8.5 Natural Ressources

Question 1

Natural resources investments

Answer 1

entail investments in physical land and products that come from the land

Question 2

While there is no universally accepted classification system, natural resources can be defined as including the following categories:

Answer 2

1. Commodities
2. Timberland
3. Farmland

Question 3

Commodities

Answer 3

traditionally been defined as physical products that can be standardized according to quality/grade, location, and delivery

Question 4

“Hard” commodities

Answer 4

those that are mined or extracted (e.g., copper, crude oil)

Question 5

“soft” commodities

Answer 5

grown over a period of time (e.g., coffee, livestock).

Question 6

Land Investments vs. Real Estate

Answer 6

At first glance, investments in farmland, timberland, and raw land are similar to real estate assets in the sense that they are illiquid assets with unique features.

As with real estate investing, land is purchased in order to generate an income stream as well as potential price appreciation

Question 7

there are several important differences between these natural resources assets and real estate.

Answer 7

While real estate values can be increased by upgrading buildings and land, there is little to no ability for natural resources investors to increase the value of their assets through physical improvements. Value is determined by the quality of the soil, climate features, and/or geology (e.g., mineral rights).

Physical location and proximity to transportation are even more important for natural resources assets because transportation costs are a significant determinant of the profitability of the product (e.g., timber, crops).

Specialized resource management expertise is required. Large institutional investors often rely on timberland investment management organizations (TIMOs) to manage their current holdings and identify new opportunities for direct and indirect investments.

Compared to real estate, there are relatively few financing alternatives beyond bank loans and private debt.

Because of the high capital requirements and specialist knowledge needed to successfully manage timberlands and farmland, the number of potential investors is relatively limited.

Question 8

Farmland

Answer 8

Farmland generates revenue from the sale of row crops and permanent crops

Dairy products are another potential source of farmland income.

Because farm products must be harvested when they are ripe and spoil relatively quickly afterwards, farmers have little flexibility in terms of the timing or quantity of production.

Question 9

row crops

Answer 9

(e.g., corn, wheat) are planted and harvested at regular intervals, possibly multiple times per year depending on the climate and the crop’s life cycle.

Question 10

permanent crops

Answer 10

(e.g., nuts, grapes) grow on tree or vines

Question 11

Timberland investments

Answer 11

have long been limited to large institutions and ultra-high-net-worth individuals.

One of the main reasons for this exclusivity is the large size of timberland properties, typically thousands of hectares.

Timberland operations are conceptually similar to farmland operations in the sense that both types of properties are “factories” that produces goods that are sold to generate income.

Question 12

Farmland and timberland also share many characteristics as investments:

Answer 12

Direct ownership of properties is highly illiquid and has traditionally been the dominant form of ownership.

Investment opportunities have expanded recently with the development of indirect vehicles (e.g., REITs, LLCs).

Commodity prices are a major return driver and subject to volatility.

Climate change presents both long-term risks as well as opportunities (e.g., carbon credits, ESG objectives).

Question 13

The key difference between Farmland and Timberland investments

Answer 13

the two types of lands stems from the nature of their crops.

While farmers have little flexibility over the production of perishable crops, timberland operators can choose to harvest trees when lumber prices are high and leave trees to continue growing if lumber prices are too low. In other words, a timberland property is both a factory and a warehouse.

–> This flexibility is not without some risk. As trees mature, they become more susceptible to loss due to disease and natural disasters. At the other end of the age spectrum, a timberland property with relatively young trees may be years away from generating income. Biological growth, spot prices, and changing land values are key drivers of timberland returns.

Question 14

Commodity Investment Features

Answer 14

As investments, commodities do not generate cash inflows, but they do incur costs, such as storage, transportation and insurance.

The return on a commodity investment is determined by the change in its price, net of any carrying costs.

A commodity’s price fluctuate with changes in supply and demand dynamics and the market’s perception of its future economic value.

Question 15

How do governments impact commodity prices?

Answer 15

subsidizing domestic agricultural production and awarding contracts for mineral extraction.

State-owned energy companies are a more direct form of government involvement in commodity markets.

Environmental policies are also important considerations.

–> For example, many governments are seeking to meet their climate change targets transitioning from fossil fuels to renewable energy sources.

Question 16

Commodities can be classified into which broad sectors?

Answer 16

energy

base metals

precious metals

agriculture

Others

Question 17

what can Investors seeking exposure to commodities use?

Answer 17

derivative instruments, such as futures, forwards, options, and swaps.

Question 18

Beyond derivatives, investors can also use the following vehicles to gain exposure to commodities:

Answer 18

Exchange-traded products (ETPs)

Commodity trading advisors (CTAs)

Specialized commodity funds

Question 19

Exchange-traded products (ETPs)

Answer 19

offer the advantage of simplicity because they can be traded like ordinary common shares.

ETP managers may use leverage or hold physical assets in an effort to track the price of a particular commodity or commodity index.

“Bearish” ETPs replicate short commodity positions.

Fees are based on a percentage of assets.

Question 20

Commodity trading advisors (CTAs)

Answer 20

managed futures funds that take directional positions in one or more commodities based on technical and fundamental analysis.

While CTAs once took commodity positions exclusively, it is now common for them to supplement their portfolios with positions in equities, bond, and foreign currencies.

Individual investors may establish separately managed accounts that are managed according to their specific objectives and constraints.

Question 21

Specialized commodity funds

Answer 21

used to gain exposure to specific commodity sectors.

These vehicles are similar to private equity funds in that investors are subject to lockup periods and other constraints that limit their ability to access their funds before the end of the fund’s lifetime, which may be as long as a decade.

Specialized commodity funds are popular with institutions that have relatively long time horizons and are willing to pay fees for access to a manager’s investing skills.

Commodity-based mutual funds are a more popular option for individual investors due to their greater liquidity and lower management fees.

Question 22

the cost of carry

Answer 22

explicit costs of storage, transportation, and insurance

Question 23

convenience yield

Answer 23

which is a non-cash benefit that an asset’s owner gains from having physical possession of it

it exists to counter the costs of agreeing to sell an asset in the future

Convenience yields are typically higher for commodities when their inventory levels are relatively low (and vice versa

Question 24

The terms used to describe the shape of a forward price

Answer 24

contango

backwardation

Question 25

contango

Answer 25

occurs when the forward price curve is upward-sloping due to a relatively low convenience yield compared to the cost of carry.

This pricing dynamic is most likely to be observed when inventory levels are high and there is less incentive to own the underlying asset physically.

a contangoed market is preferred by investors with short forward positions.

Question 26

backwardation

Answer 26

describes a downward-sloping forward curve that occurs when the convenience yield exceeds the cost of carry.

This is often observed in the shape of the crude oil price curve, particularly when inventories are low due to scarce availability of the underlying putting upward pressure on spot prices.

In general, backwardation improves returns for investors who have established long forward positions

Question 27

Supply of commodities

Answer 27

dependent on production and inventory levels.

Production quantities are stable in the short-term because adjustments take time to implement.

–> For example, it can take years to build up the capacity to increase mineral extraction.

–> However, severe weather events can lead to supply shortages, particularly if they negatively impact crop yields for soft commodities.

Question 28

demand of commodities

Answer 28

based on the needs of end-users, which will grow during economic expansions and contract during downturns.

Non-hedging market participants also have a short-term impact on demand, particularly for certain commodities.

For example, investors hold more physical gold as a safe haven asset and store of value during periods of market turmoil.

Question 29

The primary risk for timberland and farmland

Answer 29

The weather

Question 30

Timberland investment management organizations

Answer 30

Entities that support institutional investors by managing their investments in timberland by analyzing and acquiring suitable timberland holdings.