Submitted by Eric Peters, CEO of One River Asset Management
Cost of Production
“The commodity index price is roughly at the cost of production,” said the CEO, trained in tracking supply and demand. “Prices sometimes falls below production costs, but those periods are brief,” he continued. We were reviewing his historical charts of a range of the world’s most important commodities, each told a story. “By our calculation, only four times has the average marginal cost of production been below the commodity index price: in 2001 it was -5% below, 2008 it was -7% below, 2015 it was -12% below, and now it’s -2%.”
“But in every other year since 2000, the commodity index price was substantially higher than the average marginal cost of production,” said the same CEO. “In 2002, the price was 20% above, and that was just one year after prices were -5% below production costs.” In 2007 prices were over 50% above. In 2008 they were -7% below. By 2010, prices were nearly 70% above.
“When commodity prices fall below production costs, you kind of have an embedded put because producers cut supply, and demand draws down excess inventories. Longer-term, producers usually need roughly a 20% margin to continue capex and production.”
“From 1970-2009 the return for the commodity index (SPGSCI) and the S&P 500 both annualized at roughly +10%” said the same CEO. In the 1970s the S&P 500 annualized at +6.7% in nominal terms while the SPGSCI annualized at +21.2%. In the 1980s, the S&P annualized at +12.0% (SPGSCI +10.7%). In the 1990s the S&P 500 annualized at +14.1% (SPGSCI +3.9%). In 2000-2009 the S&P 500 annualized at +10.1% (SPGSCI +5.1%).
“Then QE kicked in. And from 2010-2018 the S&P 500 annualized at +11.7% while the commodity index annualized at -7.7%. So now commodity prices are -23% below where they were in the depths of the worst financial crisis since the Great Depression.”
“Why are people so uninvested in commodities?” asked the CEO, repeating my question. The Middle East is at war, yet oil trades 5% below the worldwide average marginal cost of production according to his estimates. While gold and silver trade roughly 50% above production costs, wheat and cotton trade 30% below their marginal cost to grow. And when you average out 21 major commodities, they’re about as cheap as they ever get relative to their marginal production costs.
“If I’ve learned one thing in all these years, it’s that people rarely look for value in commodities, they buy when things start going up,” he said.