Profit from escalating commodity prices

For the generation known as Millennials, inflation must have seemed, until recently, a fairly abstract concept. The headline figure was never more than a couple of percentage points, and the important things in life - iPods, DVDs - got cheaper and better year by year.

Older generations, however, remember when prices for life's essentials went up in annual double digits; in 1975 inflation hit a staggering 24.2%, wiping out savings and leaving families struggling to cope.

Inflation is now firmly back on the radar. Nobody expects to be pushing their money around in a wheelbarrow, true, but at a time of austerity the prospect of steeply rising prices for fuel and food is one causing popular alarm.

And it's hardly surprising that many people are wondering if they can counter some of the personal impact of that inflation by investment - profiting from rising prices to wipe out at least some of their own increase in household expenditure.

Impact of inflation

Today's overall rate of inflation is still modest by former levels. The latest figures released in April showed the Consumer Prices Index up 4% year-on-year, while the Retail Price Index - calculated differently and drawing on a wider range of expenses, most notably housing costs - was up 5.3%.

Both these figures, though, conceal a much more significant spike in specific areas of spending.

The CPI rose by 18% between March 2005 and March 2011. Over the same period, electricity, gas and other household fuels went up by 74%; petrol and motor oil by 52%; and food by 31%. (It's worth noting that car and travel insurance was also a big riser at 78%.)

These increases in UK shop prices reflect global trends in raw commodities. For example, the World Bank's food price index rose by 15% just between October 2010 and January 2011, leaving it 29% above its level a year earlier, and only 3% below its 2008 peak.

And there is a compelling argument that inflation in both food and energy is not just a temporary phenomenon, but is set to continue for the foreseeable future.

Recent spikes in food prices have been largely caused by crop failures - the result of drought in Russia and floods in Australia, for example, which some believe will become increasingly common.

Other factors

But other long-term drivers are likely to continue the upward pressure on prices.

The world's population is growing faster than food production can keep pace; in emerging markets such as China and India, consumers are shifting from a grain-based diet to one that includes much more meat; and incentives to produce bio-fuels are seeing huge areas of agricultural land converted from food production.

In the case of oil and gas, political turmoil in North Africa and the Middle East has been responsible for a spike in prices this year, but the long-term drivers of inflation are supply constraints, the cost of conforming with climate change legislation (including more expensive alternative fuels) and ever-growing demand from the emerging markets.

Earlier this year, in a review of the energy sector, Italian bank Unicredit warned starkly: "According to our analysis, a typical UK energy bill could rise from the current level of £1,000 per year to over £2,000 per year by 2015. As investment occurs, bills could double every five years until 2020, in our view."

The reasons it cited included cost pressures from environmental and social programmes, rising network charges and commodity price movements; the result, "customers likely having to spend more of their disposable income on their energy bill in the future".

So how can you benefit?

But is investing to hedge against household inflation a sensible - or practical - idea? Justin Modray, founder of the Candid Money website, expresses qualified support for the idea, but only over longer time scales.

He says: "I'd caution against investing in either food or energy short term as a hedge against inflation as I think the potential risks are too high. But I'm keen on both as long-term investments as they should benefit from continued emerging markets growth."

For those willing to have a go, there are a number of possible options, which range from buying the commodity itself - whether that be food or oil - to buying companies trading in the commodity or even funds that give exposure to the sector.

It doesn't take long to work out that investing in the physical commodity itself is not much of an option.

Gold is compact in relation to its value and comes in a number of handy forms such as krugerands and gold bars; but if you wanted to buy oil - or even petrol - on a forward-looking basis, you would have all the problems of storage associated with that. The same is true for food commodities.

The fund approach

The safest approach to investing in either food or energy is to take the fund approach - even if the direct link to the commodity itself is even further diluted.

"An agriculture fund has the advantage that it will invest in the whole food chain, from farm to fork," says Ben Yearsley of Hargreaves Lansdown. "So the fund manager will place the emphasis wherever he thinks the best return is to be made at that time."

He favours the Sarasin AgriSar fund, which had the misfortune to launch in March 2008 and dropped heavily in its first year but is now 16% up from the launch price.

Gavin Haynes adds to that choice the Barings Agriculture Fund, which also invests across the spectrum of food production and distribution. It launched in January 2009 and has risen by more than 50%. "There have been quite a few of these launches over the past few years and I would expect to see more," he says.

On the energy side, he picks out the newly launched Artemis Global Energy fund as one to look at. "It's managed by John Dodd who managed Artemis Smaller Companies successfully for a decade, during which time he made a lot from opportunities in the energy sector." As well as conventional energy investments, the fund will invest in alternatives such as thermal coal.

And for utilities, he picks out EcoFin Water & Power Opportunities, a split-capital investment trust. "We have invested in this arena in the past, although profit growth has been constrained recently because governments across the world have been looking to tax utility companies because of economic pressures."

With many families now spending several thousand pounds each year on petrol, and similar amounts on domestic heating and food, you would have to invest very significant sums to cover your spending altogether from investment returns. But it should certainly be possible to cover the inflation element. 

Few would claim that it is possible to track the prices of energy or food with any degree of precision through any of the routes discussed here, but it's certainly worth making the effort.

Even in the unlikely scenario that you had no exposure to rising costs yourself, these are likely to be two profitable themes to pursue in the years ahead. And if you don't act now, when oil reaches $150 a barrel, you may be regretting it.

This article was taken from the June 2011 issue of Money Observer.