Why You Should Consider Cold, Hard, Commodities

Victor is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The broad commodity markets have been uneventful during the past couple of years.  While some commodities have outperformed others, and windows of volatility proved good for trading, the broad commodity markets ended up down in 2011 and 2012.  That said, commodities should be attractive from a long-term perspective.  Natural resources like oil, metals, and even livestock and agriculture are ultimately finite, even as global demand for them increases every year.

An unbalanced world

But you may not realize just how imbalanced global consumption can get.  Using oil as an example, the United States has a population of about 315 million people, and consumes about 7 billion barrels of oil per year.  That equals over 22 barrels per person annually.  

Meanwhile, China has a population of over 1.3 billion, and consumes about 3.4 billion barrels of oil per year.   That equals about 2.5 barrels per person annually. In other words, Americans consume about 9 times as much oil as the Chinese.

In truth, the US consumes more oil per year than China, India, and Russia combined, even though those countries' total population more than eight times larger than that of the US.  

The graph below shows a summary of these disproportionate population and consumption numbers.


<img height="227" src="/media/images/user_15926/popoilcons_large.png" width="388" />

This is an extreme imbalance, and it's only a matter of time before the billions of people in developing countries start demanding their own 22 barrels of oil per head.  The same is basically true for other commodities.   Given our fixed supply of natural resources, it is reasonable to assume that long-term commodity prices have significant upside potential.  

It's worth noting that countries like China, which used to love accumulating US dollar reserves, have gradually cut back their holdings in favor of cold, hard, commodities like oil and gold.   If other countries follow suit, it could push prices higher, faster. 

The puzzle of pricing

Commodities can be hard to price and value. Unlike other assets, commodities have virtually no cash flows (i.e. interest, dividends, earnings, rent, etc.). That makes standard pricing and valuation tools (like discounted cash flow analysis) ineffective. Since intrinsic value is hard to estimate, fair value is often replaced with whatever price the next greater fool is willing to pay.

This is one of the reasons that commodity markets can be very volatile and highly speculative. Fortunately, by using some simple assumptions, we can come up with a reasonably sound estimate of fair value.

For example, assuming commodity supplies are finite, and that demand for them will continue, we can expect commodity prices to at least keep pace with inflation over time (all else being equal).  Of course, there are plenty of variables we have not considered, but at the most basic level, this should make sense.   

With that in mind, look at the graph below.  It plots the real price (inflation adjusted price) of the DJ UBS Commodity Index over the past twenty years (in blue).  Also included is a trend line, which plots expected real prices based on a 2% inflation rate (in red).   Note that long-term average inflation levels are closer to 3% or 4%, but 2% is a reasonable average for the period considered.

<img height="184" src="/media/images/user_15926/rcompr_large.png" width="405" />

While commodity prices had wide swings, they generally reverted around the trend line. We can think of the trend line as being the “fair value when all else is equal” threshold.  Looking at the chart, it appears that commodity prices have been bouncing around fair value since 2009. 

To be clear, I think there is more downside from here due to the huge run up that ended in 2008 - corrections tend to over correct.  Still, two important points remain. 

First, prices are not high relative to where they were in 2007. Second, prices have been wavering around a key threshold.  The point is, I think it is worth watching commodities closely from here on out. Trying to time a bottom is futile, but I think it makes sense to build a position over time by buying in chunks on price weakness.

There is certainly no shortage of ways to gain exposure to commodities.  Exchange-traded products (ETPs) have made it very easy to gain access to the asset class. A few popular ETPs that will provide broad exposure to commodities include the iShares S&P GSCI Commodity Index Fund (NYSEMKT: GSG), iPath DJ-UBS Commodity Index TR ETN (NYSEMKT: DJP), and the PowerShares DB Commodity Index Fund (NYSEMKT: DBC).  Keep in mind that not all ETPs are created equal, and that there are important differences between them. 

For example, while the iShares fund is one of the most popular, over 70% of the fund is invested in energy.  The iPath fund only has about 30% energy exposure, but it is structured as an exchange traded note instead of an exchange traded fund, which comes with its own set of considerations. 

The PowerShares fund has similar structure to the iShares fund and similar exposure as the iPath fund, but it has the highest expense ratio among the three (0.87%). 

The point is that these commodity funds can be significantly different and can even have different risks.  It is important to understand both the risks and differences before investing in them.  You can read more about differences between ETPs by visiting this blog posting.

BellwetherCM has no position in any stocks mentioned. Victor Lai is an investment adviser representative with Bellwether Capital Management LLC, a registered investment adviser. Clients of Bellwether Capital Management LLC may own positions in the securities referenced in this post.  This post is for informational purposes only and does not represent investment advice. You should conduct proper due diligence and/or consult with professional advisors before taking investment action.

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