Why invest in commodities?
All investors should understand commodities as they served as a hedge against a bear stock market. This is because commodities and stocks are negatively correlated – commodities in bull run while stocks in bear run. The central issue of what makes commodities price go up or down is due to the law of supply and demand. Demand higher than supply = higher prices.
Commodity trading is a big market with US$2.2 trillion transacted daily of the top 35 annual most active commodities. Commodities take time to be found, grown, produced and shipped; hence, the supply shortage takes a long time to keep up. This explains the long bull run of average 17 years for commodities. The current commodities bull run began in 1999, and if according to the average, the bull run will end around 2016. Stocks are now overpriced, bonds are offering very low interest rates and dollar is weakening. Since 1 August 1998, Rogers International Commodities Index has increased 254% after 8 years.
Supply and demand for commodities is having great imbalance currently. US investors have been putting money into tech stocks and neglecting companies carrying out commodities production and exploration. Supply hence has been depleting while demand increased tremendously, especially with populated China booming.
Studies have proved the negative correlation between stocks and commodities. One of them from Barry Bannister of Stifel Nicolaus and Co. – “stocks and commodities have alternated leadership in regular cycles averaging 18 years.” Roger’s explanation is that when commodities or raw materials are cheap, companies are able to enjoy low cost operations and higher profit margins. If the situation reverses, such that cost of raw materials increased, profits of companies will be reduced, and hence affects performance of the stocks.
- Even in a long bull run in commodities, expect periodic corrections from time to time.
- In the coming years, China will be influential to the world. If her demand for commodities drop, prices will tumble. Such setbacks are actually good buying opportunities
When will the bull run end?
The end of commodities bull run entails fundamental changes and bascially, when supply is more than demand. For example, more alternative energy are used, more oil fields found and operating, people switching to energy conserving devices, etc; would bring supply higher than demand. Rogers foresee such fundamental changes to be at least a decade away.
Stocks vs Commodities
Volatility in stocks are considerably more than the volatility in commodities. Furthermore, “Facts and Fantasies Abou Commodity Futures” found that the annual average return on their commodities index is comparable to that of S&P 500. Another important fact is that prices of commodities can never go to zero, unlike stocks.
Rogers comment on recent tech stock craze: “Technology can neither feed us nor keep us warm, and the demand for commodities will never disappear.”
It is all about supply and demand
The must have analysis tool of supply and demand of commodities is CRB Commodity Yearbook. Here are some sources for current supply information:
- U.S. (or other countries) government, state, and industry websites
- U.S. Geological Survey (minerals)
- Industry associations and services (e.g. American Bureau of Metal Statistics)
- How much production is there worldwide
- Are there new sources of supply
- Are there new potential supplies
- What is this commodity most used for
- Which of the current uses will continue
- What alternatives are available to replace it if the prices go too high
- What new technological advances might require this commodity that did not exist before
How to take advantage of rising commodity prices
- Buy shares in companies that produce commodities or service those companies (investing directly in commodities will yield higher returns)
- Invest in countries that produce commodities (Canada, Australia, New Zealand, Brazil, Bolivia, Chile) important to take consideration of political stability
- Invest in real estate in areas and countries rich in commodities (Oklahoma, Iowa, Nebraska, Montana, Colorado, Canada, New Zealand, Australia, Chile)
- Buy commodities (best method)
How to buy commodities?
- Individual account: open an account with a registered Futures Commission Merchant (FCM) who handles your trades. For expert traders.
- Managed account: paying someone else to make investment decisions. In addition, a Commodity Trading Advisor (CTA) can be hired for more advice.
- Trading futures options: Rogers does not recommend this as most options end up worthless
- Commodity pool: Commodity Pool Operator (CPO) makes the trade for a group of investors
- Mutual Funds: Rare for commodities. PIMCO CommodityRealReturn Strategy Fund (PCRAX) tracking Dow Jones-AIG Commodity Index; Oppenheimer Real Asset Fund tracking Goldman Sachs Commodity Index
- Index Investing: Recommended. Rogers International Commodity Index Fund or futures contract based on Reuters-CRB Futures Price Index offered in New York Board of Trade or futures contract based on Goldman Sachs Commodity Index offered in Chicago Mercantile Exchange.
Nature of commodities trading
Trading commodities is equivalent to trading futures – “buy and sell fixed amounts of a certain commodity at a specified location at a future time for a predetermined price.” 3 kinds of players in the commodities market – producers, buyers and speculators. Speculators are mainly the investors or traders looking to profit in the market and have no intention to consume the commodities they buy under the futures contract. Usually, speculators would never trade contracts during the delivery month so as to prevent the actual delivery of physical goods. Studies found that less than 3% of future contracts result in actual delivery or consumption of the commodities.
Unlike the stock market, losses and profits are collated at the end of each day in the commodity market. Funds are taken from the losers to pay the winners. Commodity trading usually allows leverage, and it is excessive leverage that often result in large losses when market goes against the traders’ positions. Extra care and considerations must be taken when trading on leverage.
Rogers’s rule of thumb for shorting: “I don’t like to sell something short unless it’s unbelievably expensive.”
China is growing at an exponential rate and demands a lot of commodities to fuel its growth. As the standard of living improves in China, 1.3 billion people are going to consume many more products and resources. At the time of writing, China is the no. 1 consumer of copper, steel, iron ore and soybeans; no. 2 consumer of oil and energy products. Chinese
Other positive facts about China:
- Capable politicians managing the country’s transition from communism to capitalism
- Chinese people save and invest 40 percent or more of their income
- They have good work ethics that are essential for building great companies
- A creditor country
- Clash of interest between Maoist supporters and capitalists
- High inflation rate
- Rural poor takes up 60% of the whole population and not involved in the boom of China
- Providing 9 million new jobs a year to keep people employed
When China stumbles, it would be momentary, and hence, it will pose as a good opportunity to invest in commodities at low prices.
- No major oilfield discovered since 35 years
- OPEC is suspected of inflating the amount of oil reserve
- Oil producing countries like Nigeria and Venezuela are politically unstable
- Russia’s poor pipeline capacity, backward technology and poor maintenance of oilfield equipment hurts supply and delivery
- 2006, 85.5 million barrels per day and declining (supply) vs 84.8 million barrels per day and increasing (demand). 2007 IEA estimates demand to be 86.4 million barrels per day
- Saudis have not been able to increase production to the level they promised– No independent sources to verify Saudi’s reserve claims
- In 2004, analysts forecast zero net growth in non-OPEC oil
- Hubbert’s Peak may be reaching soon or may even have reached
- Extracting useable oil from tar sands is difficult and expensive
- Asia is estimated to double its oil demand within 6 to 12 years
- Among the alternative energies, wind power seems most promising
- Gold unlike other commodities, does not get consumed
- More than half of the existing metals exploration in recent years are for gold
- Gold is oversupplied
- Rogers does not favor gold and only owns some as insurance
- Production has generally been declining since 1999
- There are only 3 lead smelters left in US
- Lead-acid batteries and computer monitors (lead to block radiation) would be in high demand while China booms
- Lead prices have outpaced gold prices for the past 30 years
- New deposits are getting harder and more expensive to reach
- Existing mines are old and exhausted
- Environmental regulations slows down mining process or even restrict setting up of new mines
- Demand more than supply due to the conversion of sugar to ethanol (which is used to mix gasoline)
High oil prices will divert more sugar to produce ethanol and inevitably decrease the supply of raw sugar
Brazil remains the world’s largest exporter of sugar
China has began importing sugar in recent years (she used to be self sufficient)
- Supplies have declined with less growers
- Bad weather will further affect the supply
- World demand for coffee has been increasing at a rate of 1.3% for the past decade
- Supplies will need years to increase (coffee trees take time to grow)