Commodities
Physical commodity supply dynamics are determined by production (in the case of hard commodities), seasonal crop yields (for soft commodities), and inventory levels in the short term, while commodity end user/consumer use of these basic inputs drives ultimate demand. Supplies of physical commodities are determined by production and inventory levels and secondarily by the actions of non-hedging investors.
Farmland and Timberland
Farmland and timberland, in contrast, are far less frequently traded and derive their value from different sources. In the case of farmland, it is multiple growing seasons over time that generate the return. In the case of timberland, it is the longer forest/tree growth cycle and the demand for lumber that determine returns once the lumber has been cut down.
Inflation Hedging and Diversification Benefits of Natural Resource Investments
Hedge against Inflation
The argument for commodities as a hedge against inflation derives from some commodity prices being components of inflation calculations. Commodities, especially energy and food, affect consumers’ cost of living. The volatility of commodity prices, especially energy and food, is much higher than that of reported consumer inflation. Consumer inflation is computed from many products, including housing, whose prices change more slowly than commodity prices, and inflation calculations use statistical smoothing techniques and behavioural assumptions.
Portfolio Diversification
Farmland, timberland, and commodities exhibit potential for portfolio diversification. Historically, all three of these asset classes have low correlations with investment returns from traditional assets (i.e., stocks and bonds) during the business cycle.
