ETFs Drive Commodity Prices

05/07/2008 12:00 am EST


Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

Richard Lehmann, editor of the ISA ETF Investor, says investor interest in commodities spurred the creation of many ETFs-and helped push commodity prices higher.

Commodities of all types have been soaring, particularly agricultural commodities. Part of the reason is the effect of corn being diverted to ethanol production. At least this was the initial impetus.

Since ethanol was subsidized and production mandated by the government, other crops were squeezed out in favor of corn production. This shift distorted the plans of farmers, who planted less wheat, rice, and other crops in order to get the higher prices from corn.

Even those who continued planting other crops reaped windfalls from the supply distortion. It's been reported that one-third of corn planting is now intended for ethanol production.

Coincident with the rise in corn prices was the sharp rise in oil prices. This only served to increase the profitability of ethanol and encourage yet more corn planting to the detriment of other crops.

In addition to corn, other commodities such as gold, silver, nickel, copper, etc., began rising for the same reason as oil-increased demand from China and India's booming economies. The demand for such commodities puts pressure on suppliers to increase production. Many producers are hesitant to commit to such large capital-intensive projects because of the uncertainty regarding future prices for their product.

After the stock market swoon, commodities began to be seen as an investment class in themselves. Demand grew for commodities because they are an asset class that is not typically "correlated" with other asset classes. (They tend not to move in the same direction as stocks or bonds-Editor.)

In addition, most tax-advantaged accounts such as IRAs and 401ks are restricted from [direct investments in commodities]. The demand spurred the creation of new investment vehicles based on exchange traded notes (ETNs) and exchange traded funds (ETFs) and a smattering of closed-end funds.

Since the investment community discovered commodities as an investment vehicle, volatility has swept the markets. The formation of a commodity bubble is also a distinct possibility, since speculators now increasingly influence the supply/demand characteristics of the market.

This phenomenon was illustrated when the iShares Silver Trust ETF (Amex: SLV) was first introduced: Silver prices rose substantially in anticipation of silver buying by the fund. Today, silver and gold funds hold more of the metals than most foreign governments hold as reserves. There are now at least 45 exchange traded commodity funds, many of them recently created.

The tax status of ETNs, which are structured like a zero-coupon long-term bond, are unclear at this time. Holders may have to pay implied gains, but the IRS has yet to make a definitive ruling. These ETNs are best kept in tax-advantaged accounts to avoid the issue.

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