Consider climate change and the forecast for commodities

The topic of climate change has generated intense interest and debate in circles from academia to Hollywood to Wall Street. Most recently, a leaked draft of the latest report by the United Nations’ Intergovernmental Panel on Climate Change warned of adverse effects of rising temperatures on the world’s food supply. These and other implications of climate change that affect the global economy are creating both challenges and opportunities for investors, particularly in the long term.

As a result, financial advisers can’t afford to ignore the effects of climate change on commodities markets and the impact of those changes on their clients’ portfolios.

WEATHER PATTERNS

For the equity portion of client portfolios, weather patterns are, for the most part, irrelevant in making investment decisions. But for those with allocations to alternatives — commodities futures in particular — the influence of meteorological events on investment performance can’t be ignored.

Consider the impact of climate change as a “ripple effect.”

Rising global temperatures and the increasing frequency of extreme weather events such as tropical storms and droughts are often cited as results of climate change that have the potential to affect the economy. That, in turn, influences the markets, which affect investment portfolios, particularly commodity prices.

For example, over the past two summers, droughts across the Midwest drastically lowered corn and soybean output. In addition to affecting the market for those specific commodities, the shortage led to increases in the cost of cattle feed and parching of grasslands, which forced livestock producers to shrink herds.

The New York Times this year reported that the nation’s cattle herd had shrunk by 2% at the end of 2012, from a year earlier, to less than 90 million head, the lowest level since 1952. This reduced supply resulted in very high prices for cattle.

REDUCING PRODUCTION

Conversely, an unusually active monsoon season in India, the world’s second-biggest sugar producer, after Brazil, has led to a 10 million ton bumper crop of sugar, driving down its price in the international commodities markets.

Some scientists have also linked climate change to steadily rising temperatures, especially in tropical regions. The report issued by the climate change panel indicates that global warming could reduce agricultural production by as much as 2% each decade for the rest of this century, while demand is expected to rise as much as 14% every 10 years as the world’s population continues to grow and people in developing countries acquire the money to consume richer diets.

As temperatures rise, growing conditions for crops in many areas of production will decline, while conditions in climates that are too cold for those crops will improve.

This shift in temperatures potentially will force farmers and other commodity producers to move to new regions with suitable growing climates. Those in the Northern Hemisphere will be pushed north by the rising temperatures, while those in the Southern Hemisphere will have to move south.

The costs of relocating crop production operations are high, and in regions such as South America, shifting production to a new climate may mean crossing the border into a new country. A move of this nature creates significant challenges related to currency values, exchange controls and competition for desirable cropland, which raise the price tag even higher.

In some sectors, producers are already beginning to see the effects of climate change and are anticipating the ways in which they will need to adapt in order to maintain supply.

Rising temperatures and increasingly irregular rainfall patterns pose significant challenges to growers in the world’s main coffee-producing countries, particularly Brazil and Vietnam, according to the Initiative for Coffee and Climate, a development partnership dedicated to helping coffee farmers respond to climate change.

The organization is exploring potential adaptations, including implementing new farming techniques such as shade management, planting new varieties of coffee beans that are better suited to future conditions, and securing weather insurance to offset the potential losses from unpredictable events such as storms and droughts. How successful such measures will be in addressing the effects of climate change, and how much they will affect supply and influence the commodities markets, are still uncertain, but they warrant monitoring by advisers and investors who have these assets in their portfolios.

Changes in long-term agricultural production patterns have a number of financial implications of which advisers need to be aware in order to maintain portfolio performance and provide counsel to clients who invest in commodities. Advisers should recognize a gradual increase in the price structure of raw agricultural commodities as a likely long-term effect of rising global temperatures.

If the U.N.’s predictions about the increasing gap between the supply and demand for food products such as corn, wheat and beef are accurate, the prices of these commodities will rise accordingly in the coming years.

Advisers should also be aware of the degree to which extreme weather exacerbates the imbalance between supply and demand in agricultural commodities. One-off weather events such as one large storm or persistent drought can change the market overnight because large surpluses generally don’t exist for most agricultural products.

For instance, in 2006 and 2007, a severe drought in Australia dramatically affected the nation’s wheat production. Supplies of the crop were already tight relative to the level of demand, and the deficit created by the drought resulted in a major shortage and a sharp rise in global wheat prices.

And as the frequency of severe weather is increasing — of the 10 most expensive hurricanes in U.S. history, eight happened within the past decade — the unpredictable nature of weather patterns in a changing climate creates significant challenges for investors who rely on a discretionary analysis of supply and demand. This creates uncertainty in the markets as traditional financial models are challenged by sweeping changes in climate and the resulting impact on production.

INVESTMENT OPPORTUNITIES

When it comes to addressing the implications of climate change with clients, advisers should monitor the trends outlined above and look for ways to capitalize on long-term market effects that result from these shifts, especially where agriculture commodities are concerned. In particular, advisers should evaluate the potential to employ commodities as an alternative investment to hedge against risk in traditional portfolios.

One of the main ways to gain exposure to commodities and agricultural assets is through managed futures. Introducing managed futures into a portfolio reduces risk due to the negative correlation in performance among asset groups.

Other opportunities to take advantage of the effects of climate change may include long-only commodities funds, though it may be challenging to identify funds of this nature that aren’t heavily weighted toward energy assets.

Additionally, investment vehicles in cropland, particularly in regions where rising temperatures result in improved growing capabilities for crops such as corn, wheat, cotton and soybeans, may represent opportunities for advisers to make positive use of the effects of climate change in their clients’ portfolios. Likewise, these may be difficult to identify.

As evidenced by the continuing dialogue in the scientific community about the repercussions of climate change, researchers and experts are still trying to understand how far-reaching its effects will be, and how governments, businesses and individuals will need to adapt to the new realities of our environments. As advisers, the ability and responsibility to keep abreast of these developments and understand the implications for investors’ portfolios is critical to maintaining successful client relationships and a thriving practice in all kinds of weather.

Robert T. Keck is president and chief investment officer of 6800 Capital.

Related Topics: Asset Allocation