Wednesday, November 24, 2010 3 comments ++[ CLICK TO COMMENT ]++

Thoughts from a commodity bull

I've bearish on commodities for years but as long time readers know, I like to cover dissenting views that contradict me. This post is one such case.

I ran across a Globe & Mail interview with the author of The Little Book of Commodity Investing, John Stephenson, covering commodities. I don't know anything about this author or how good his record is but sometimes it doesn't matter what the track record of someone is; what matters is their ideas.

Here is an excerpt of some of the key questions, along with my thoughts. Since I'm bearish I'll be challenging the author's points (most of you have heard my arguments before so skip to the article directly if you are not interested in that):

Q: Many commodities have had huge gains already. Isn’t it too late to jump in?

John Stephenson: The average length of a commodity cycle is 20 years and, even accounting for the rise in commodities at the start of 2000, we are at most four innings into the rally. The average mine takes the better part of a decade and more than $1-billion to bring into service, which is why the cycle is so long. What’s more, when commodity prices are high, manufacturers have difficulty passing on these raw material increases in their finished products, so their margins and stock prices tend to suffer. Since rising raw material prices are inflationary and higher interest rates tend to follow higher inflation, bonds suffer when commodities zoom. Commodities zig when bonds and stocks zag, so if you're not considering commodities, why not?
Realistically, one needs to chop the 20 year figure in two or maybe two-thirds. The trough-to-trough (or alternately peak-to-peak) cycle may be 20 years, but you, as an investor, need to get out near the top. There is no point making a full-circle back to a trough. I haven't looked at the numbers deeply but, as an example, the commodity bull market in the 60's-80's may have lasted 20 years but the peak was in 1980, while the trough was around 1966 or 1968 (depending on what you are looking at). The trough-to-peak cycle was just 10 to 12 years.

The current bull market in commodities (again depending on what you look at) started in 1998—I pick 1998 because that's when oil bottomed at around $8/barrel—and has been going on for 12 years already. My guess is that we are closer to the peak than the trough. In fact, it is quite possible that a multi-decade peak was set in 2008 and commodities may have actually entered a secular bear market. It's hard to mark tops, except in hindsight, so it remains to be seen if commodities will surpass their 2008 peaks (some already have but key ones like oil are nowhere near their 2008 prices). [The definition of a bull market I use is rising peaks (or troughs) so if a price peak isn't surpassed, I consider it as a bear market.]

The bond/stock vs commodity argument has been true historically but it hasn't really been as true in the last decade. Yes, there were periods when commodities were strong and stocks/bonds were weak but, for the most part, all of them were moving together—almost every single asset, except the US$, was in a bull market for most of the 2000's, especially post-2003. Even right now, the correlation is really high. Followers of markets may be cognizant of the fact that almost everything rallied from the 2009 bottom. Conversely, almost everything, including commodities, crashed in 2008.

What’s the biggest factor driving prices higher?

JS: In the long term, all that matters for commodity prices is supply and demand. To understand demand is to understand China, which is the engine of demand growth. After more than two decades of underinvestment in commodity production and [then] the global financial crisis, supply is nowhere to be found. Copper inventories on the London Metal Exchange represent just eight days of global consumption – a very tight market.

During the 1960s and 1970s, around 75 million people entered the global middle class in Europe, Japan and North America. This time around, hundreds of millions of people in Asia are entering the global middle class while the supply situation is way worse. Prices will go higher and stay higher for longer than anyone suspects. Eventually, supply will adjust and demand will be satisfied and the bull market in commodities will be over – it just won't be any time soon.

I agree with the author that supply & demand matters in the long run. However, related to that, one needs to factor in the marginal cost of production as well. I notice that commodity bulls tend to rely on demand to judge the future whereas many commodity bears, including me, look at supply. As I have pointed out before, commodity prices can fall even if demand is increasing (as happened to oil from the early 80's to 1998).

What’s your favourite commodity?

JS: Oil. It's a miracle fuel that powers your car, buses, airplanes and is used to make perfumes, plastics and other everyday items and it's cheaper than orange juice on a volumetric basis.

I don't mean to be rude and call out this comment but the volumetric argument—this is when you look at cost per unit volume—is completely meaningless. There is no reason oil should trade at a $/volume price that approaches another good.

Least favourite?

JS: Natural gas. We have way too much of it in North America and U.S. producers are drilling not because it makes economic sense, but to retain their land base. With no producer discipline, prices are likely to remain in the basement for the foreseeable future.

Being a contrarian for the sake of contrarian is the dumbest thing ever, but since I tend to be contrarian, I would rather bet on natural gas than oil (opposite the author's stance). Although there appears to be massive oversupply of natural gas, whereas some suggest there is less excessive production in oil, the price may reflect this outlook. Although I'm not predicting this, which is more likely to triple: oil from $80 to $240, or natgas from $4 to $12?

On another note, the author also suggests that investors should consider ETFs that invest in physical commodities. It's not clear if the author is talking about ETFs that solely hold physical commodities, or if he is also including ETFs that hold derivatives (such as futures and structured notes) that track commodity prices. The former is pretty safe for long term investors, but apart from gold and silver, which are quasi-currencies unlike other commodities, hardly any other commodity can be stored for long periods of time. The latter is dangerous and investors should be careful. If the ETF or ETN tracks a price or owns commodity futures, then the long-term payoff is dependent on the path the price takes—going down 5% in one year and up 5% later will produce a different result from if it went up 5% first and then down 5%—or the structure of the commodity futures curve—you will lose money if the futures curve is in contango and make more money if it is in backwardation.

So, if you are taking a bullish position, on top of forming a strong opinion of the future price, do analyze the mechanics of security you are buying. Commodities are easier to analyze than stocks but they are likely harder than bonds (BTW, just because something is easy doesn't mean you make more money since the market prices assets properly most of the time).


3 Response to Thoughts from a commodity bull

Parker Bohn
November 25, 2010 at 9:57 PM

I'm not sure I buy the "commodities as an investment" idea.  Commodities seem more like a speculation to me.  Stocks and bonds are not easy to value, but they both provide owership over a stream of income, and as such there are empirical data-based methods for valuing them.

Commodity valuation arguments (both bull and bear) on the other hand are invariably narrative based.  This is because the only way to benefit is to correctly anticipate price changes.

I do own some shares in CVX (oil) and PKX (steel), but these are investments in companies, not commodities.

Sivaram Velauthapillai
November 26, 2010 at 11:18 PM

According to some, such as Jim Rogers, commodities are easier to value than stocks. With commodities you just need to gain an understanding of supply & demand, whereas stocks are more complicated. Commodities do involve more emphasis on figuring out the supply & demand picture in the future but I would argue the same thing applies to stocks. If you don't have a good sense of the future environment for the shares of a company, you can lose just as easily (e.g. investing in declining industries). So, commodities aren't necessarily bad.

In some rough sense, investing in commodities is akin to investing in competitive, cyclical, industries--say auto manufacturing or homebuilders. Needless to say, modern Buffett-type investors avoid these industries like the plague, for reasons they avoid commodities: problems with overcapacity, no pricing power, etc.

However, I personally think the big problem with commodities is storage costs, or if using futures, penalty from contango (when you keep losing money every time you roll your contract if spot prices are lower than future prices). If the storage cost was low, I think commodities would be much more attractive and start approaching an asset such as real estate. Real estate, which has characteristics of a going-concern company (i.e. stock) and a commodity, is historically one of the best performing assets and isn't too far off the 10% per year return posted by stocks.

Sivaram Velauthapillai
November 26, 2010 at 11:23 PM

Parker Bohn: "I do own some shares in CVX (oil) and PKX (steel), but these are investments in companies, not commodities."

Yeah but unless you bought when they were really cheap, I'll bet your return will be determined more by the underlying commodities--oil and steel--than the companies themselves. Perhaps the companies themselves are great but I wonder about these situations. A lot of value investors, including Warren Buffett who got burned with ConocoPhillips, sort of pay more attention to the company than the commodity but it can be dangerous.

The problem with these commodity companies is that they have no pricing power and it's hard to run a capital-efficient operation. Sure, there are some exceptions like ExxonMobil but I'll bet that the ROE of the whole commodity complex over a 30 year period will be way below the market average (12%). The commodity price will still be the main driver of returns, I suspect.

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