Manage Risks at the Origin – The Commodities Way
V. Shunmugam*
Dalal Street Investment Journal

Pg 16-17; March 15-28, 2010

Being so closely related to the basic existence of mankind, no doubt, commodities will remain the fundamental recommendation of any portfolio manager and that is what makes them so important

Man is born due to commodities, lives with commodities. Not less importantly, his end of the era on the earth also needs commodities to ceremoniously complete the same apart from other things. In short commodities are so essential to human kind’s existence on the planet for which they compete, complement, and compromise to live together in a society to produce, earn, share and use it. It is the way mankind earned these commodities and used them, that had led to the creation of an economy and the opportunities that had come along with it. To share these among themselves according to the innate value these could command for the provider and its outer use value to its receiver, money came into being which also over a period of time transformed from sheep and goats to gold/silver coin and to the current bearer note that we use today. Noted economist Keynes rightly said that money remains the only bridge connecting the values from the present to the future and with the past as well so that transactions among the stakeholders can take place smoothly easing out the happening of economic activities as well.

Unfortunately, as the innate value and the outer value of commodities differ as it takes several transformations and quite a bit of time to reach the ultimate user, it tends to give excess of money in the hands of all those who are involved in this process under normal conditions. Mankind saved this excess keeping in mind his productive and unproductive period of life besides keeping in mind the uncertainties of life. To save this excess, the economy created opportunities and paid something in return for those who have provided access to this excess in its need of creation of newer opportunities which had longer payback period such as investments in industry, infrastructure and the services sector. To trade these opportunities, mankind also created markets to function under certain own rules and regulations for the smooth conduct of its activities. In this logical sequence, no wonder, why the markets emerged first for commodities to be later replicated for the financial instruments such as stocks, bonds, interest rates and currencies in the ring, if we trace the global history for origin of financial markets. Not only because that it is the savings of the very same mankind that goes into these markets for various asset classes (stocks, bonds, currencies, etc) but also because these are connected in one way or another to deliver the primary commodities as industrial commodities or services to the ultimate users added with mankind’s own efforts (labour) in the process.

While the value addition opportunities tended to flourish in economies as they developed, increasing population and its quest for commodities other than just for its basic existence, led to a situation where commodities were getting scarcer by time and alternatives for them were hardly emerging through. Also, it led to a situation of fear among the stakeholders leading to the building up of irrationality in the markets, naturally, when emotion starts ruling the participants’ mindsets, if one were to cut him off from the short-term fluctuations especially the one which is the result of recent financial crisis there has been consistently secular trend of increase in commodity prices. Besides that, the interconnectedness of the other markets and the irrationality in them had led to a strong cross-influence on the commodity markets as was witnessed during the current financial crisis. In a nutshell, it means that one who has an exposure in one market, will be in one or another way getting affected by what is happening in the other markets. The basic cause remains that producers of goods or owners of asset classes fail to manage their risks themselves in a better way. Even if they were to, perfect risk management by any of the stakeolders is something not feasible in the real world situation.

It makes a strong case for Markowitz’s portfolio theory which suggests that an efficient portfolio should essentially be diversified, not only to yield better returns but also to guard against risks in related asset classes. Being so closely related to the basic existence of mankind, no doubt, commodities will remain the fundamental recommendation of any portfolio manager. If one takes into account the following commodity intensive industries and their raw material prices, as is evident in the table that their stock prices and their raw material/finished produce prices have a strong correlation among themselves. This is fundamentally due to the fact that risks in their raw material costs or finished product prices are not appropriately managed by them. It provides a strong case for those investing in the mentioned stocks in the table to have appropriate position in the raw materials or the finished products produced by those companies which are traded on commodity exchanges so that one can manage volatility in the stock prices directly on the commodity price movements and further earn the pure business profits, the stock of the company can generate.

Easy and cost effective way of managing this risk arising out of price movements in commodities is being enabled by way of electronic national online commodity exchanges such as MCX trading on global asset classes since 2003. While a part of the corporate sector with relevant commodity being traded on the exchange are participating in the platform, another part is allowing these risks to partly eat into their profits or manage these in the same old traditional way of managing it costlier in the physical markets. Hence, the stock market participants have traditionally tracked the international commodity prices and took notice of company’s risk management policy and accordingly decided the stock prices while trading in commodity related stocks. No wonder, why the stocks of the companies taken up for a simple correlation analysis showed a strong and statistically significant correlation with their input or output prices as traded in the commodity markets. However, with companies in themselves participating in commodity price risk management on futures exchanges we had seen some of the companies’ stock prices in the recent times show a very low correlation with the related commodities as traded on exchanges.

Another reason for commodity investing is to protect one’s wealth against inflation, the main cause of which arises out of increases in the commodity prices and hence its contagious effect on the manufactured and the services. The fact that the future is not predictable, makes savings compulsory for most human beings. However, comparative tendency of human beings (inter-personal or inter-temporal wealth) and the natural phenomenon of inflation build expectations of returns among the savers leading to the look-out for the best investment opportunities that exists in the markets. Thus emerged the markets for various such investment opportunities and the pioneer among them globally remains the commodity derivative markets followed by other asset classes. Be it for inflation management or for protecting the risks in portfolio, the best way is the manage these at the origin i.e. commodities.

*Author is Chief Economist, MCX India Limited, Mumbai. Views are personal.