Natural Resources include commodities (hard and soft), agricultural land, and timberland. Hard commodities are either mined or extracted (e.g. copper, oil). Soft commodities are grown over a period of time (e.g. livestock, grains, coffee).

Characteristics of Natural Resources

Commodities

Commodity returns are based on changes in price and do not include an income stream such as dividends, interests, or rent.

Commodity derivatives are financial instruments that derive their value from the value of the underlying commodities. They include commodity futures, forwards, options and swaps.

Commodity spot prices are determined by market supply and demand.

The price of a commodity futures contract is determined by the spot price, risk-free rate, storage costs and convenience yield.

Futures Price ≈ Spot Price (1 + r) + Storage Costs - Convenience Yield

Convenience yield is the additional value gained by holding the commodity rather than having a long forward or futures contract on it, such as the ability to take advantage of shortages.

Under normal market conditions, the spot price would be lower than the futures price due to the cost to carry. This is referred as normal carry charge market or contango.

Under abnormal circumstances such as shortage of supply of a commodity in the short term, the contango can be reduced or even reversed. In this case the spot price can become higher than the futures price. This process is known as backwardation.

Timberland and Farmland

Timberland offers an income stream based on the sale of trees, wood and other products. It can be thought of as both a factory and a warehouse. Plus, it is a sustainable investment that migrates climate-related risks.

Farmland has an income stream component related to harvest quantities and agricultural commodity prices. However, farmland does not have the production facility of timberland, because farm products must be harvested when ripe.

Risk/Returns of Natural Resources

Commodity investment objectives:

• Potential for returns;
• Portfolio diversification.
• Inflation protection.

Commodity spot prices are determined by supply and demand. Supplies of commodities are determined by production and inventory levels. The supply levels cannot be adjusted quickly. Demand levels are influenced by global manufacturing dynamics and economic growth.

Weather is a unique and exogenous risk for farmland and timberland. Global international competition environment can also cause interruptions in crop prices.

Diversification Benefits

Commodities are effective inflation hedges. In fact, some commodity prices are included in inflation calculations.

Because of the low correlation between commodities returns and traditional asset classes' returns, commodities are effective in portfolio diversification.

For some investors, there are ESG considerations by including timberland and farmland in their portfolios, as timber and crops consume carbon as part of the plant life cycle.

Instruments

Commodity investment may involve investing in actual physical commodities or in producers of commodities. However, most investors do not want to get involved in storing commodities such as cattle or crude oil. Typically, such investments are made using commodity derivatives (futures or swaps), which can be traded on exchanges or OTC.

There are also other means of achieving commodity exposure: Exchange-traded products (ETPs), CTAs, and funds that specialize in specific commodity sectors.

Investment funds are primary investment vehicles for timber and farmland.