Table of Contents

Executive summary

Commodities as an investment vehicle

Investment products

  • Commodity indices
  • Index funds
  • Structured commodity products

Commodities investors

  • Pension funds
  • Hedge funds
  • Investors and market dynamics

The sell side

The big issues – food price inflation and biofuels

The outlook for commodities

  • Let the buyer beware

About this report

Postscript, 30 April 2008

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Chapter 01 - The commodities universe

Commodities as an asset class

Commodity price dynamics

Commodity trading technicalities

  • Backwardation and contango
  • Futures versus spot returns

The investment case

  • Commodities reduce risk in a portfolio
  • Commodities enhance portfolio returns
  • Commodities offer an attractive risk/return profile

Alpha and beta investment strategies

  • Adding alpha to beta

Commodities investment

  • Methods of investing in commodities
  • Advantages and disadvantages
  • Commodity indices
  • Index funds
  • Structured commodity products

Commodities investors

  • Pension funds
  • Hedge funds
  • Non-commercial traders

Financial investors’ relationship with commodities markets

  • Motivating determinants
  • Financial investors and market dynamics

The sell side

  • Banks’ expansion strategies
  • The competition for talent

The big issues – food price inflation and biofuels

  • Changing composition of FTSE 100

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Chapter 02 - Commodity buyers and investors

Overview

Pension funds

  • Global pension assets
  • Changing asset allocation
  • North American pension funds
    • CalPERS
    • Other US pension funds

European pension funds

  • UK pension funds
  • Asia-Pacific pension funds
  • Japanese pension funds

Case study: PGGM’s commodity investment strategy

Pension funds turn to hedge funds

  • The Bridgewater investment approach

Hedge funds

  • Hedge funds and commodities investment
  • Hedge funds go from trading to owning commodities
  • Impact of hedge funds on commodity prices
  • Diversification into transportation and production
  • Changing outlook for hedge funds

Sovereign wealth funds

  • SWFs and commodity investment

SWFs – facts and figures

SWFs defined

  • Key considerations

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Chapter 03 - Investment products

Overview

Collateralised commodity obligations

  • How a CCO works

Mean-reversion

  • Advantages of CCOs
  • Structural variations
  • Risks to CCO structures
  • CCO issuers

Exchange-traded funds and exchange-traded commodities

  • Commodity ETFs
  • Exchange-traded commodities

Derivatives and futures

Commodity derivatives

Structured investments

  • Gold-linked notes
  • Digital options
  • Capital guaranteed structures
  • Combination structures
  • Non-combination structures
  • Analysing investment structures

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Chapter 04 - Commodity indices

Overview

  • Generating higher risk-adjusted returns
  • Protection against inflation

Commodity index versus equity investment

  • Recent index performance

Commodity indices as an inflation hedge

  • The JOC-ECRI Index

The commodity index as an asset class

Index funds

  • Passive investment vehicles
  • How index funds make money

Commodity index construction

  • Number of components and weights
  • The treatment of futures rolling
  • Rebalancing

Commodity index profiles

  • CYD commodity indices
  • CX commodity Index (CX)
  • Diapason Commodities Index
  • Deutsche Bank Liquid Commodity Index (DBLCI)
  • Deutsche Bank Liquid Commodity Index – Mean Reversion
  • Deutsche Bank Liquid Commodity Index – Optimum Yield
  • Deutsche Bank Liquid Commodity Index – Optimum Yield Broad
  • Deutsche Bank Liquid Commodity Index – Optimum Yield Broad
  • Deutsche Bank Liquid Commodity Index – Optimum Yield Balanced
  • Dow Jones–AIG Commodity Index (DJ-AIGCI)
  • Lehman Brothers Commodity Index (LBCI)
  • Merril Lynch Commodity Index (LBCI)
  • Reuters-Jeffries/CRB Index (RJ/CRB)
  • Rogers International Commodity Index (RICI)
  • Standard & Poor’s Goldman Sachs Commodity Index (S&P GSCI)
  • UBS Bloomberg Constant Maturity Commodity Index (UBS CMCI)
  • Baltic Dry Freight Index

Sources of returns within a commodity index

  • Energy returns
  • Storage and convenience yield

Roll yield

  • Total return swaps

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Chapter 05 - Agricultural commodities

Agricultural commodities markets

  • A super bull-run for softs?
  • Food price inflation
  • Food demand: income growth is the key driver
  • Food production versus biofuels

Agricultural commodities

  • Coffee
  • Corn
  • Cotton
  • Lumber
  • Palm oil
  • Soybeans
  • Sugar
  • Wheat

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Chapter 06 - Energy commodities

Energy markets

  • Alternative and renewable energies
  • Oil prices
  • Changing oil market dynamics
  • Oil reserves
  • OPEC

Energy security

  • Improving security measures

Biofuels

  • Production concerns
  • Brazil – biofuel super-power
  • EU/US biofuels trading deal

Carbon emissions trading – the new commodit

  • Emissions and climate change
  • Exchange traded and price conventions
  • Energy commodities
  • Coal
  • Crude oil
  • Refined oil products
  • Ethanol
  • Natural gas
  • US power

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Chapter 07 - Industrial metals

Industrial metals markets

Industrial metals

  • Aluminium
  • Copper
  • Lead
  • Nickel
  • Tin
  • Zinc
  • Iron ore
  • Steel

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Chapter 08 - Precious metals

Precious metals markets

Precious metals

  • Gold
  • Silver
  • Platinum
  • Palladium

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Appendix 1 - Sources

Appendix 2 - Glossary

List of tables and figures

  • Table 1.1 Commodity futures contracts 2005
  • Table 1.2: Estimated fixed storage cost for various commodities, 1989–2005
  • Table 1.3: Average historical correlation of commodities and other investments, 1970- 2005
  • Table 1.4: S&P GSCI-TR, 2002–2005 (%)
  • Table 1.5: ML US investor model allocations with/without commodities, as of November 2005 (%)
  • Table 1.6: Participants in OTC trading on the ICE, 2004–06 (%)
  • Table 1.7: Regression results
  • Table 3.1: Correlation of monthly returns, July 1997–April 2007 (%)
  • Table 3.2: Comparison of derivative amounts outstanding by type, 2005–06 (US$trn)
  • Table 3.3: Hypothetical price performance of five assets over a five-year period 
  • Table 4.1: Average annual total returns for various commodity indices, Aug 1999–Nov 2005
  • Table 4.2: Incorporating an index with a portfolio of stocks and bonds, Jan 1991–Aug 2006
  • Table 4.3: Correlation of commodity sub-indices with major indices, 1982–2007*
  • Table 4.4: Historical returns, volatility and Sharpe ratios compared, July 2006*
  • Table 4.5: Correlation of commodity indices with other asset classes, Jan 1991–Aug 2006
  • Table 4.6: Comparative performance of commodity indices against the equity market, Nov 2005
  • Table 4.7: MLCX & GSCI provide the highest returns during an equity market downturn
  • Table 4.8: Major commodity index weights, 2006
  • Table 4.9: Commodity indices classification – weight, rolling and rebalancing
  • Table 4.10: The commodity index universe
  • Table 4.11: Composition of returns from the DBLCI, 1989–2004
  • Table 4.12: Composition of returns of the DBLCI, 2005
  • Table 4.13: RJ/CRB Commodity Index weights
  • Table 4.14: Commodity weights of the RICI, April 2007
  • Table 4.15: Commodity weights of the S&P GCSI, April 2007
  • Table 4.16: Commodity weights of the UBS CMCI, January 2007
  • Table 5.1: Top 10 coffee producers, consumers, exporters and importers, 2006
  • Table 5.2: Top 10 corn producers, consumers, exporters and importers, 2006
  • Table 5.3: Top 10 cotton producers, consumers, exporters and importers, 2006
  • Table 5.4: Top 10 softwood lumber producers, consumers, exporters and importers, 2005
  • Table 5.5: Top 10 sugar producers, consumers, exporters and importers, 2006
  • Table 5.6: Top 10 wheat producers, consumers, exporters and importers, 2006

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  • Table 6.1: Top 10 oil producers, consumers, exporters and importers, 2006
  • Table 6.2: Index of global warming potential of GHGs relative to CO2
  • Table 6.3: Top 10 coal producers, consumers, exporters and importers, 2005*
  • Table 6.4: Oil demand growth in key consuming nations, 1990–2010e (mb/d)
  • Table 6.5: Refined products by type
  • Table 6.6: Top 10 ethanol producers, 2006 (m gal)
  • Table 6.7: Top 10 natural gas producers, consumers, exporters and importers, 2005
  • Table 7.1: Top metals futures contracts, 2005
  • Table 7.2: Base metals demand growth, 1990–2007
  • Table 7.3: Top 10 aluminium producers, consumers, exporters and importers, 2005
  • Table 7.4: Top 10 copper producers, consumers, exporters and importers, 2005
  • Table 7.5: Top 10 lead producers, consumers, exporters and importers, 2005
  • Table 7.6: Top 10 nickel producers, consumers, exporters and importers, 2005
  • Table 7.7: Top 10 tin producers, consumers, exporters and importers, 2005
  • Table 7.8: Top 10 zinc producers, consumers, exporters and importers, 2005
  • Table 8.1: Central bank gold holdings, end December 2007 (tonnes)
  • Table 8.2: Top 10 gold producers and consumers*, 2005
  • Table 8.3: Top 10 silver producers and consumers*, 2005
  • Table 8.4: Top platinum producers and consumers, 2005
  • Table 8.5: Top palladium producers and consumers, 2005
  • Figure 1.1: Futures vs. spot returns
  • Figure 3.1: Structure of a CCO
  • Figure 3.2: Half pipe copper note
  • Figure 3.3: Bonus note
  • Figure 4.1: Performance of crude oil returns, OIX index and WTI frontline, 1993–2007
  • Figure 4.2: Cumulative performance in negative bond months, Jan 1989–June 2007
  • Figure 4.3: Cumulative performance in negative equity months, Jan 1989–June 2007
  • Figure 4.4: Correlation of equity, bonds and commodities to inflation, July 2006
  • Figure 4.5: JOC-ECRI Index movement, 2005–07
  • Figure 4.6: Commodity weights of the CYD Market Neutral Plus, Sept 2006
  • Figure 4.7: Commodity weights of the CX, June 2007*
  • Figure 4.8: Commodity weights of the DCI, July 2007*
  • Figure 4.9: Base metals price volatility, 2007
  • Figure 4.10: Underlying base metals market performance, 2007
  • Figure 4.11: DBLCI-MR sector weights, 2000–06
  • Figure 4.12: DBLCI-OY Broad, S&P GSCI & DJ-AIGCI sector weights compared, July 2007
  • Figure 4.13: DBLCI-OY Balanced, S&P GSCI Light Energy & DJ-AIGCI sector weights compared, July 2007
  • Figure 4.14: Commodity weights of the LBCI, January 2007*
  • Figure 4.15: Commodity weights of the MLCX, January 2007
  • Figure 4.16: Commodity weights of the RJ/CRB, July 2007
  • Figure 4.17: Total returns for single commodity indices, 1989–2007
  • Figure 4.18: Commodity curves and convenience yields
  • Figure 4.19: Commodity volatility and convenience yields, 1988–2004
  • Figure 4.20: Total return swap
  • Figure 5.1: Coffee turnover by exchange, 2005 (futures only, m lots)
  • Figure 5.2: Coffee prices, 1957–2005 (US cents/lb)
  • Figure 5.3: Corn turnover by exchange, 2005 (futures only, m lots)
  • Figure 5.4: Corn prices, 1972–2005 (US$/bushel)
  • Figure 5.5: Cotton turnover by exchange, 2005 (futures only, m lots)
  • Figure 5.6: Cotton prices, 1957–2005 (US cents/lb)
  • Figure 5.7: Sugar prices, 1957–2005 (US cents/lb)
  • Figure 5.8: Wheat turnover by exchange, 2005 (futures only, m lots)
  • Figure 5.9: Wheat prices, 1972–2005 (US cents/bushel)
  • Figure 6.1: The WTI forward curve moving into a strong backwardation, September 2007 (US$/bbl)
  • Figure 6.2: A strong trend in the front-to-second month WTI spread (US$/bbl)
  • Figure 6.3: OPEC 10 countries’ output, 2006–07 (mb/d)
  • Figure 6.4: Projected and implied global inventory change, 2006–07 (mb/d)
  • Figure 6.5: Profit margin captured by value chain player (US$/gal)
  • Figure 6.6: Carbon emission IPE, Nov 2006–Oct 2007
  • Figure 6.7: Liquidity in emissions trading, 2004–06 (mt)
  • Figure 6.8: Refined product futures annual turnover by contract, 2005 (futures only, m lots)
  • Figure 6.9: Corn use in US ethanol production, 1980–2004 (m bushels)
  • Figure 7.1: China consumption of metals, 2000–05 (% of world consumption)
  • Figure 7.2: Performance of far forward base metals, 2003–07
  • Figure 7.3: Curves flatten in most markets
  • Figure 7.4: Base metals inventory levels, 1985–2007
  • Figure 7.5: World refined copper consumption, 1900–2030 (000 tonnes)
  • Figure 7.6: China consumption of industrial metals, 1990–2006 (% of world demand)
  • Figure 7.7: Lead cash price, 1957–2005 (US$/tonne)

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