“The situation in Ukraine makes the inflation hedge of commodity investments extra relevant”

Published on: 22 March 2022

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.”   

Huge investments

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.” 

Dōjima Rice Exchange

In 1710, the very first futures contracts were traded at the Dōjima Rice Exchange in Osaka, Japan. It is easy to guess why the first futures had agricultural commodities as their underlying assets. Producers of rice or other commodities could thus hedge their price risk. By establishing in advance when and at what price he would sell his rice later, a producer was no longer exposed to the vagaries of the market - for example, rock-bottom prices as a result of overproduction in the sector. The buyer of such a future also gets a certain degree of security. By fixing the price and delivery date now, the buyer will not have to pay the highest price in the event of a disappointing harvest. The buyer of a future contract goes “long” and when someone sells such a contract, this is called “going short”.

Further into the future
In addition to the protection that commodity investments offer against inflation, there is another important feature that makes this asset class especially interesting for a large investor of pension money. This is because commodity investments behave differently from other classes, such as stocks and bonds. In this way, they bring diversification to the overall investment portfolio. Verbaken: “Compared to shares and bonds, commodities offer returns at slightly different points in the economic cycle. At the top of an economic cycle, equities start to perform less well. After all, share prices are based on investors’ expectations of companies’ future cash flows. The value of a company and therefore the price of a share are determined by looking further into the future than is the case with commodities. The market for commodities is a spot market, in which the price is determined based on supply and demand at the time.”

Those who want to get a concrete idea of that “different behavior” of commodities need only take a look at recent return figures. “Our commodity investments yielded 40 percent last year. And the return for this year is already at 30 percent. APG has a widely diversified portfolio. With equities and bonds actually doing worse, you can put the return on commodity investments to good use. It is very good to have it in your portfolio, because it offers risk diversification and a certain degree of security.”

Right to buy

Given the impact of fossil fuels on the climate, is it still responsible to invest in a commodity like oil? Verbaken: “That is certainly a valid question, but you have to realize that APG does not invest in the commodities themselves. We don’t buy oil, we buy the right to buy oil at a certain price, on a certain date. By being active in the oil futures market, we are not providing financing to producers, nor are we causing additional carbon footprint. If no one were active in that derivatives market anymore, producers could hedge their price risk a little less easily, but it has no effect whatsoever on the amount of oil produced. That’s one point. The second point is: today’s inflation is largely caused by increased oil and gas prices. If you want to generate a return for pension fund members that compensates for this inflation as much as possible, then you must ensure that a portion of your investments moves along with oil and gas prices. If you do that through derivatives, such an investment is not only financially defensible for the participants, but you can also justify it in social terms.”

Metals dominant

But, Verbaken says, there will be a time in the future when a raw material like oil will play an increasingly smaller role in the economy. And that has everything to do with the energy transition. “The energy transition is a process that will take decades. But as soon as oil and gas become less attractive as a result of this transition to more sustainable forms of energy, you will also see this reflected in the mix of a commodities portfolio. The share of oil and gas will decline, while the share of metals will become more dominant.”

Why metals in particular? Verbaken: “To make that transition, we need a lot more copper, aluminum and smaller metals including nickel - for example, for the infrastructure needed for electrification and for batteries. These are absolutely crucial elements for the energy transition.”