Thursday, July 16, 2009

The Hard and Soft Commodities

In my investment portfolio for my clients, I'd allocated around 10%-20% towards commodities funds. In theory, Commodities are supposed to be able to hedge against inflation and provide some sort of diversification from Equities and Bonds. Some commodities funds gain direct exposure by investing into commodity futures and some invested into shares of commodities related companies.

There are 2 main types of commodities which we termed as hard and soft. For simplicity, we consider commodity that can be grown or raised as soft commodity, and commodity that you have to mine or drill as a hard commodity.

Hard Commodities
* A hard commodity are commodities such as metals, crude oil, or coal. This term generally refers to commodities that are mined, rather than grown.
* They require extensive capital expenditures in order to be retrieved from the earth. These commodities are finite in nature and have limited resources.
* Demand for these resources has rose significantly over the years to service the fast growing global economy, especially in the emerging markets of China and India.
* The demand for hard commodities normally follows economic growth cycles and that prices of oil and industrial metals will pick up fast when the economy booms.
* From the supply side, the hard commodities that are mined and drilled may not fast enough to meet this rising demand. This is because it become more expensive to drill for each drop of Oil or to extract each piece of metal plus the fact that exploration budgets are slashed all over the world resulting in fewer resources from the grounds are found.
Soft Commodities
* A soft commodity are commodities such as coffee, cocoa, sugar, corn and fruit, etc. This term generally refers to commodities that are grown, rather than mined.
* Soft commodities tend to have a renewing characteristic. Crops can be re-grown, and typically in the same spot as the previous crop and meat commodities are the result of animal breeding with accurate forecasting.
* Soft Commodities are non-finite in nature. As long as "Ice Age" doesn’t strike the earth, grains will always be grown and cows, pigs or chickens will never become extinct.
* Soft commodities may be impacted by the rate of growth in the economy. As wealth increases, the demand for meat will increase. When meat demand increase, demand for grains will also increase.
* Food supply can also be influenced by nature such as weather or natural disasters. A drought or a locust attack in a major growing area may affect supply and hence prices. They can also be influenced by political such as trade barriers or even labour strikes, etc

How I view both commodities if a Bull comes around
* In a Bull Market, Soft commodities may not move as fast as hard commodities but at a later stage of a bull market, prices of soft commodities can be affected by the rise in price of hard commodities.
* Some soft commodities which are closely correlated to oil may rise fast during a economic bull. Eg, Sugar for Ethanol, Crude Palm Oil or even corns
* An expected weaker US dollar can also be positive for commodities as they are traded in that currency. From a non-US purchaser's perspective, a weakening dollar would raise purchasing power, theoretically demand should increase as well.
* Speculations will start to create havoc to the world like what had happened in 2007 and 2008 when oil prices reaches $147/barrel. Its in no time that oil will start trading at $100/barrel again.

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