prices above futures prices.

In May 2020, was the NYMEX oil futures curve in contango or backwardation? What drove this?

Contango. COVID-19 collapsed demand and storage became extremely costly, pushing futures prices above spot prices.

How does timberland investment generate returns?

Through (1) biological growth of trees, (2) harvest quantities and sale of trees/wood/timber products, (3) lumber prices, (4) price appreciation of land, and (5) lease revenue.

How does farmland investment generate returns?

Through (1) harvest quantities and sale of crops/agricultural products, (2) commodity prices, (3) price appreciation of land, and (4) lease revenue.

What is the key difference between timberland and farmland in terms of harvest flexibility?

Timber harvest timing can be chosen by the investor (trees can be left to grow), whereas farmland crops follow a regular, fixed harvest cycle.

What is the primary risk specific to farmland versus timberland?

Farmland is highly sensitive to unexpected weather changes and climate developments that can destroy crops and eradicate revenues. Both share biological/disease risks; farmland bears more weather risk.

What are the main risks for raw land investment?

The risk of best alternative use — i.e., whether the land has higher-value competing uses that could affect its valuation.

What is a TIMO?

A Timberland Investment Management Organisation — a specialist manager that institutional investors (e.g., pension funds) use to manage direct timberland investments due to the specialised knowledge required.

How do land investments (farmland/timberland) differ from real estate?

Land investments are unique, illiquid assets with distinct geographic features, but unlike real estate there is limited or no focus on physical improvements to the land.

Who are the typical owners of timberland vs farmland?

Timberland: mostly institutional investors, some individual. Farmland: mostly individuals, some institutional.

 

What ownership structures are available for timberland investment?

Direct ownership, limited partnership, REIT, and TIMO.

What are the three main investment motivations for natural resources?

Potential for returns, portfolio diversification, and inflation protection.

Why do commodity returns tend to positively correlate with inflation?

Some commodities (e.g., oil, food) are direct components of consumer price indices. During periods of strong economic growth, inventory levels fall and commodity prices rise, which feeds into inflation. So commodity price gains and inflation tend to move together.

How do farmland/timberland and commodity correlations with stocks compare?

Farmland and timberland historically exhibit almost no correlation with global stock returns. Commodity returns show only moderate correlation with stocks.

What is the correlation of natural resource investments with bond returns?

Virtually uncorrelated, supporting their portfolio diversification potential.

Why can commodity producers not quickly respond to price signals by increasing supply?

Extended lead times are required to alter production levels — e.g., drilling new wells, planting new crops, or building processing facilities takes months or years.

Why are indirect investment vehicles for land growing in popularity?

Direct land investments suffer from illiquidity and limited price transparency. Farmland funds, limited partnerships, and publicly traded REITs offer more accessible and liquid routes to land exposure.

What ESG motivations drive institutional investment in farmland and timberland?

Sustainability, water conservation, and carbon offsetting objectives.

What does the forward pricing formula predict when convenience yield is zero?

F₀(T) = S₀ · e^((r + c)T) — the futures price simply exceeds the spot price by the full cost of carry, meaning the market is always in contango with no offsetting benefit from holding the physical asset.

What happens to the futures curve shape as convenience yield rises relative to cost of carry?

The futures curve flattens and eventually inverts — moving from contango towards backwardation as the benefit of physical ownership increasingly outweighs storage/financing costs.

Distinguish between an ETF and an ETN as commodity investment vehicles.

Both are Exchange-Traded Products (ETPs). An ETF holds the underlying assets or futures directly. An ETN is a debt instrument issued by a bank promising the return of an index — it carries issuer credit risk that an ETF does not.