CHAPTER 5: NATURAL RESOURCES Flashcards
Natural resources include:
- Commodities
- Farmland
- Timberland
Commodities: Can be further classified into:
HARD & SOFT
HARD= MINED
SOFT= GROWN or FATTENED
- Hard: Commodities that are mined e.g., copper, gold, silver; and commodities that are extracted e.g., crude oil, natural gas.
- Soft: Commodities that are grown over a period of time e.g., grains, livestock, and cash crops like coffee.
FARMLAND
Investments in land used for the cultivation of crops or livestock.
Income can be generated from the growth, harvest and sale of crops or livestock; or by LEASING the land back to farmers.
TIMBERLAND
Investments in natural forests or managed tree plantations.
The return comes from the sale of trees, wood, and other timber products
HISTORICAL VS CURRENT INVESTMENT APPROACH
Historical Investment Approach:
Past Investment Method:
- Investors sought exposure to natural resources via financial instruments like stocks and bonds.
- Focus was on companies producing natural resources rather than the physical assets themselves.
Current Investment Approach:
Modern Direct Investment Options:
- Investors now have access to a variety of direct investment options.
- Instruments include ETFs, limited partnerships, REITs, swaps, and futures.
- These options allow investors to participate directly in natural resource assets.
Timberland Investment Overview:
Income Stream:
- Provides income through the sale of trees, wood, and other timber products.
Dual Function:
- Acts as both a factory and a warehouse.
Storage Flexibility:
- Trees can be stored by not harvesting them.
Price-Based Harvesting:
- Harvest more when prices are high.
- Delay harvest when prices are low.
The three return drivers for timberland investments include:
- biological growth
- change in prices of lumber (cut wood): unique to timberland
- underlying land price change.
Additionally, since trees consume carbon as part of their life cycle, timberland considered a sustainable investment that mitigates climate related risks.
TIMBERLAND VS FARMLAND
TIMBERLAND: longer life asset/product: don’t die: you can decide when to sell (usually when price is high)
FARMLAND: GROW crops or livestock: sell when ripe, or it’ll get spoilt or die: you can’t decide when to sell
Timberland gives you both YIELD & GROWTH, which is not the case with farmland.
Similar to timber land, the return drivers for farmland are:
- harvested quantities
- commodity prices, and
- land price appreciation.
Farmland is also considered a sustainable investment that mitigates climate-related risks.
Farmland Investment Overview:
Inflation Hedge:
- Perceived to provide a hedge against inflation.
Types of Farm Crops:
- Raw crops: planted and harvested seasonally.
- Permanent crops: grow on trees.
Income Component:
- Related to harvest quantities and agricultural commodity prices.
Production Flexibility:
- Unlike timberland, farmland lacks production flexibility.
- Farm products must be harvested when ripe.
Land Investments vs. Real Estate
Similarities & Differences
Similarities:
Nature of Assets:
- Unique, illiquid assets.
- Distinct geographic locations and features.
Differences:
Development Focus:
- Real Estate: Focus on physical development of the property.
- Land Investments: Quality of soil and climate are more critical.
Location Importance:
- Proximity to transportation hubs and markets increases value.
- Transportation expenses significantly impact the price of products from timberland and farmland.
value:volume ratio= onions & tomatoes take a lot of volume, but don’t have a lot of value (giffen goods). transportation as a % of value becomes a lot. therefore, proximity to hubs is important
TIMO
TIMBERLAND INVESTMENT MANAGEMENT ORGANIZATION
Land Investments vs. Real Estate
Investing Requirements:
Specialized Knowledge:
- Investors need expertise specific to natural resources.
- Example: Investing directly in timberland requires forest management expertise.
Institutional Investors:
- Often lack the necessary specialized knowledge.
- Rely on Timberland Investment Management Organizations (TIMOs).
- TIMOs use their expertise to analyze and acquire suitable timberland holdings for institutional investors.
RAW LAND
Return Drivers
Source of Direct Revenue
Value Factors
Main Risks
Owners
Ownership Structure
Return Drivers:
- Price of land
Source of Direct Revenue:
- Price appreciation
- Lease revenue
Value Factors:
- Physical location
Main Risks:
- Best alternative use
Owners:
- Mostly institutional, some individual
Ownership Structure:
- Direct ownership
- Partnership
FARMLAND
Return Drivers
Source of Direct Revenue
Value Factors
Main Risks
Owners
Ownership Structure
Return Drivers:
- Harvest quantities
- Commodity prices
- Price of land
Source of Direct Revenue:
- Sale of crops and other agricultural products
- Price appreciation
- Lease revenue
Value Factors:
- Physical location
- Soil quality
Main Risks:
- Weather factors and climate change
- Biological factors, diseases
Owners:
- Mostly individuals (since smaller), some institutional
Ownership Structure:
- Direct ownership
- Partnership
- REIT
Features and Forms of Farmland and Timberland Investments
TIMBERLAND:
Size:
- Typically thousands or more acres
Ownership:
- More commonly owned by institutions
Advantages:
- Larger scale investments
FARMLAND:
Size:
- Frequently owned in smaller tracts of tens or hundreds of acres
Ownership:
- More suited to family ownership
Advantages:
- Broader universe of agricultural product price exposures compared to futures contracts
- Ownership allows for cultivation of crops not traded on futures exchanges
TIMBERLAND
Return Drivers
Source of Direct Revenue
Value Factors
Main Risks
Owners
Ownership Structure
Return Drivers:
- Biological growth
- Harvest quantities
- Lumber prices
- Price of land
Source of Direct Revenue:
- Sale of trees, wood, and other timber products
- Price appreciation
- Lease revenue
Value Factors:
- Physical location
- Growth cycle
- Quality of timber
- Phase in timber production
Main Risks:
- Biological factors, diseases
Owners:
- Mostly institutional (since bigger), some individual
Ownership Structure:
- Direct ownership
- Partnership
- REIT
- TIMO (Timberland Inv Management Org)
Common Features between Farmland and Timberland Investments
Common Features:
Price Transparency:
- Limited price transparency or information to guide investment decisions
- Assistance from sector specialists required
Illiquidity:
- Direct investments are illiquid
Weather Sensitivity:
- Farmland is highly sensitive to weather changes, which can drastically reduce harvest yields
COMMODITIES
Commodities are physical products that can be standardized on quality, location, and delivery for investment purposes.
Which of the following is a common source of direct revenue from raw land, farmland and timberland investments?
A Lease revenue
B Sale of agricultural products
C Sale of trees and wood products
A is correct. Lease revenue and price appreciation are common sources of direct revenue from raw land, farmland and timberland investments.
B is also a source of direct revenue from farmland investments while C is another value driver applicable to timberland investments.
Which of the following types of investment is most suited to family ownership?
A Farmland
B Timberland
C Both A) and B)
A is correct. Farmland is more suited to family ownership, whereas timberland is more commonly owned by institutions.
This is because timberland tracts are typically thousands (or more) of acres in size, whereas farmland is frequently owned in smaller tracts of tens or hundreds of acres.
Which of the following is most likely an advantage of institutional ownership of physical farmland as opposed to buying exposure to crops through futures contracts?
A No requirement for sector specialists
B Exposure to broader universe of agricultural products
C Transparent pricing of farmland
B is correct. Futures contracts are only available on a few common crops (such as wheat and corn). Ownership of physical farmland allows for the cultivation of crops that are not traded on futures exchanges, resulting in a broader universe of agricultural product price exposures.
A and C are not correct because assistance from sector specialists is required due to limited price transparency or information to guide investment decisions.
COMMODITIES
Commodities are physical products that can be standardized on quality, location, and delivery for investment purposes.
Commodity Investments
Method: Derivatives due to high storage and transport costs.
Return Focus: Primarily based on price changes rather than dividends.
Commodity Investment Forms
Indexes: Use futures contract prices for transparency and replicability.
Commodity Sectors
- Energy: Includes oil, natural gas, coal, and electricity.
- Base Metals: Such as copper, aluminum, and zinc.
- Precious Metals: Like gold, silver, and platinum.
- Agriculture: Covers grains, livestock, and coffee.
- Others: Includes carbon credits, freight, and forest products.
Commodity Investment Forms
Method: Derivatives due to high storage and transport costs.
Return Focus: Primarily based on price changes rather than dividends.
Indexes: Use futures contract prices for transparency and replicability.
Commodity Sectors
- Energy: Includes oil, natural gas, coal, and electricity.
- Base Metals: Such as copper, aluminum, and zinc.
- Precious Metals: Like gold, silver, and platinum.
- Agriculture: Covers grains, livestock, and coffee.
- Others: Includes carbon credits, freight, and forest products.
HOW ARE COMMODITY FUTURES PRICED?
Basic Formula: Future price ≈ Spot price (1 + r)
No Arbitrage Condition
Basic Formula: Future price ≈ Spot price (1 + rf)
With Storage Costs:
Future price ≈ Spot price (1 + rf) + storage costs
Cost of Carry (COC): Includes both storage and interest costs.
COC= Spot Price (1+rf) + Storage Costs
Commodity Futures Pricing Formula
Formula: Future price ≈ Spot price (1 + rf) + storage costs - convenience yield
OR
COC-Convenience Yield
Spot price: Current market price of the commodity.
r: Short-term risk-free interest rate.
Storage costs: Cost to store the commodity until contract maturity.
Convenience yield: Value of holding the physical commodity.
Convenience Yield
Reason for Subtraction: Reflects the lost benefit of not possessing the commodity until contract maturity.
Adjusted Formula:
Future price ≈ Spot price (1 + r) + storage costs - convenience yield
= COC - Convenience Yield
Commodity Futures Pricing
Relationship Between Future and Spot Prices
Futures prices can be higher or lower than spot prices based on the convenience yield.
Market Conditions
Contango:
- Future price > Spot price
- Occurs when convenience yield is low or non-existent.
Backwardation:
- Future price < Spot price
- Occurs when convenience yield is high.
Spot Price is directly proportional to Convenience Yield
Impact of Inventory Levels
Low Inventory Levels:
- Market participants prefer owning the physical commodity.
- Raises spot prices relative to forward prices.
- Results in backwardation.
Forms of Commodity Investments
Derivative-Based Investments
- Futures, forwards, options, swaps.
- High storage and transportation costs of physical commodities.
Other Forms of Commodity Exposure
ETFs
Managed Futures (CTAs: commodity trading advisor)
Sector-Specific Funds
Exchange-Traded Products: Funds or notes for simplified trading via brokerage accounts.
Managed Futures (CTAs): Trading strategies predicting bull or bear trends.
Sector-Specific Funds: Private equity partnerships similar to PE funds for sector exposure.
Which of the following is least accurate about commodity investments?
A Commodity investments take place through derivative instruments.
B The underlying asset of a commodity derivative may be a single commodity or an index of commodities.
C The return on these investments is based mainly on income stream such as dividends.
C is correct. The return on commodity investments is based mainly on price changes rather than an income stream such as dividends.
When future prices are higher than the spot price, the commodity forward curve is:
A upward sloping and prices are referred to as being in contango.
B downward sloping and prices are referred to as being in contango.
C downward sloping and prices are referred to as being in backwardation.
A is correct. A downward sloping curve occurs when the futures prices are lower than the spot price. This condition is called backwardation.
Opposite is true for contango.
Which of the following futures market price conditions would be most expected in a period of high commodity inventories?
A Backwardation
B Rising prices
C Contango
C is correct. Markets tend to be in contango (Future price > Spot price) when there is little or no convenience yield.
High inventories of a commodity indicate surplus and would be more likely to contribute to a fall in price for the commodity.
Backwardation market is the opposite of contango market which is the case when the inventory levels of a specific commodity are low.
high inventory (surplus)= contango i.e. FORWARD>SPOT
market participants don’t like holding physical commodity
low inventory (deficit)= backwardation i.e. SPOT>FORWARD
market participants like holding physical commodity
WHY COMMODITIES?
Commodities offer potential for high returns, portfolio diversification, and inflation protection.
Natural Resource Investment Risk, Return, and Diversification
Benefits:
High Returns: Potential for significant profits.
Diversification: Low correlation with traditional investments.
Inflation Protection: High correlation with inflation; some prices are components of inflation calculations (e.g., food, energy).
Factors Influencing Commodity Spot Prices
Supply and Demand:
Supply: Production and inventory levels.
Demand: Consumption needs of end users.
Economic Conditions:
Growth: High demand, low supply.
Slowdown: Low demand, high supply.
Price Volatility: Quick demand changes can cause supply-demand mismatches.
Characteristics of Commodity Investments
Derivative Contracts: Futures, options, swaps.
Leverage: High leverage leads to volatile returns.
Farmland and Timberland Investments
RISKS
ESG CONSIDERATION
DIVERSIFICATION BENEFITS
Risks
- Weather Risks: Droughts, flooding can dramatically decrease yields.
- Global Competitive Landscape: Impacted by global trade factors, unlike local real estate.
- Market Characteristics: Infrequently traded in private markets, appear less volatile than commodities and stocks.
ESG Considerations
- Sustainability: Suitable for responsible and sustainable investing.
- Climate Change Mitigation: Can help mitigate climate change.
Diversification Benefits
- Low Correlation: Exhibit low correlation with traditional investments, providing effective diversification benefits.
LO. Explain features of raw land, timberland, and farmland and their investment characteristics.
Farmland and Timberland
Timberland
Income Stream: Sale of trees, wood, and other timber products.
Functionality: Acts as both a factory and a warehouse.
Sustainability: Trees consume carbon, mitigating climate-related risks, making it a sustainable investment.
Farmland
Income Stream: Related to harvest quantities and agricultural commodity prices.
Production Flexibility: Lacks flexibility as farm products must be harvested when ripe.
LO. Describe features of commodities and their investment characteristics.
Instruments: Generally made through derivatives due to high storage and transportation costs.
Return Basis: Mainly on price changes, not on income streams like dividends.
LO. Analyze sources of risk, return, and diversification among natural resource investments.
Commodities: Attraction to Investors:
- High correlation with inflation over the last 30 years, making them effective inflation hedges.
- Effective portfolio diversification due to historically low correlation with traditional investments.
Farmland and Timberland
Trading: Traded infrequently and in private markets, appearing less volatile than publicly traded assets despite significant risks.
Risks: Significant weather-related threats and international competition.
ESG Investing: Suitable for responsible and sustainable investing, helping mitigate climate change.
Diversification: Exhibit low correlation with traditional investments, providing effective diversification benefits.
Which of the following is least accurate about timberland and farmland investments?
A They have similar risks as other real estate investments in raw land.
B Weather is a major risk factor for these investments.
C They are not impacted by global factors.
C is correct. Unlike other real estate that is mainly impacted by local factors, timberland and farmland produce commodities that are globally traded; therefore, they are impacted by global factors.
Which of the following statements is least correct about commodity investments?
A They are an effective inflation hedge as returns are driven by commodity price changes, and inflation partially reflects these changes.
B Typically, commodity investments are made directly resulting in stable returns.
C They provide effective portfolio diversification.
B is correct. Typically, commodity investments are made through derivative contracts, which are highly leveraged financial instruments. As a result, the observed returns are extremely volatile.
A & C are true statements
Farmland and timberland investments are least likely to:
A trade frequently in mostly public markets.
B help mitigate climate change.
C appear less volatile than commodities and other publicly traded risky assets (such as stocks).
A is correct. Farmland and timberland investments are traded infrequently and in private markets. As a result, even though both asset classes face significant risks, such as weather-related threats, they are likely to appear less volatile than commodities and other publicly traded risky assets (such as stocks).
ESG investors looking for responsible and sustainable investing can include timberland and farmland in their portfolios. These investments can help mitigate climate change.
