TRADING IN COMMODITIES part 1 - THE NEXT INVESTMENT BOOM

The following is a brief overview of the most active commodity markets. They all have different qualities, different supply and production criteria and different demands and uses. Some have fascinating histories that date back beyond the dawn of civilization but they all have one thing in common - sooner or later they will come back into fashion and their respective values will soar. It seems as if commodities are the ‘black sheep’ of the investment family. This is wrong. They deserve your respect and your consideration both from the basis of absolute return and as a hedge against inflation.
Ignore them at your peril
Aluminium
What is it?
Aluminium is the most abundant metallic element found in the world. The ancient Greeks and Romans used salts of this metal as dyeing mordants and for dressing wounds. Since it was first discovered, aluminium has been extremely difficult to separate from rock and it is still the world’s most difficult metal to recover despite being the most common. First isolated in 1825, it wasn’t until 1886 that the first practical process for producing this silvery, lightweight metal was discovered and, today, electrolytic reduction is still the primary method.

Who produces it?
The world’s largest producers of aluminium are China, Russia, the United States and Canada.

What is it used for?
Aluminium’s excellent strength-to-weight ratio makes it very popular in the construction of automobiles, boat hulls, railway carriages and aircraft. In addition, because of its high heat conductivity, it is used to make the pistons of the internal combustion engine as well as cooking equipment. Aluminium is also used in low-temperature nuclear reactors owing to the fact that it absorbs very few neutrons.

Cocoa
What is it?
Cocoa is the name given to the powder derived from the seeds of the cacao tree, a tree that can take over five years to reach maturity but then live for another 45 years or more. Labelled by the Spanish over 500 years ago as ‘the food of the gods’, it still remains a commodity in strong demand. Essentially, cocoa comprises 40 per cent fat, 20 per cent protein and 40 per cent carbohydrate and also contains the stimulant theobromine, an alkaloid related to caffeine.
Who produces it?
Nearly half of the world’s production is accounted for by the Ivory Coast with two other African nations, Ghana and Nigeria, supplying a further 20 per cent. Outside of Africa, the main producers are Brazil, Malaysia, Indonesia and the Dominican Republic.

What is it used for?
Originally used by the Aztecs as a drink, nowadays nearly two-thirds of cocoa bean production is used to make chocolate and chocolate-based products. It’s still, in my humble opinion, ‘the food of the gods’.

Coffee
What is it?
As a cash commodity it is the second most valuable in the world. The coffee tree is actually a tropical evergreen shrub but it has the potential to grow to 100 feet tall. It grows in the regions between the Tropics of Cancer and Capricorn, where it requires and receives year-round warm temperatures combined with a plentiful amount of rainfall. Coffee is classified into two types of beans: arabica, which is the most widely produced representing nearly 70 per cent of world production, and robusta, which is grown at lower altitudes and has a stronger flavour.

Who produces it?
Behind the obvious leader in world production, Brazil, you might be surprised to learn that the second-biggest coffee grower is Vietnam whose recent production numbers have knocked Colombia into third place. Indonesia is also another significant producer.

What is it used for?
Although wine was actually the first drink to be produced from coffee, we are now all familiar with the warm beverage made from the roasted coffee bean, be it a latte, cappuccino, mocha or espresso.
Copper
What is it?
Dating back over 10,000 years, copper is humankind’s oldest metal,
with its name derived from the Mediterranean island of Cyprus,
which was originally the primary source of the metal. Copper is one
of the most widely used industrial metals because of its many varied
qualities. It is an excellent conductor of electricity, has strong corrosion-
resistant properties and is ‘biostatic’, which means that bacteria cannot
grow on its surface, making it very attractive for hygienic applications
such as food processing and air-conditioning equipment. In addition,
it is also used to produce the alloys bronze (a copper-tin alloy) and
brass (a copper-zinc alloy), both of which are actually stronger than
the pure metal itself.

Who produces it?
Chile is the world’s largest producer of copper and responsible for over a third of its supply, with the United States, Indonesia and Australia also accounting for significant output.

What is it used for?
Nearly three-quarters of copper demand relates to electrical products, particularly in relation to building and construction.

Corn
What is it?
Corn is a native grain of the American continents with fossils of its pollen found under Mexico City dating back over 80,000 years. A member of the grass family, it is a hardy plant capable of being grown at a wide variety of altitudes from sea level up to 12,000 feet, and it can also grow in areas with little natural water right up to tropical climates with extensive annual rainfall.
Who produces it?
The United States accounts for over 40 per cent of world corn production with China contributing a further 20 per cent. The next largest producers are Brazil and the European Union. Particularly important for the supply/demand argument of this book is the fact that China, despite being the world’s second-largest producer, actually consumes more corn than it produces!

What is it used for?
Predominately as a feed for livestock. Other uses for corn include gasoline additives, adhesives, cooking oil, sweeteners, margarine and food for humans.

Cotton
What is it?
Used by humans for many thousands of years and in particular by the ancient civilizations of China, India and Egypt, cotton is a vegetable fibre grown naturally from small trees and shrubs. It requires stable conditions of sunshine and water during its growth season and then a dry period for harvesting, which can make it extremely vulnerable to changes in weather patterns.

Who produces it?
The world’s largest cotton producers, namely China, India, Pakistan and the United States, are also the world’s largest consumers, which can lead to very tight supply/demand margins during periods of poor crop production.

What is it used for?
It is used in a wide range of products from clothing and linen to medical supplies.
Crude oil
What is it?
Crude oil, also known as ‘black gold’ to many commodity players, was formed many millions of years ago from the decayed remains of tiny aquatic life. Believed to have medicinal properties by many ancient civilizations, it was also used as an adhesive for the building of ships and the making of weapons and jewellery. The pyramids were held together by it, as were the great walls of Babylon. Until the invention of the kerosene lamp in 1854, most oil discoveries made by prospectors drilling for water or brine were met with dismay. The Industrial Revolution and the subsequent advances made during the 20th century changed this perception of oil for ever. Today, it is the single-largest product in world trade.

Who produces it?
The world’s largest producers of oil are Saudi Arabia, Russia, Norway, the United States, Iran, China, Mexico, Venezuela and Indonesia although, as widely documented, the United States, China and Indonesia all now consume more oil than they produce!

What is it used for?
Various grades of crude oil from the heavy ‘sour ’ crude to the lighter
‘sweet’ crude have different applications dependent upon the capacity
of each respective refinery. For example, sweet crude is preferred by
refiners in the production of diesel fuel, jet fuel, gasoline and heating
oil.

Gold
What is it?
Mined by the Egyptians over 4,000 years ago, gold has been coveted for centuries for its unique blend of beauty and rarity. The first gold coins date back to the 6th century BC, when they were produced upon the command of King Croesus of Lydia. It is a yellow, dense metallic element with a high lustre and is an inactive substance, unaffected by heat, air, moisture and most solvents. Because of this virtual indestructibility, all the gold that has ever been mined is still in circulation around the world in one form or another.

Who produces it?
It is mined on every continent except Antarctica, where mining is banned. South Africa is the largest producing nation, closely followed by the United States, Australia, China, Russia and Canada.

What is it used for?
Apart from the obvious cosmetic uses such as jewellery and decorative gold leaf, it is a vital industrial commodity, where its prime application is in electronics because of its excellent qualities as a conductor of heat and electricity. Another important industrial demand comes from dentistry, where gold has been used for nearly 3,000 years.

Heating oil
What is it?
Heating oil is a petroleum-based product that represents approximately a quarter of the refining output from a barrel of crude oil.

Who produces it?
The main consumer of heating oil, namely the United States, produces 85 per cent of its own requirement and imports the remainder from Canada, Venezuela and the Virgin Islands.

What is it used for?
As the name suggests, it is primarily used for providing fuel to heat properties.

Lead
What is it? d

Lead was one of the first metals known to humankind. It is a dense, bluish-grey and highly toxic metallic element. Originally used in paints, plumbing and face powders and as a preservative in wine, many civilizations, including the Roman Empire, were unaware of its toxic effect, which resulted in vast numbers of their citizens being slowly poisoned by its use in everyday applications. Lead is usually found in ore with copper, silver and zinc but more than 50 per cent of the lead currently in use comes from recycling.

Who produces it?
China and the United States combined are responsible for nearly half of the world’s lead smelter production, with Germany and the United Kingdom also smelting a notable percentage.

What is it used for?
Owing to its high density and nuclear properties, lead is used extensively in protective shielding for radioactive materials such as X-ray apparatus. It is also used in the construction industry and in the manufacture of electric cables and storage batteries.
Lean hogs (I do not participate in this market) What are they?
‘Hogs’ is a US term for pigs. They are generally bred twice a year in a continuous cycle. The gestation period is three and a half months, producing an average litter of 9-10 piglets, and the time period from birth to slaughter is usually around six months.
Who produces them?
China is the largest producer of pork, followed by the European Union and then the United States. For the supply/demand argument of this book, as well as being the biggest producer of pork China is also the world’s biggest consumer.

What are they used for?
The meat is primarily used as a food for humans. Following slaughter, an average carcass produces 85 pounds of lean meat, of which 21 per cent is ham, 20 per cent is loin, 14 per cent is belly and 3 per cent is spare ribs, with the remainder providing sundry carnivore products. The skin is often used to produce suede for clothing and footwear.
Live cattle (I do not participate in this market) What are they?
Live cattle form part of the beef industry. Most ranchers manage their herds to produce new crops of calves every spring following a gestation period of nine months. Calves are weaned from their mothers after approximately six months and then spend the next 10 months foraging on summer grass or winter wheat until their weight reaches around 600 pounds. The cattle are then sent to a feedlot where they add a further 600 pounds and are ready for slaughter.

Who produces them?
The world’s largest producer of beef is the United States, followed by Brazil, the European Union and China.

What are they used for?
The meat is primarily used as a food for humans and its consumption has recently enjoyed an increase following the popularity of high-protein diets such as the Atkins. The animal skin is used in the supply of leather for the manufacture of clothing and footwear.

Lumber
What is it?
Basically lumber is wood. It is produced from both hardwood, which comes from deciduous trees with broad leaves, and softwood, which comes from cone-bearing trees. Humankind has used wood for tools, building and energy since prehistoric times, and despite advances in the building and construction industry demand for this raw material remains as strong as ever.

Who produces it?
Wood is grown and utilized throughout the world, with the largest producers being the United States, Canada and Russia.

What is it used for?
Higher-quality wood is used for furniture, panelling, flooring and other decorative pieces whilst the lower grades are used for all manner of industrial applications, in particular home building.

Natural gas
What is it?
Natural gas is a colourless and odourless fossil fuel when in its natural form and is a mixture of many hydrocarbon gases including methane, propane and butane. Over 2,500 years ago, the Chinese harnessed the power of natural gas energy when they directed it through bamboo-shoot pipes and then burnt it to boil sea water to create fresh water
Who produces it?
Russia and the United States are responsible for nearly two-thirds of the world’s natural gas production, with Canada the other significant producer.

What is it used for?
Being a far cheaper source of energy than electricity, natural gas is
widely used in residential properties for both heating and cooking.
Large industry is also a major consumer for the same economic
reasons.

Nickel
What is it?
Nickel is a hard, ductile metal and slightly silvery in appearance. It is found in all soil and also on the ocean floor and in meteorites. Its uses can be traced back as far as 3500 BC, when bronzes from what is now Syria had a nickel content. The Chinese also minted coins from this transition metal over 2,000 years ago. It is a good conductor of electricity and heat and is often combined with other metals, such as iron, copper, zinc and chromium, to form alloys.

Who produces it?
Russia, Australia, Canada and Indonesia are the world’s largest miners of nickel.

What is it used for?
Nickel is primarily used in the production of corrosion-resistant alloys such as stainless steel. It is also employed as a replacement for silver in coins and in electronic circuitry, and nickel-plating techniques are uti-
lized on rolled steel strip, helicopter rotor blades and turbine blades.
Orange juice
What is it?
Apart from drinking orange juice, the other exposure you may have
had to this market is if you remember watching the hit film Trading
Places starring Eddie Murphy, Dan Ackroyd and Jamie Lee Curtis
where the final sequences heavily featured the orange juice futures pit
in New York. The orange tree is semi-tropical and its fruit, the orange,
is technically a kind of berry. There are three varieties of oranges: the
sweet orange, the mandarin orange (also known as a tangerine) and
the sour orange.

Who produces it?
Brazil is the largest producer, responsible for over a third of the world’s oranges, with the United States and Mexico combining to produce another 30 per cent plus.

What is it used for?
Sweet oranges are primarily used for the production of orange juice, a healthy drink rich in vitamin C. Sour oranges are predominately used in the manufacture of marmalade and also as an ingredient in some liqueurs. Orange oil is a by-product obtained from the peel prior to juice extraction and is used in a variety of products from cleaning agents through to flavourings and perfumes.

Platinum What is it?
Often referred to as ‘the noble metal’, it is one of the world’s rarest commodities. To illustrate, if all the platinum ever mined in the world was collected together, it wouldn’t fill an average-size living room. In addition to being limited in supply it is also extremely hard to produce, requiring the mining of between 8 and 10 tons of ore to produce just one pure ounce of platinum. It is a greyish-white, chemically inert metallic element that weighs almost twice as much as gold and has a greater value. It is also considered to be ‘the metal of the future’ because of its importance in various environmentally friendly applications.

Who produces it?
South Africa accounts for nearly 75 per cent of world supply with Russia, Canada and the United States the other principal producers.

What is it used for?
Platinum is highly prized by the jewellery industry, which accounts
for just over half its consumption. The remaining demand comes from
a variety of applications from fibre optic cables and infrared detectors
through to anti-cancer drugs. However, the largest industrial use for
platinum comes from the manufacture of automobile catalytic con-
verters, devices fitted to vehicles and designed to convert harmful
exhaust emissions such as oxides of nitrogen into water and other
harmless substances.

Silver
What is it?
Mined in Asia Minor since before 2500 BC, silver was used by the ancient Greeks to produce the first silver coins around 700 BC and still today in many countries silver is used as a circulating coinage. Silver is a white, lustrous metallic element and is usually found combined with other elements in ores and minerals.

Who produces it?
In ancient times, silver was easy to find, with many deposits located on or near the earth’s surface. Today, the majority of silver comes from Mexico, Peru, Australia, China and the United States where it is mined in conjunction with zinc, copper and lead.
What is it used for?
Because silver conducts heat and electricity better than any other metal, its primary application is as an industrial commodity. Photographic materials account for over half of its demand followed by conductors and contacts for the electronics industry. Surprisingly, only a small percentage, less than 3 per cent, is used for jewellery.

Soybean
What is it?
The soybean is a member of the oilseed family and is the common name for the leguminous plant and its seed. An ancient food in the Far East, it has a high protein content that has made it a popular food source throughout the world. The seeds are usually light yellow in colour, contained typically three to a pod with the plants themselves generally reaching maturity around 140 days after planting.

Who produces it?
The United States accounts for nearly 40 per cent of total world production with Brazil producing a further 20 per cent plus. Argentina is another major source of soybeans, closely followed by China, although as with most commodities nowadays China consumes considerably more soybeans than it produces.

What is it used for?
To produce a varied and diverse number of food products. Soy-based
products are particularly popular with vegetarians because of their
high non-meat protein content and also with consumers of non-dairy
products such as soy milk, soy baby formula, soy cheese and soy nut
butter.
Soybean meal
What is it?
Soybean meal is produced through the processing of soybeans, which are separated into both meal and soybean oil. This process is known in the industry as the ‘soybean crush’. The conventional ‘crush’ model states that one bushel of soybeans, weighing approximately 60 pounds, will produce after processing: 11 pounds of oil, 44 pounds of minimum content protein meal, 3 pounds of hulls and 1 pound of waste. Meal represents about 35 per cent of the weight of raw soybeans, and pro-
cessors aim to produce a conditioned product with a minimum protein content of 48 per cent, a minimum fat content of 0.5 per cent, a maxi-
mum moisture content of 12 per cent and a maximum fibre content of
3.5 per cent.

Who produces it?
The world’s largest producers of soybean meal are the United States, which is responsible for 25 per cent of production, closely followed by Brazil, China and the European Union.

What is it used for?
The majority of soybean meal is used as a feed for poultry where it accounts for approximately two-thirds of the world’s high-protein animal feed. The remaining meal is further processed to produce soy flour and isolated soy protein.

Soybean oil


What is it?
It is the natural oil extracted from whole soybeans as a result of the ‘soybean crush’ process. The conventional ‘crush’ model states that one bushel of soybeans, weighing approximately 60 pounds, will pro-duce after processing: 11 pounds of oil, 44 pounds of minimum content
protein meal, 3 pounds of hulls and 1 pound of waste. The oil content of each crop is directly correlated to the amount of sunshine and the temperatures during the soybean pod-filling stage. Typically, nearly 20 per cent of a soybean’s weight can be extracted as oil.

Who produces it?
The United States accounts for over a quarter of world soybean oil
production. Brazil is also a significant producer responsible for nearly
20 per cent, with the European Union accounting for a further 8 per
cent.

What is it used for?
Being high in polyunsaturated fat and cholesterol free, soybean oil is used in a number of edible products from margarine to cooking and salad oils. It is also used in a number of inedible products such as resins, plastics, paints and varnishes.

Sugar
What is it?
Sugar is a carbohydrate compound. It is a white crystalline organic substance also known as sucrose. Whilst it is found in most plants, it occurs with the highest concentration in sugar beets and sugar cane. The former is grown in cooler climates whilst sugar cane prospers in the tropical regions between the Tropics of Cancer and Capricorn where it benefits from the warmer and more humid conditions. Although the sugar contained in both is identical, sugar beet is an annual grown from seed whilst sugar cane is a perennial plant grown from cuttings of the stalk and provides around 75 per cent of all sugar produced.

Who produces it?
Well over a hundred countries produce sugar, with Brazil currently
the largest. Other major producers include the European Union and
India.
What is it used for?
Primarily as a taste additive to foodstuffs and as a source of energy
both for humans and in the composition of fuel derivatives such as
ethanol.

Tin
What is it?
Tin is a soft and pliable metallic element with a high crystalline struc-
ture. Silver-white in appearance, it has been in use for over 5,000 years. During the Roman Empire, Cornwall was responsible for the majority of tin production and continued to be a leading source of the metal until the late 19th century. Nowadays, tin deposits are generally small and are often recovered as a by-product of mining lead and tungsten.

Who produces it?
Currently Indonesia is the largest miner of tin, responsible for over a
third of world production. Not far behind is China, which produces
nearly 25 per cent, and Peru, which accounts for a further 20 per cent.
The world’s largest producers of smelted tin are China, Indonesia and
Malaysia. Although a large user of tin, the United States does not mine
a single ounce of the metal and, apart from recycling scrap, it has to
import the rest.

What is it used for?
Tin is primarily used in the manufacture of coatings for steel containers used to preserve food and beverages. It is also used in electroplating, plastic, ceramics and solder alloys. As tin is relatively low in toxicity, modern research is now focused on incorporating tin into a number of applications as a lead replacement.
Unleaded gasoline
What is it?
Gasoline is a mixture of hundreds of lighter liquid hydrocarbons and is primarily used to fuel the internal-combustion engine. It is a product refined from crude oil with refineries able to turn more than half of every barrel of crude into gasoline. The gasoline is then blended with ethanol (an alcohol-based product made from corn, wheat, barley and sugar), to produce a fuel with less harmful exhaust emissions.

Who produces it?
Refineries of varying size and capacity exist all over the world for the purpose of converting crude oil into gasoline and other petroleumbased products.

What is it used for?
Its primary use is as a fuel for the internal-combustion engine most
commonly found in automobiles, articulated transporters and motor-
cycles.

Wheat
What is it?
Originally a wild grass, wheat has been grown and cultivated by humans since prehistoric times. Now technically regarded as a cereal grass, it is responsible for supplying about 20 per cent of the food calories to the world’s population.

Who produces it?
The European Union, thanks in part to heavy central government subsidies, is the world’s largest producer of wheat, closely followed by China, India, Russia and the United States. Once again, for the supply/demand argument of this book, China, despite being the world’s second-largest producer, actually consumes more wheat than it produces!

What is it used for?
Wheat is primarily used to produce flour but also has other applications including the making of oil, gluten, bedding, brewing and distilling alcohol and as a feed for livestock.

Zinc
What is it?
A bluish-white metallic element, zinc is never found in its pure state but rather as an oxide, sulphide, carbonate or silicate. It is also found in many minerals such as smithsonite, franklinite, sphalerite, hemimorphite and zincite. Zinc is used as an alloy with copper to make brass and also as an alloy with magnesium and aluminium.

Who produces it?
The world’s largest producer of zinc is China, which is responsible for nearly 25 per cent of world smelter production. Canada, Japan and Australia are the other significant producers.

What is it used for?
It is used as a protective coating for other metals such as steel and iron. Zinc is also used in the manufacture of certain battery cells used in cameras, watches and other electronic equipment and, additionally, in medical applications primarily as an antiseptic.

The CRB Index (The Reuters/Jefferies CRB Futures Index)
The CRB Index offers commodity exposure in a similar way to how a stock market index provides exposure to a broad spectrum of capital weighted stocks and shares. It is calculated to produce a broad representation of the average overall trend in commodity markets, and the Commodity Research Bureau constantly monitors the component commodities to ensure the index provides as accurate a representation of price movements as possible. Following its ninth re-weighting in July 2005, the Reuters/Jefferies CRB Index currently comprises the following 19 commodities:

aluminium cocoa live cattle coffee natural gas copper nickel corn orange juice
cotton silver crude oil soybeans gold sugar heating oil unleaded gas lean hogs
wheat

The CRB Index began life in 1957 and is now recognized as the main
barometer of overall commodity trends. It serves as an excellent price
measure for macroeconomic analysis. It provides an efficient and
cost-effective option for those seeking to gain a simple exposure to
commodities as an asset class. The only potential drawback is a fixed
minimum weighting of 33 per cent for the energy sector. Whilst this
is a lower weighting than the Goldman Sachs Index discussed later,
such a weighting can make the CRB more of an energy proxy than was
previously the case. However, it is still a viable alternative for those
investors who have neither the time nor the expertise to deal with
individual commodities.

The DJ-AIGCI (The Dow Jones-AIG Commodity Index)
The components of the Dow Jones-AIG Index are annually re-weighted based upon the procedures set forth in the DJ-AIGCI Handbook, which states the composition of the index is ‘dependent on a combination of factors related to liquidity and US dollar-weighted production data over the most recently available five years’. It attempts, as all the other commodity indices attempt as well, to represent as accurately as possible the importance of a diversified group of commodities and their economic significance. The Dow Jones-AIG Commodity Index currently comprises the following 20 commodities:

aluminium live cattle cocoa natural gas coffee nickel copper silver
corn soybeans cotton soybean oil crude oil sugar gold unleaded gas heating oil wheat
lean hogs zinc
Despite the differences in its method of weighting, this index also
carries a heavy energy sector component, with the combined energy
commodities representing more than a third of its total performance.
However, it is still a viable alternative for those investors who have
neither the time nor the expertise to deal with the individual commodity
markets.

The GSCI (The Goldman Sachs Commodity Index)
The components of the Goldman Sachs Index are weighted based upon the world production figures of each respective commodity. They state that ‘the quantity of each commodity in the index is determined by the average quantity of production in the last five years’. Goldman Sachs feel it’s better to construct their index in this way because it assigns the correct weighting in relation to the proportion of the amount that each commodity flows through the economy. Using this method to determine the composition of the index generally means a stronger weighting towards the energy sector and, as at 30 June 2005, the current weightings detailed on the Goldman Sachs Commodity Index website show that the energy sector is responsible for a massive 75 per cent of the performance of the entire index. This can be a double-edged sword because, if the energy commodities have a strong performance, as is currently the case, this index will perform better than any other commodity proxy. However, should the energy sector underperform, then an investment in the Goldman Sachs Index will lag behind a similar investment in the other commodity-based indices. The Goldman Sachs Commodity Index currently comprises the following 24 commodities:

aluminium lead Brent crude oil lean hogs cocoa live cattle coffee natural gas
copper nickel corn red wheat cotton silver crude oil soybeans
feeder cattle sugar gas oil unleaded gas heating oil zinc
Similarly to the other commodity indices, the Goldman Sachs Commodity Index provides an efficient and cost-effective option for those seeking to gain a simple exposure to commodities as an asset class. The only reservation I have with the GSCI is its over-concentration of exposure to the energy sector, which makes this index more of an energy proxy than a commodity proxy. However, it can still be a viable alternative for those investors who do not wish to deal with the individual commodity markets.