Investing in Commodities

by Rich Hamilton

If the answer is “cyclical” the question must be “commodities?”.

Commodities – oil, copper, silver, uranium, etc, exemplify the boom to bust business cycle. Even dilithium fits the bill. Imagine a long time from now in a galaxy far, far away:

The Federation is running out of dilithium. The price is rising faster than a chili powered starship. Forget American Idol, everyone who’s anyone wants to be a dilithium prospector.

Time passes and human ingenuity (or greed at any rate) is rewarded and new dilithium deposits are found, mines sunk, and production begins. Everyone starts imagining what they’re going to do with the money that will soon be showering down on them. And then, and then …

The price crashes to Earth with a bump. In fact, it collapses.

But “why”, my more naive readers cry, “why did dilithium’s price fall?”

For the deprived few who didn’t cut their economics’ teeth watching The Trouble with Tribbles, and there must be some, the answer is, of course, supply and demand. The new mines are pumping out more dilithium than even the most power-crazed Klingon commander could use in a million years. People are even spreading dilithium on the roads to keep them ice-free in winter.

The secret to profiting from commodities is to invest in dilithium before the Federation runs into significant shortages and to sell it before the new production facilities pump out enough dilithium to flood the market. And if you’re not interested in the dilithium futures market, just substitute almost any commodity of your choice for dilithium.

I should point out that some investors believe the cyclical commodity paradigm I’ve outlined above will not persist in future. They believe ongoing shortages of commodities will drive prices ever higher. John Mauldin, in a recent newsletter, quoted Charles Gave, who describes these investors as “Disciples of Malthus”. (Malthus lived in Britain, 1766 to 1834. He believed human population growth would ultimately be higher than the planet’s finite resources could provide for.)

Gave writes: http://www.2000wave.com/

“For such investors, commodities cannot not be in short supply over time given the growth of the world’s population and of overall global incomes. Commodity prices will thus have to rise given that we are confronting a world with too many Chinese/Indians/Asians… and not enough oil/copper/gold/iron-ore etc… For Malthusians, the solution is thus simple: load up on commodities or commodities producers or load up on gold and stay outright bearish of most asset classes. Most of the perma-bears (as opposed to cyclical bears) we have met over the years tend to be disciples of Malthus.”

If you’re a Malthusian, how should you best express your world view from an investment standpoint?

Obviously, you buy commodities – any commodities you think will be in demand in a few years’ time.

To whet your appetite, I’ve jotted a few notes about the more obvious contenders. Now that we have commenting enabled, please feel free to add your own favorites.

Oil

Pros: Evidence suggests the planet is close to peak production of conventional oil. If this is true, prices may rise strongly.

Cons: If prices rise strongly, you may find investments in oil companies turn to losses. During the last oil-price surge, the Russian government grabbed western oil company assets, as did the Venezuelan government. Other countries could do likewise – particularly if an oil crisis developed. Companies could also find themselves taxed punitively. Politicians in both the USA and UK seriously proposed windfall taxation of oil company profits during the last price surge, conveniently forgetting that the industry needs to make money to fund exploration and production in ever tougher environments.

For these reasons, if you’re wearing your Malthusian hat and you’re determined to bet on expensive oil, it could be best to take a position purely on the price of oil and not invest directly in an oil company.

Other cons are the possibility of unconventional oil displacing conventional oil – for example the tar sands in Alberta, and shale gas, which America has vast reserves of. If America’s cars were converted to run on shale gas instead of gasoline, the nation would no longer be dependent on imported fuel. Shale gas also produces significantly less “greenhouse” gases than burning conventional oil and gasoline.

Gold

Pros: Since before humans could write, gold has been used as a store of value. It doesn’t rust and the gold of the Ancient Egyptians looks as beautiful to us as it no doubt did to them. In times of economic crisis, the value of gold rises relative to other assets because it is perceived to be safe. In a time when central banks have decided they can solve economic problems simply by printing money (quantitative easing) the attractiveness of gold rises.

Cons: Writing at the beginning of 2010, the price of gold is very high compared with the preceding few years. You’ve missed the chance to buy gold at less than $300 an ounce in the late 1990s and early 2000s and you now need to pay over $1,000 an ounce. Gold bugs (as fans of the commodity are called) believe it will continue to rise – talking about prices of $2,000 and even $3,000 an ounce, but, having already bought their gold, they would say that, wouldn’t they.

I’ve graphed the historical price of gold below using figures from the National Mining Association.

Price of Gold 1833 to 2010