Natural resources like commodities, farmland, timberland, oil and gas represent a unique asset class for investment portfolios. With rising global population and development, demand for natural resources is increasing, making them potentially attractive investments. However, these real assets also carry unique risks like commodity price volatility, climate change impacts and illiquidity. When investing in natural resources, it is crucial to understand their characteristics, valuation approaches, risks, and expected returns compared to other assets. Proper due diligence and portfolio allocation is key to harnessing their diversification and inflation-hedging benefits while mitigating risks.
Analyze supply and demand factors affecting natural resource prices
The prices and returns of natural resources are driven by their supply and demand dynamics. On the demand side, global economic growth, population growth, and rising living standards increase consumption of resources like energy, metals and agricultural products. However, demand can be volatile and cyclical, fluctuating with business cycles and consumer discretionary income. On the supply side, factors like extraction costs, available reserves and OPEC policies impact commodity outputs. Weather and climate change also affect agricultural yields. Analyzing both macroeconomic and sector-specific trends enables estimating risk-adjusted price projections when valuing natural resource investments.
Use appropriate valuation models for different natural resources
Proper valuation is critical for natural resource investments. Agricultural products can be valued using DCF models based on projected harvest quantities and commodity prices. However, convenience yields must be incorporated for inventory-sensitive crops. Forestry investments can be valued via DCF using timber growth projections and lumber price forecasts. Oil and gas reserves are valued using DCF on projected production volumes and hydrocarbon prices. However, adjustments for political risks and exploration upsides/downsides are required. Commodity futures can be valued relative to spot prices based on cost-of-carry models. Overall, investors must select suitable valuation models for each resource that properly capture its unique cash flow and risk characteristics.
Evaluate and manage risks like commodity volatility and illiquidity
While natural resources can diversify portfolios, they carry significant risks. Commodity prices tend to be more volatile than stocks and bonds, subject to supply/demand shocks. Investors must forecast price variability in valuations and manage volatility via hedging. Political risks can disrupt supply chains, requiring geographic diversification and scenario analysis. Natural resource investments are also highly illiquid given large lot sizes, requiring higher return expectations and limits on allocation sizes. Other key risks include climate change, environmental regulations, and lease contract risks, which must be assessed via stress testing. Portfolio diversification, active risk management, and expertise in navigating these risks are critical.
Understand how natural resources perform in different market environments
Historical data shows natural resource returns tend to have low/negative correlation with stocks and bonds, making them valuable portfolio diversifiers. However, performance varies across market cycles. When inflation is high, rising commodity prices can boost natural resource returns. But in periods of weak economic growth like 2008, natural resource returns may fall along with other risky assets. Investors should evaluate how different natural resources performed in prior recessions, recoveries and inflation shocks when assessing their roles in portfolios. Cyclical commodities with more demand elasticity often underperform in recessions but outperform with rising inflation.
Use appropriate benchmarks tailored to specific natural resources
Given their distinct risk/return profiles, conventional asset class benchmarks like the S&P 500 are unsuitable for natural resources. Investors can choose from various natural resource-specific benchmarks to evaluate performance, including commodity futures indices like the Bloomberg Commodity Index, agricultural land price indices, and timberland/farmland value benchmarks. However, even these may not fully capture a particular project’s idiosyncratic risks. Where suitable benchmarks don’t exist, hurdle rates may be tailored to an investment’s expected risks. Investors should also adjust returns for management fees. Incorporating appropriate tailored benchmarks is vital for performance assessment.
When accessed prudently, natural resources like commodities, land and minerals can enhance portfolio returns and diversification. But their unique valuation, illiquidity, volatility and ESG considerations mandate rigorous due diligence of project economics combined with active risk management. Their performance also varies with market cycles. By following structured evaluation and allocation approaches, investors can tap their potential while mitigating pitfalls.