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Commodities: Time To Go Long and Physical
By Dian L. Chu, Economic Forecasts & Opinions
Deutsche Bank AG recently noted that commodities will continue to “struggle” as the dollar strengthens and China seeks to restrain growth. Looking at the recent performance between the CRB index, S&P 500 and Legg Mason Emerging Market [LGEMX] would certainly seem to support Deutsche’s view. (Chart 1)
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Bears Gripping Commodity
Right now, due to the sluggish growth in industrialized nations, China remains the single largest consumer and buyer of many commodities.
Although China’s long term growth prospect remains strong, Beijing has started monetary tightening measures, amid concern of asset bubbles and inflation. The latest PMI data also suggests China's economy could be slowing down.
Furthermore, with the euro and European Union saddled by PIIGS, thedollar could continue to strengthen against euro in the near to medium term amid global risk aversion. Since most commodities are priced in dollar, a stronger dollar typically would depress the price and returns of commodities.
Market Over-reacting
The current momentum of key commodities, including oil, copper and gold, should be moving higher. This will happen as soon as investors feel less nervous about the Greek and European drama, and with the euro gaining support from four major central banks today, and signals of continuing easy monetary policy around the world.
The Gulf oil spill seems to be another event which the markets are having anxieties over. It is true that the Gulf oil spill disaster does have an economic and environmental impact on the U.S. Gulf coast, but in the global scheme of things, this most likely will not cause significant enough impact to the fundamentals of crude oil or economic direction to warrant a full blown commodity bear market.
Instead, this recent pullback on commodities from the market's mis-reaction should serve as a good entry point for long-term investors, and I will discuss a few options in the following sections.
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Physical ETFs
Long term investors looking for exposure to the spot market prices for potential better returns, could look for an ETF fund that takes physical possession of the underlying commodity. But unfortunately, these are presently limited to precious metals funds in the ETF category. (See Table)
Beware of Futures-Based ETF
Commodities, with a historic track record of uncorrelated returns to other markets, can play a role in a longer-term balanced asset allocation. ETFs have made this asset class accessible to the masses.
However, many commodity ETFs, such as the very popular United States Natural Gas Fund (UNG) and United States Oil Fund (USO) are based on futures contracts.
Since futures prices differ from spot prices due to a number of factors including storage costs, and seasonal demand pattern, the returns of futures-based ETFs generally differ from the spot price movements of the underlying commodity or basket of commodities. (Chart 2)
Contango Saps Futures ETFs
Lately, many commodity ETFs returns have been sapped by futures markets that are mostly in contango (Chart 2), with near-term contracts trading at a discount to those maturing at later dates. Investors in futures-based commodity funds, particularly shorter-dated ones like UNG, typically pay a premium as contracts expire and roll.
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That predicament will only ease when markets flip into backwardation that is when worries about current supplies worsen, which seems an unlikely scenario based on recent economic data.
Hard Assets Producers
Instead of subjecting to the impact of contango on certain ETFs, investors may also take a look at equities of commodity-intensive companies as an alternative, since the profitability of hard asset producers is often tied to the underlying prices of the related commodities.
There are plenty of solid blue chip resource producer stocks out there. Some very solid energy stocks battered by the Gulf oil spill worries are now looking attractive--ExxonMobil (XOM) and Schlumberger (SLB)--are two examples.
For investors with higher risk appetite, BP, PLC (BP) could be a good candidate with ExxonMobil serving as a prior example of one phoenix risen form the ashes of an oil spill ruin.
There are also some ETFs such as Market Vectors RVE Hard Assets Producers ETF (HAP) and PowerShares Global Steel Portfolio ETF (PSTL) offering broad-based exposure to asset producers, miners, steelmakers, etc.
Commodity Mutual Funds
Depending on the portfolio makeup, and preference, mutual funds and ETFs are two fund families with different characteristics that may suit the different investment objectives.
The best known broad-based commodity mutual funds include Oppenheimer Real Asset Fund [QRACX], and PIMCO Commodity Real Return Strategy [PCRAX].
Long-Dated Futures
In addition to the aforementioned investment vehicles, more seasoned investors with appropriate risk tolerance may look into longer-dated futures contracts with stop loss as another way to play in the commodity sector. This strategy could also help augment the futures-based ETFs in your portfolio.
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Read comment from ARP, The Commodities Con:
http://www.arpllp.com/core_files/The%20Absolute%20Return%20Letter%200510.pdf
http://www.youtube.com/watch?v=vWz9VN40nCA
I think this is posted here as a market thermometer. Not new information, not well formulated, but what is being broadcast.
I can't believe a post like this is allowed on ZH. The author's thesis to going long commodities is based purely on the fact that the market has over-reacted... yet the author provides almost NO proof/discussion of why the current price movement is an over-reaction.
Hey, I thought this was the ZH comic strip.
Conventional wisdom holds that declines in production relative to consumption will cause nominal prices to rise.
What is happening instead is that high nominal prices are a governor on economic activity much the same as European fiscal austerity constrains the ability of nations to service their debts. Call this 'materials austerity'.
Instead of prices rising, people don't earn enough money -ultimately from resource- derived commercial activities - to be able to afford fuel at any price.
Crude prices rise leading to economic declines which in turn reduce demand, which in turn results in lower prices, which in turn have two effects: a) constrain production as it is not profitable and b) reinforce the value of the reserve currency.
The US dollar is morphing from being a proxy for commercial activities to being a proxy for the physical good itself. As the currency becomes apparently more valuable it is preferred over other abstract forms of investment such as bonds, stock, other commodities and currencies.
What is happening in the Eurozone, China, Japan and other areas is the this dollar preference being exercised. The dollar is a defacto hard currency backed by crude oil; it is exchangable on demand for the valuable physical good.
At the same time, real crude prices - the relationship between crude cost and commercial output - are rising. This allocates capital away from commercial investments that might effect crude utilization efficiency. The outcome is identical to what gold- basis economies of the early 1930's experienced; little commercial activity yet much arbitrage between currencies and within banking systems in the efforts to accumulate gold.
The world's productive economies will collapse as more activity is directed toward buying and selling currencies (and currency derivatives) to obtain dollars - and crude at a remove. This process is well underway and appears unstoppable.
I've been calling for the past seven months to close out all dollar- short trades. Now, I'd start moving out of Treasuries and other dollar- exchange trades. As dollars disappear from circulation, Treasury and commercial debt derivative holders will sell them - at increasing discounts - to gain cash dollars. Since ordinary business activities are too expensive - because of the high real cost of fuel inputs - there is no other way to obtain dollars to obtain fuel. Currency speculation will destroy commercial economies directly by removing currency from circulation. This will be amplified by the dollar demand by oil producers who have little to gain (from the proceeds of commercial activities) by selling their crude cheaply or for other currencies/derivatives.
This means China, Germany, Japan and the US government will be all trying to sell debt derivatives at the same time.
The Fed cannot print its way out of the dollar/crude relationship. High real fuel costs render the Fed irrelevant. It cannot 'inflate' or devalue, as the value relationship is set in large markets will vast public participation (unlike current gold markets). The massive gross debt overhang is a first claim on currency (liquidity trap). Afterwards, constrained commerce results in funds flowing into crude would cause a price spike, which in turn would cause the world's economies to crash, which in turn would lead to very low prices - which would still be unaffordably high relative to smashed purchasing power.
After a period, demand would increase and fuel prices return to the current peg level and the dollar/crude relationship would reestablish itself.
This cycle was demonstrated in miniature beginning a couple of months ago. $87 is the new $147. We are all that much poorer. Like the 1930's there is no alternative to deflation but to go 'off oil' as countries went off gold. Do nothing and defiation will take place none the less. The hard dollar will result in currency hoarding - and by proxy energy hoarding.
Steve you speak a lot of wisdom but there is a helluva lot of shyte out there that is going to be sold before US Treasuries and the Dollar. Deleveraging is just getting warmed up. You are too early on this call.
Agree with what you are saying, however, the USG has the worst debtservice problems WRT a strong dollar of any entity on the planet.
The discontinuity will be when the oil/dollar peg is broken. It cannot be maintained because of the growing need for dollar supply to service the compound interest on existing money against the reality of a decline in oil production worldwide.
There is literally no way out of this from a mathematical perspective because interest rates don't control oil flows. Wells produce and peak at ZIRP just as surely as at 5%