The Professor Of Commodities: Interview with James Doran (Part I)

Mike Norman, anchor, HardAssetsInvestor.com (Norman): Hello everybody, and welcome to the HardAssetsInvestor.com interview series. I'm Mike Norman, your host. Today my guest is James Doran, professor of Finance at Florida State University.

Professor Doran, thank you very much for coming on the program; I really appreciate it. We should say your specialty is commodities and commodity derivatives. You teach that in the Finance Department. I would be surprised if you told me that in the last several years, your classroom enrollment has not exploded given the trends we've seen in commodity markets.

James Doran, professor of Finance, Florida State University (Doran): It has increased steadily. The students are willing and able to learn and appreciate it, and the opportunities that are afforded them in terms of jobs and placement have definitely improved. The need for strong quantitative skills in this area is quite strong, and so the students tend to go where demand is highest.

Norman: And clearly it is quite strong, because what we've seen over the past few years - you know this better than anyone - is that commodities now have really been embraced as a separate asset class by major institutions, pension funds, endowments, large hedge funds, etc. Your specialty is in the area of derivatives, and certainly we've seen a lot of growth in this area. It has provided a way for investors to take exposure to this asset class through different sorts of vehicles. Talk about that a little bit.

Doran: That's absolutely true, Mike. What we've noticed especially here is the increased liquidity we've observed in these markets, and not just in the equities markets, but within the derivatives markets, the structural pricing that goes on for these products has changed. This is an asset now that investors consider to be something that they can long term hold. The usual viewpoint on a commodity was that this was a resource that was bought and consumed. Now that's not the case; now we can hold this asset and hold it as if it were a true investment without actually holding the physical good.

Norman: OK, but what changed? I've been involved in commodities for 30 years, and that was a pitch all through the history of my career. We did see these periods where you'd have a spike in prices, there'd be a flurry of interest, but then the forces of supply and demand would take hold. What changed insofar as this view that we can hold these long term?

Doran: What we've seen is that investors demand diversification. It's a basic principle that we teach in finance. It's a very important principle that we teach in finance. You can't just hold a traditional basket of equities, whether that be in technology or telecommunications, biotech or whatever it is. With the increased demand for commodities and this increased liquidity, it's become a very attractive alternative and almost a necessary staple for investors to put their money in, as was the case with real estate. Before we talk about the adverse affects of real estate in the markets and so forth, it was a chance for people to put cash into a place that gave them diversification. Commodities in a sense offers a very similar outlook without, again, the potential downsides that we've seen from the real estate markets, and so we've introduced a level of sophistication, access to investors, that has changed how we think about those things. We've really seen them over the past five years.

Norman: Now historically, commodities have had very high volatility. There's been a large degree of fluctuation there. That means there's inherently more risk. How does that influence the investor's approach to that?

Doran: This again is also a very good point. The volatility that you observe in the commodities markets - where there's crude oil or natural gas - whatever it may be, are volatilities you're not going to see in the equities markets. The prices can fluctuate 10% or 15% on any given day, and if we had a 10% or 15% drop in the Dow or the S&P 500, the markets would be going crazy. But this is not uncommon in the commodities market. But with this risk comes higher expected rates of return, and absolutely great chances for diversification. You don't want to think of the total risk as something that you're bearing on; you need to think about what that means in terms of a portfolio sense and how that offers you a level of diversification. High risk is not necessarily bad.

Norman: It's not, and we've seen that investors are embracing that. We're going to be back for the second part of my interview with Professor James Doran. 

See part II here.