As if we needed a reminder that our food, fuel and clothing are all subject to global political, meteorological and market developments. The turmoil in the Middle East and North Africa has now intensified investors' focus on commodity markets, which once belonged to farmers and a tight club of traders. Now, investors more broadly consider real assets an ongoing component of their investment portfolio. Witness the assets under management for commodity-related mutual funds, which grew from $20.8 billion at the end of February 2006, to $155.7 billion five years later, according to research firm Strategic Insight. We've received the message about commodity investing, but did we get the right message? To address that question, let's consider commodities from three perspectives: supply, demand and risk.
We are now inundated with analyses of when the world will run out of some essential commodity. The early 19th century scholar and early contributor to the field of economics, Thomas Malthus, famously argued that increasing populations would inevitably overtake the earth's ability to produce food. That concern has continued into modern times. Even before the oil shocks of the early 1970s pushed gasoline to the then unthinkably high price of $1.00 per gallon, petroleum has been on the verge of global depletion. As I recall, the mid-1950s forecast scheduled for the last drop to be pumped around now.
Today's concerns about peak oil continue this debate about what logically is a finite substance. A similar discussion revolves around other extractive resources, especially when — as currently the case with rare earths — a political dimension limits access to such raw materials. There's a seemingly obvious investment implication: If we're going to run out of something that everyone needs, I want to own a chunk of it for when the supply gets tight.
The problem with the supply-side argument for owning commodities that you don't intend to use, is that supply has generally proven more flexible than worriers thought. Projections about diminishing supply haven't always held much water — another commodity that faces scarcity —because the supply at one price will be quite different from the supply at a higher price. Brazilian pre-salt crude, for example, will probably cost $40 per barrel to extract, making it part of the world's oil supply at $100 a barrel, but not at $30.
Agriculture also responds to demand. Malthus' forecast didn't anticipate the improvements in transportation and farming methods that vastly increased both usable crop land and the amount of food that could be produced on a given piece of land. And here is where we come to the critical investment issue. Parallel to the world's increasing demand for raw materials is technology's increasing ability to innovate and meet that demand. Over the past 20 years, for example, the annualized rate of return from West Texas Intermediate crude oil (WTI Crude Future Contract) was 8.83%, while the annualized total return from the equity of the oil services company Schlumberger was 11.93%, according to Bloomberg. An investor who correctly anticipated the continuing supply constraints of oil would have profited either way. But, the investment returns from finding a successful innovator in accessing oil turned out better than the returns from the commodity itself.
Malthus thought that food shortages would lead to population decline. That is, demand would prove — in an unpleasant way — self-limiting because there would be fewer surviving mouths to feed. Statistics on world population growth and on obesity belie Malthus' demand-side expectations. Supply-side advances have, so far, kept us eating. Increasing demand for more and higher quality food, as millions around the world emerge from the poverty of subsistence agriculture has, however, kindled what appears to be sustainably higher demand for commodities — both for food and for resources like energy needed to produce food. Growing global demand, coupled with an unusual onslaught of droughts, floods and earthquakes, has driven the price of agricultural commodities, such as wheat, corn and soybeans, up by 25% to 60% over the past year.
As with supply, high prices are part of the solution to demand, as innovators figure out how to produce more and consumers shift what they buy. In developed countries, we may drive less, switch to more energy efficient cars, or settle for chicken at home, rather than steak in a restaurant. Does $2.00 a bushel for cotton mean we have to reacquire a taste for polyester? In emerging economies, the transition from subsistence agriculture to a market-based economy does provide such easy decisions, and for both political and humanitarian reasons, we cannot expect the process to reverse. For investors, owning an interest in agricultural commodities may be a way to benefit from this growing demand. But as with supply constraints, investors are more likely to profit from finding the enterprises that innovate to meet this growing demand.
Much of the above discusses commodity investing from the perspective of profiting from relative price changes, or purchasing commodities when they appreciate faster than the prices of what we consume or invest in, and then selling them when they don't appreciate. However, in my opinion, commodities can also help preserve wealth and purchasing power when the economy faces significant shocks.
During inflationary periods, such as the 1970s, commodities can help to protect investors, as the price of everything — except stocks and bonds — rockets upward. I don't consider inflation to be a clear and present danger for the United States. However, the risk of an inflationary surprise justifies a more or less permanent, broad-based commodity allocation. I don't expect a house fire either, but I keep my homeowner's insurance current.
A similar investment logic uses hard assets to cushion investors' wealth from events outside the usual range of economic developments. As a decade of market and geopolitical shocks has shaken investors' confidence in financial assets, currencies and even real estate, the appeal of owning commodities has risen. In my opinion this shock absorption function is the strongest argument for adding commodities to a traditional investment portfolio.
The recent behavior of oil markets is a case in point.
Political events in North Africa and the Middle East may reshape governments across the region, but markets have exaggerated their impact on the economics of oil. Libya, where supply disruptions currently have the greatest supply impact, produced 1.8 million barrels of crude on an average day in 2010 — about half the amount Saudi Arabia can produce in its daily production. Interruption of Libyan supply matters but, from a pure supply perspective, not enough to cause the price of crude purchased for delivery one month hence to rise more than 20%. The difference is risk, a premium investors will pay, not because there's less supply, but because the range of future supplies has become significantly less clear.
Gold's appreciation, more than doubling over the past five years, provides another example of commodities' response to increasing risk. I prefer to think of gold more as a currency than as a commodity. Currencies store the value that we create by working or investing. We accept dollars as pay for our labor because we can eventually exchange those dollars for goods and services. A riskier (or more uncertain) world, however, raises doubts about how much our dollars will one day actually buy. With that worry in mind, I might exchange some of my dollars for another sovereign currency. But if I'm also concerned about the backing for euro, yen or real, I might use the alchemy of commodity markets to turn the dross of paper currency into gold, which no government can debase by printing.
A Place for Commodities
We invest to maintain or enhance our future purchasing power, and commodities can play a role in achieving that purpose. But as with all investments, we must remain cautious about using today's headlines for investment advice. Investors may profit from owning commodities if their superior insight tells them that over a given investment horizon certain commodities will appreciate faster than new supplies, or attractive substitutes can come to market.
The problem with commodities, however, is that they are financially inert. A bushel of corn doesn't pay interest and can't readily be managed to enhance its earnings. The very term commodity indicates something undifferentiated. What commodities can do is maintain their market value when supply or demand shocks threaten to make them scarcer, or when inflation makes everything more costly. This property of commodities can mean that they perform best as investments when other holdings — stocks, bonds or real estate — slump. Thus their role as fire insurance: own them in case of trouble, but don't complain if they prove unnecessary.
Innovation and shifting of demand limit the long term appreciation potential of raw materials. We own commodities to cushion unanticipated, ill-timed events, the risk that the future for which we invested becomes tomorrow and tomorrow is the day a commodity price shock occurs.
Commodities as the foundation of an investment portfolio? I'm skeptical. Commodities as an insurance policy? A portfolio component worth considering.
Dr. Jerry Webman is the chief economist
at OppenheimerFunds, Inc. in New York.
He can be reached at this address.
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