For the past year and a half to two years, our economy has been showing rising inflation rates. But the war in Ukraine has kicked that monetary devaluation into high gear. There are, however, investment types that offer a counterbalance, and investments in commodities are a good example. Peter Verbaken, Head of APG’s Commodities Team, explains the characteristics of commodity markets, and how an investor can use them as protection against inflation. “Prices can fluctuate a lot, but experience has shown that commodities do well during periods when inflation is rising.”
Oil, gasoline, gold, silver, aluminum, copper, nickel. That’s what you should think of when it comes to the commodities that APG invests in for clients. But also agricultural commodities like wheat, corn, sugar, coffee, cocoa and soybeans. Important to emphasize: APG does not invest in the commodities themselves, but in derivatives. Futures in this case; contracts to buy or sell a certain commodity at a predetermined price, on a predetermined date, in the form of a futures contract.
In the extreme
A key reason why commodities are so suitable as an investment for pension funds and their participants is that they provide some protection (hedge, or risk coverage) against inflation.
Verbaken: “Our economy has shown low inflation rates for years, throughout the decade. A year and a half to two years ago, that came to an end and a whole new dynamic emerged. So, there was already accelerated monetary depreciation, but the conflict in Ukraine pulled it to the extreme. Mainly because the prices for fuel and energy have shot through the roof, but grain prices have also exploded. With some delay, this in turn leads to higher animal feed prices and thus higher prices for meat and eggs. And that has a negative impact, including on pension fund participants. It helps if your fund has investments whose return grows along with that inflation. The war in Ukraine has made this protection effect even more relevant.”
Commodity investments offer such a return, Verbaken says. “Experience has shown that commodities do well in periods when inflation is rising. Within those periods, prices may fluctuate significantly, but the trend is upward. The demand for commodities moves with the economic cycles, while supply often cannot move because production capacity cannot be increased overnight. The lead time required to create new production capacity is very long for most commodities - sometimes five to ten years. And during that time, huge investments are made. This makes the supply relatively inflexible. So, the increased demand that accompanies a boom soon results in price increases.”
One example where we have seen such price increases is in the production of oil. “In the early 2010s, the market for U.S. shale oil was booming. But when the price of oil went down, a number of producers went bankrupt and these companies became much more cautious about investing in production. The focus shifted to profitability rather than production capacity expansion. That capacity is not going to come back immediately. And then the production capacity for shale oil can be expanded relatively quickly. Conventional oil producers take much longer. And they have become more cautious about new investments related to the energy transition.”