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THE
CASE FOR COMMODITIES With
the recent slowdown in the bullish stock markets of the 1990s, fueled by
the IT, Internet, e-Business, and telecommunications revolution, there
continues to be a lack of well-defined leadership in the markets. A
potential emerging leader is the commodities market. This paper presents
the case for commodities at this time and concludes that there is
significant upside potential for the commodities market in the
long-term. What are Commodities and what is the Commodities Market? Commodities are raw materials of a wide variety of areas:
The commodities market consists of the trading of forward contracts or futures contracts; forward contracts are contractual agreements to buy/sell any commodity between two entities; futures contracts are market agreements to buy/sell very specific commodities between two entities over a recognized commodities exchange. The most popular way to monitor futures contracts for the generic commodities market is through an index known as the Commodities Research Bureau (“CRB”) Index - the most widely followed basket of commodities in the world. The Index consists of 17 equally-weighted commodities divided into these sectors – grains, livestock, precious metals, industrials, softs, and energy. The
index was created back in 1957 and since then, there have been nine
revisions to the Index components, the first on April 3, 1961 and the
latest on December 6, 1995. Commodity Prices and History Commodity prices have generally been in a very long-term bear market for the last twenty years. The last real bull market in commodities occurred during the 1970s stagflation time period. Many of the 17 commodities in the CRB Index are trading at their all-time lows, in particular coffee, cotton, and silver.
As the above graph seems to indicate, there appears to be an excellent opportunity now in commodities. In many ways, the current global situation is representative of the situation in the 1968-1969 time period, just before the massive bull run in commodities. The DiTomasso Group of commodities observes that with a long-term perspective view, if reversion to historical values takes place, then commodity prices, in aggregate, could double. The chart below depicts the changes in commodity prices for certain time periods since 1921, indicating also whether the time period was bull or bear.
In the period from 1980 to 2000, commodity prices generally were under constant downward pressure; in this sense, there was deflation in commodities. During the 1970s, commodity prices were quite high, and this encouraged a massive expansion in the supply of commodities during that time. From the lows in 1968/1969 to their highs in 1973/1974:
Commodity prices can increase under any economic conditions provided that there is excessive monetary and credit creation and the confidence of investors has been shaken. The situation at the current time appears to be quite similar to the 1970s in this sense. In the next sections, the very favorable environment for the commodities market is examined. Why Invest in Commodities? There are a number of drivers and current conditions that point towards the very favorable environment for the commodities market. 20-Year Low One positive for commodities is the 20-year low in commodity prices. The last 20 years have been a bear market for commodities. As the above graph shows, commodity prices today are even lower than they were at the beginning of the 1970s. Some representative graphs of the commodity areas are given below – for the metals; for the soft commodities or, also known as, tropicals; and for the grains. The graphs illustrate the very long-term low in their prices.
Demand from Asia Another positive for commodities is Asia. The 1997 depression in Asia led to very weak demand for commodities; however, as Asia’s economies rise back, there will naturally be a strong rise in demand for all types of commodities as the region grows. There is also a strong correlation between the performance of emerging markets and the performance of commodities. Demand from China Another driver for commodities is China. China is one of the few countries in the world today with a steady, long-term high-growth rate. As Marc Faber mentions in his book “Tomorrow’s Gold” that “China will become the top consumer of Asian natural resources, send out Asia’s largest number of tourists, and invest heavily around the region in joint ventures or take over entire businesses.” Therefore, China’s demand for commodities is expected to escalate during the coming years. Marc Faber concludes on China: “In fact, I regard the purchase of a basket of commodities as the safest way to play the emergence of China as the world’s dominant economic power.” US Dollar Depreciation Yet another positive factor for commodities is US Dollar depreciation. With the US Dollar currently depreciating, the question is what will the US Dollar depreciating against and where will investors go into from here – the Euro? The Yen? Most likely neither as the Euro is not a particularly encouraging currency with Euroland experiencing significant economic problems recently, although the expansion of Euroland into Eastern Europe is promising and could present a significant boost to the currency; therefore the Euro is not expected to appreciate significantly compared to the US Dollar. And the Yen is also not entirely in good condition, due to the on-going decline in the Japanese economy and on-going banking problems. In recent months furthermore, Japan has applied intervention extensively to maintain a low Yen, attractive for Japanese exports. Therefore the Yen is also not expected to appreciate significantly compared to the US Dollar. Rather most likely, with the US Dollar depreciating, investors will therefore go to a hard currency, such as gold, and a basket of commodities. This would mean commodity price increases as the US Dollar value decreases. Deflation or Inflation Commodity prices in the coming years will be influenced by two the forces of deflation and inflation. If deflationary forces dominate, commodity prices will tend to decrease; if inflationary forces dominate, commodity prices will tend to increase. However, this is not always and necessarily the case. There has been much discussion recently about whether the United States is heading for generally much higher inflation or a deflationary depression; in either case, commodity prices have a tendency to rise. During the last twenty years or so as mentioned above, commodity prices have essentially been in a long bear market with declining inflation rates. This decline in inflation has even now gone to the point of a general fear of impending deflation. This is especially true when consideration of the massive export potential of China to produce manufactured goods at significantly lower cost than the Western industrialized countries. However, the loose monetary policies of the Western industrialized countries, discussed in the next sections, could lead to much greater and even severe levels of inflation in the near future. This in turn could raise commodity prices significantly likewise. In the case of inflation, it is easier to understand; however in the case of deflation, it may appear to not make sense. But in the Great Depression, commodity prices doubled from a low in 1932 to a high in 1934. If the decline in the demand of commodities in a deflationary recession is met with a larger decline in the supply of commodities, commodity prices may then likely increase. This is essentially the case now in the global economy; last year, commodity prices increased by more than 20% in this regard. The current situation is somewhat like the beginning of the stagflation of the 1970s – with inflation in some areas and deflation in other areas. In particular, it appears as if inflation is appearing now in areas involving resources and deflation is appearing in areas involving mostly Asian exports of low-cost manufactured goods, clothing, and household items. There is much discussion as to whether deflation may also extend to the real estate sector. Inflation in areas involving resources means rising commodity prices. US Federal Reserve Board Policies Some significant conditions for rising commodity prices are the loose monetary and fiscal policies of the US Federal Reserve Board. Excessive monetary stimulus and rapid credit expansion will always eventually lead into hard asset markets such as real estate, commodities, and precious metals, which then, in turn, lead to higher inflation rates. The Federal Reserve Board recently published an essay entitled “Preventing Deflation; Lessons from Japan’s Experience in the 1990s” (International Discussion Paper, Number 729, June 2002). In this essay, the Federal Reserve Board mentions “that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus – both monetary and fiscal – should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.” The effect of these loose monetary and fiscal policies have the overall effect of US Dollar depreciation, leading to the situation described above under the section entitled “US Dollar Depreciation”. Furthermore, following a January 2002 meeting of the Federal Open Market Committee (FOMC), a Federal Reserve Board mentioned that in the extreme event that its loose monetary and fiscal policies become ineffective, it would take “unconventional measures” such as the “buying of US equities” or any “state or local debt, real estate and gold mines – any asset”. And more recently, the next potential likely incumbent of the Federal Reserve Board Chairman after Alan Greenspan, Ben Bernanke, mentioned his now famous statement about the government having a technology called the printing press to which it can use in fighting deflation. All of these Federal Reserve Board policies are setting an environment that will be very conducive for a depreciating US Dollar currency and ensuing rising commodity prices. Rising Government Budget Deficits Rising government budget deficits, at both the federal and state levels, will add significant pressure to a depreciating dollar, in turn providing another factor for rising commodity prices. Energy Situation A very positive factor for commodities is the energy situation. The current longer-term relatively higher energy prices, such as oil, are creating a situation similar to the energy crises of the 1970s. There have been numerous recent studies which indicate that current oil and gas fields have peaked in their maximum levels of production, that the easy-to-get oil and gas reserves are being depleted, and that future potential reserves will be much more expensive to mine and extract. And not to mention the growing demands and usage of energy by the developing world - especially from such countries as China, Vietnam, and India. All of these factors point towards much higher oil and gas prices, translating to much higher commodity prices in general. It is to be noted that many of the other commodities, such as soft agricultural commodities, are either derived from or produced with oil and gas products. Recession or Recovery Another point worth noting is that commodity prices will increase significantly in the periods immediately after the end of a recession; this is because after recessions, demand for commodities generally picks up considerably. As the global economy expands, the demand for commodities will correspondingly rise and with it, commodity prices. An economic recovery will generally demand a higher usage of commodities, resulting in higher commodity prices. Geopolitical Events Recent geopolitical events, resulting in unstable markets and potentially adverse commodity distribution (such as in oil from the oil producing countries) are causing commodity prices to rise. The following is brief list of countries where such has been the case: Oil Producing:
There has been considerable recent analogy made between the current United States as an empire and the Roman empire in decline. The Roman empire in decline, as most other empires in decline as well, was characterized by on-going skirmishes and wars at the fringes of its lands, accompanied by rising inflation and a depreciating currency. With United States beginning to appear to fall into the empire mold, given recent geopolitical events, the likelihood of rising inflation and a depreciating currency increases, and with these increases, it is to be expected a general rise in commodity prices. Ways to Invest in Commodities Futures and Physical Delivery Futures are the standard way of investing in commodities. And physical delivery of the actual commodities can also then be demanded and taken, though usually this is not done, as it would be prohibitive to store 5 tons of sugar or coffee in one’s home or storage space. One can revolve a variety of commodities in a continuous fashion, without ever taking delivery. Managed Futures Another way to invest in commodities is through futures funds, of which there are some such as the following:
Natural Resource Stocks Another way to play the commodities market is to invest in equities in such sectors as oil and gas, mining, and agriculture. These include:
Emerging Markets Another way to play the commodities market is to invest in resource-rich emerging markets, such as the following below. Each of these countries has extensive mineral, energy, and agricultural wealth. With rising commodity prices, the markets of these economies will very likely do quite well.
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