Wednesday, June 21, 2006

Commodities Trading

Commodities are the basic “things” that serve as the raw materials of the industrial society. Steel, coal, corn, and oil are all commodities, and investing in commodities is a big challenge. You can count on the price of commodities to rise to some degree, but the amount of human effort involved in pulling one pound of iron of the earth has been steadily decreasing for a thousand years. The price of commodities is a continuous conflict between inflation, the price of production, and demand.

This plot shows the inflation adjusted relative purchase power of gold from 1792 to the present. Althogh it has experienced wide swings, the purchasing power has tended to remain fairly constant (adjusted for inflation). Compare this to the exponential growth of the stock markets and you will realize that commodities are very different beasts. Data from the American Institute for Economic Research.

Commodities have recently returned about as much annual profit as the S&P 500 (in the last 30 years or so). Additionally, these returns were non-correlated with the stock market so that if you mixed commodities into your portfolio you would typically make just as much money with less volatility. Unfortunately commodities have recently become strongly correlated with the stock market so that they no longer serve this purpose. If you owned commodities in the last few years you would see them rise and fall in remarkable synchrony with stocks. Additionally commodities over the longer term have returned very little real price appreciation, tending to cancel out inflation and do little more.

The basic difference to recall in buying commodities is that they are “sterile” assets. A pound of copper does not come up with new ideas or make earnings. If you buy copper futures and sell them later you are buying an object and selling it later, which is a lot different from buying a piece of a growing business. Most commodities trading is fairly short term and news-driven.

And yet people constantly make bets in the futures markets. Some of the players have genuine business reasons for buying futures. An airline can lock in fuel prices by buying them years in advance (as Southwest airlines famously did before the current oil run-up, saving the company over a billion dollars) or a farmer can sell his crop before he even plants it and use the money to pay for seeds and tractor fuel to grow the crop.

Obviously most investors (or “speculators” as the commodities markets refer to those who aren’t producers or consumers) buy with the intention of selling later. If you want to be a speculator I will share with you the best advice I know of but please be cautious. Commodities trading uses different rules than stock trading and a small investment in futures can turn into a bankruptcy situation if held too long. Remember: the market can always stay illogical longer than you can stay solvent.

The best advice I have on commodities trading comes from Dwight Anderson of Ospraie Management, LLC (with $4 billion under management). He studies the companies involved in a given commodity, their balance structures, loan terms, labor laws in the affected regions, and even the functioning of the machines used for production. He tries to figure out the prices where there are discontinuities in the way the production market works so that he can see what prices are industrially significant. As an example consider copper. On average it costs about 80 cents to produce and refine a pound of copper. Unfortunately it also costs a fair bit of money to shut down a plan so he figured it wouldn’t make financial sense to shut down a plant until the price gets below about 72 cents per pound. Competition in the marketplace also means that people don’t want to be the first to shut down so there are delays on all sides.

This model became active in late 2001 when copper suddenly dropped to 60 cents a pound. At first nobody wanted to be the first to shut a plant in case prices recover so Dwight knew that reserves would build up and the prices would stay down for a bit. This implied that production would have to be cut and raise prices, so he took a big position in copper. Soon two of the biggest producers, Phelps Dodge (metioned here) and BHP Billiton, announced cutbacks in production. As the reserves dwindled in 2002 prices started rising and passed 75 cents and then continued to climb. As prices passed a dollar and then $2 all the mines opened again and now miners are financing new mines. This suggests to Dwight that supplies will start to climb faster than his projected demand growth of 5.1%, so maybe it’s time to sell.

Follow all that? It starts with in depth analysis of all the companies in a market and grows from there. I’ll take good old stock investing, personally. Read it again if you like.

I actually started this article in early June. The day after I wrote the sentence “so maybe it’s time to sell” copper posted its biggest one-day decline in 20 years, dropping more than 6%. Since many people use leverage of 5 or 10:1 in the futures market such a drop certainly changed a lot of people’s economic condition.

One of my best friends happens to love commodities trading, and he still has money so clearly it is possible to do okay in the commodities market. All I can say is that I highly recommend you learn your industry inside and out and do a lot of homework. Don’t just try to make moves based on weather reports or information in the paper. Remember you’re up against people like Dwight, who have the whole market mapped out and $4 billion behind them.

To help you get started I have listed a few books here, and I will be checking with my commodities trader friends to see what other books they might recommend.

Click back to the main page!


Anonymous Anonymous said...

If you want to invest in commodities, there is now an easy way without getting into the challenges and risks associated with futures markets. There is an ETF traded on the Amex exchange under the symbol DBC that tracks the Deutsche Bank Liquid Commodity Index Excess Return. Toy can check out the facts here

While it is a fairly new fund, launching in February this year, it tracks the broad Reuters/Jeffries CRB index extremely well (so far).

One final point to note about commodities is that they generally move opposite or inversely to the value of the US dollar as reflected by the US Dollar Index. As the dollar drops in value, commodities will generally increase in value.

Ben Zeen (C6H6)

4:50 PM  
Anonymous Anonymous said...

And spell checkers fail slow moving, aged eyes (Toy should be You)


4:52 PM  

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