The market has had its run- is it time for commodities?

In an effort to gain a basic understanding of commodity investments, I recently read “The Little Book of Commodity Investing” by John Stephenson.  I currently hold some commodity exposure (NEM, SCCO, and RIG) to give my portfolio a little diversity and I’m interested to learn more given the general consensus that many commodity investments have a relatively low correlation factor with the stock market and bonds and tend to thrive in low growth environments (like the 70’s when commodities had their big bull run).  Reading the book sparked a considerable amount of interesting ideas and thoughts, but given my relative ignorance of the topic, I will hold off on offering any personal opinion in this post and simply share some “power notes” I took from the book:

-One of the largest bull cases for commodities is that if China decides to lighten their allocation to U.S. treasuries, commodities is a logical place for them to invest given their current interest in the investment class (via Chinese Investment Corp) and tremendous consumption demand.  A 15-20% shift in Chinese investment from treasuries to commodities would significantly impact values. 

-The last great commodity bull run was from 1968-1982, a period of high inflation and consumption from the baby boomer population.  Stephenson argues that today’s environment is poised to show similar characteristics (end of monetary easing to eventually cause significant inflation) but with a rising Asian middle class much larger and more significant in comparison to the U.S. in the last bull commodity cycle.     

Oil/ Gas:

-Despite all the technological advancements made, approx. 2/3 of all oil still gets stuck in the ground through the drilling/ well process.

-Natural gas facts:  (i) much cleaner fuel to burn than other fossil fuels; (ii) there is currently an abundant supply of it; (iii) weather explains between 50-80% of the price variation of natural gas since it is primarily used for heating/ cooling applications.  It’s also why natural gas prices are generally higher in the winter than the summer.  (iv) a key component of the Pickens plan is to convert cars to compressed natural gas given the abundant supply and environmental benefits.  (Apparently many cars in Iran run on natural gas since its more profitable for them to sell oil overseas).

-Oil and gas used to trade in tandem based on heat content with gas trading at approximately 1/6 the price of oil ( because natural gas contains 1/6 the heat in BTU terms compared with oil).  Recently however, this correlation has weakened because gas can only be transported by pipeline and is more likely to be impacted by local supply and demand factors than oil, which is a global commodity whose price is generally set by “global supply and demand”.  (sidenote:  when reading this I wondered about OPEC, but the author didn’t mention OPEC’s influence or effect on oil prices at all in the book.)

-Tracking the number of active drilling wells at a given time has historically been a decent leading indicator of oil prices and overall oil field and service activities.  You can find this information at bakerhughesdirect.com

Gold and Silver:

-The gold play is primarily all about a weak dollar, banks under stress, and inflation.  As a hard asset with finite supply gold bugs argue that it cannot be devalued similar to currencies (via monetary easing).

-90% of known gold in the world has already been mined.  This roughly totals $4.5 Trillion, compared with $8M Trillion USD in circulation (as of 2008) and a world-wide stock market capitalization of $40 Trillion.  Additionally, the world’s entire gold supply can “fit in 2 olympic-sized swimming pools” according to the author. 

-62% of gold is used as jewelry, and 9% is stored as collateral for ETF’s and other gold investment vehicles.

-China only currently holds 600 metric tons of gold vs. approx. 8,100 metric tons for the U.S.  (Similar to the commodity argument, gold prices would benefit if China decided to lighten their treasury allocation and buy some gold). 

-Silver and gold have historically moves in relative lock step at an avg.  37:1 gold/ silver value ratio over the last 200 years, but this correlation started breaking down in 1999.  Today, the gold/ silver correlation is approx. 62:1 ($1,238 per ounce for gold, $20.13 per ounce for silver)!  (Obviously begs the question of whether a long silver/ short gold bet makes sense today with the idea that the relative pricing difference will revert closer to the historical average…). Interestingly, the total estimated inventory of silver to gold is about 10.6:1, further suggesting that maybe silver is undervalued relative to gold.

-Apporx. 50% of global silver supply is used as an industrial metal (vs. only 11% for gold).  Silver is used in many batteries given that it has the highest conductivity of all metals. 

-In terms of investing in silver/ gold plays, the GLD and SLV ETF’s allow investors to bet strictly on gold and silver prices.  Betting on the mining companies is a leveraged play on metal pricing ( e.g. Barrick and Newmont Mining for gold, Hecla, Coeur d’Alene, and Pan American Silver for silver).  Alternatively there are silver streaming companies like Silver Wheaton (SLW)  or Franco Nevada (FNV) that provide a more direct correlation to silver prices and remove some of the operational and capex risk of the mining companies. 

Steel, Copper, Aluminum, Zinc:

-Commodity prices for hot rolled steel, copper, aluminum, and zinc are often the first to move when global industrial production begins to accelerate.  (For the record, I have NOT noticed this with copper in 2013, which I suppose is primarily due to mixed news on growth in China.   I still think it’s a good investment at this time in the cycle, however.)   

-China is by far the largest demand driver of copper and steel. 

Food:

-Food inflation is a significant problem in fighting worldwide poverty.  As a result, it tends to be highly regulated and protected as a resource by various governments.

-In first world countries food expenditures account for less than 15% of average personal income, however, in developing countries this percentage can be as high as 80%, hence the challenges of food inflation!

-During the global food scare of 2007/ 2008, food prices experienced their sharpest rise in over 30 years.

-A Sept. 2008 study released by Credit Suisse cited farm commercialization as the “single most important factor driving the next decade of growth in agriculture.”  As an investor in John Deer (DE), I was happy to read this confirmation bias 😉

– DBA (DB Agriculture Fund) is a diversified ETF offering diversified agriculture exposure to items including grains, cotton, cocoa, and hogs.

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