Sunday Spectacle CCIX

Real Oil Prices

If you are looking at long-term trends with commodity prices, one should always look at the real prices (i.e. adjusted for inflation). Real commodity prices have actually trended down over the last few hundread years (only exception is something like gold, which is a currency and not really like other commodities). Over a medium time period of, say, 20-30 years, they have tended to cycle around an average--these cycles are massive and you can make a lot of money (or lose a lot) if you can capitalize on them. I turned bearish on commodities around 2007 because the prices were way above long-term real averages.

Given the big sell-off in commodities over the last few years (decline in 2014 and 2015 with rally in 2016), the question is whether they are attractive now. Each commodity is slightly different but they trend together for the most part. Crude oil has been the most important commodity in the last 50 or so years so it's worth looking at that. The chart below plots real and nominal crude oil prices in US$--I'm using USA import prices from EIA (other sources may show slightly different numbers but trend should be same)--from Jan 1974 to Dec 2016 (with 2017 and 2018 EIA forecasts).

(source: EIA real and nominal oil prices, downloaded Jan 15, 2017)

Most pure value investors typically don't invest in commodities or commodity businesses (Warren Buffett, for instance, has a mixed record with success with PetroChina but a disaster with ConocoPhillips). But if you are more macro-oriented, they are worth investigating because they have such big upside compared to most other business out there (on top of wildly fluctuating prices, commodity business also tend to have high operating leverage (can be ok if profitable company) and financial leverage (generally not good)).

The average monthly real price for the period above is around US$56 while it is around $52 if you use annual prices that go back to 1968 (not shown above). Right now the price is around $49 so we are essentially within 10% of the average for the last 40 years.

You can easily see how crude was around $30 (real price) during the bear market that lasted from mid-1980s to early 2000s. I think the risk for commodity investors is that prices can still fall to those levels (it did in early 2016) and stay there for decades. If you are investing in commodity stocks, I think you need to factor in such a scenario*. I'm researching commodity stocks and if I find anything attractive, I'll write them up (I started looking at them last year but didn't like what I saw).

(* The bearish reasons that could lead to further commodity price declines include: overcapacity in many industries, potential decline in demand if we enter a recessions (we haven't had one in almost 8 years), potential decline in demand and trade disruption due to USA-China trade war; offsetting bullish factors that support current prices include increasing demand from developing countries (less so China and more from others), rising inflation due to improving economic growth and possibly high inflation from central bank actions.)