Commodities are a good play in three circumstances:
- during inflation,
- when they are in short supply, and
- during credit bubbles
Commodities are a terrible play in two circumstances:
- during disinflation, the period after inflation is killed (eg. 1982-2002)
- during deflation, the period after a credit bubble (now!)
The troubles for investors happen when they mistake which one of the circumstances they are in.
The most common mistake is confusing the price signals from inflation or credit bubbles for shortages. Commodities were a fine investment during the Great Inflation of 1965-1982, but people mistook the rising prices from inflation for a more fundamental growing shortage. This is not that surprising, because commodities had also been rising (albeit at a slower pace) from 1949 to 1965, from rising demand due to increased post-war production. What is surprising is how whacko the mistakes were.
Rising inflation drove up commodities, particularly oil, and caused a loud set of pundits to claim the end of the world was coming. Literally. Read these pearls of wisdom from Earth Day 1970:
“Civilization will end within 15 or 30 years unless immediate action is taken against problems facing mankind.”
• George Wald, Harvard Biologist
• Barry Commoner, Washington University biologist
“By…[1975] some experts feel that food shortages will have
escalated the present level of world hunger and starvation into famines
of unbelievable proportions. Other experts, more optimistic, think the
ultimate food-population collision will not occur until the decade of
the 1980s.”
• Paul Ehrlich, Stanford University biologist
“It is already too late to avoid mass starvation.”
• Denis Hayes, chief organizer for Earth Day
“The world has been chilling sharply for about twenty years.
If present trends continue, the world will be about four degrees colder
for the global mean temperature in 1990, but eleven degrees colder in
the year 2000. This is about twice what it would take to put us into an
ice age.”
• Kenneth Watt, Ecologist
A group called the Club of Rome formed in 1974 and put out a series of dire predictions. Annoyed, a skeptic made a famous bet with the loudest voice of doom, Paul Ehrlich, who predicted that all commodities would rise in price due to shortages by 1990. He lost the bet; the skeptic cleaned his clock. A good contrarian, he is!
So what lessons can be drawn from commodities?
The first lesson for an investor is not to confuse inflation with demand shortages. And don't fall for all these eco-Cassandras and their ludicrous predictions. The eco-lunacy has gone on for 40 years. Investors have to shut the noise out and go to the core of the matter. Following the herd and listening to pied pipers is a sure way to go broke. A prophet of doom like Al Gore has pulled in $100M from his speaking and writing (as well as an Emmy, an Oscar, and a Nobel Prize), but don't follow his investment advice.
The second lesson is not to confuse a credit bubble with growing shortages. In about 2005 it became clear that something odd was going on. All asset classes were rising together. Modern Portfolio Theory was being proven wrong. There was no diversification. This is the signature of a credit bubble! And commodities began to run. Recall how in 2007, corn got so high Mexicans couldn't afford tortillas? Rice got so high that a quarter of the world was in danger of starving? And of course oil ran to $147/bbl.
Most investors got confused. They began to rationalize the price distortions of an historic credit bubble were actually the result of demand shortages. The primary villain was China and its voracious appetite for resources. Curiously, little such rise was seen before bubble, during China's fast rise in the '90s.
All these commodities rose together, and the curve was parabolic. Whenever you see a parabolic curve in an investment, watch out - they always fall sharply, and all the way back to where the curve started going nuts. The curve reflects momentum investors, not fundamentals. Oil fell from $147 all the way to under $31 in six months, and after the current bounce, it is likely to fall farther. The long-term trendline of oil would peg it between $10/bbl, the 1999 price, and $25/bbl, the 2004 price, just before the bubble began in earnest.
The third lesson is not to confuse currency machinations for shortages. A classic example is the oil price rise of the '70s. After Bretton Woods, we were on a hybrid gold standard backed by the Fed. The Fed cheated, first with Operation Twist and later to support political initiatives such as the war in Vietnam and the Great Society, at the same time. Guns & Butter, Later in the '70s, to support full employment. We ended up with neither guns, nor bitter, nor full employment.
The cheating cheapened the Dollar, and it was assaulted for being too high priced at $35/oz. The US raised it to $42. Still the assault continued. In 1971, the US went off the gold standard. The Treasury Secretary at the time, Connolly, is reported to have told President Nixon that the Dollar would strengthen once off gold. What a fool he. The Dollar promptly fell from $42/oz to well over $100/oz - essentially a 4x drop from the prior $35/oz level in a few months. What a disaster. The oil countries, led by our so-called ally, the Shah of Iran, promptly raised the price of oil by 4x. They were simply marking it to market, but a huge furor ensued, and an inordinate fear of the OPEC cartel emerged.
Another currency disaster occurred in the
mid-80s. After Reagan broke inflation, the Dollar rose sharply. Post
gold, it is usually measured in the Dollar Index, against a basket of
other currencies. The Dollar rose to 160 in the index, and the
Treasury Secretary under Reagan II, Baker, panicked. The great
bogeyman in the '80s was Japan, and the Yen was 240 to the Dollar,
meaning it was worth about a farthing (a quarter penny). The Japanese
were selling quality goods at ridiculously low prices! So Baker
coordinated a cheapening of the Dollar, and in 1986 drove it down to 80
in the Dollar Index. The Yen rose from 240 to 120, doubling in one
year. The Japanese found themselves rich overnight! Everything was
worth more! So they promptly came to the US and began buying things
like Pebble Beach and Rockefeller Center. The Crash of 1987 is linked
to this fall in the Dollar, and so is the Japanese Bubble of 1987-89.
The fourth lesson for
commodities is to do your homework. When you get past inflation, and
credit bubbles, and faux demand shortages, what is left is whether we
will face shortages when we come out of the current Great Recession.
Sure, commodities will rise somewhat in the face of demand, but is there
a more fundamental reason for commodities to shoot up? I do not have
an answer, but I know where to look.
As oil ran up in 2008, there was a lot of chatter about Peak Oil. Peak oil is not the end of oil, but the peak in oil production. We have bumped around 85M bbl/day since 2004, and might be at peak. No major new oil field has been opened for over 40 years, and oil fields tend to increase to their peak production over 40 years, then fall off over the next 40 years. Mexico, North Sea, China, and many Middle Eastern fields are dropping. We don't quite know about the Saudi fields. We do know that Iraq has so mismanaged their fields that they have not yet gotten to peak. Nonetheless, all the large fields of cheap oil seem mature, and no new ones have been found. The large new ones are deep offshore, or deep underground, or in the Arctic - all expensive to get to.
We may be at "Peak Everything," and we may be given a momentary respite as demand slackens during the deflationary depression. Rather than being fooled by rising prices, we might be fooled the other way by falling prices. The argument for Peak Everything is that all the easy iron mines, or copper mines, or ocean fish stocks, or fresh water stocks, appear way past their peak. It is not that they are gone, it is that it takes more expense - and more energy - to extract the resources.
Optimists argue that technology will find a way. Yet our industrial age is largely based on cheap energy, and no one has found the replacement. Oil is a magic elixir. It is cheaper than bottled water, and can power your large SUV for miles of driving pleasure. All the other commodities depend on cheap energy. Copper is mined with machines, the ore is crushed and refined with machines; and all of those machines run on oil. And so for farms, fisheries, and about everything else.
Solar? One square meter - about the size of a bridge table - in direct sunlight absorbs about 400 watts from the sun, and the most efficient theoretical conversion gets 100 watts out. To use it at night requires batteries. Perhaps a bridge table can power a 25 watt bulb all day. Now scale that up. A recent Scientific American piece did that. It is very compelling science fiction. It requires 30,000 sq miles of solar cells, new superconducting transmission lines, and new compressed air storage in abandoned mines. Imagine an engineering project to build 30k sq miles of plant - approximately the whole area of California between SF to LA. (LA county itself is only 4,000 sq miles of land.) The largest solar facility in California is around 1 square mile, and two huge new projects gets to 12 sq miles. So we need 30,000 more of today's solar plant. This would be an extraordinarily large building project. And at best it gets us 35% of our energy needs.
Nuclear? If it weren't for the politics, an elegant solution. Where solar is a bridge table in size, an equivalent oil is a salt shaker, and nuclear is the power in a grain of sand (well, uranium actually, but the size of a grain of sand). It would take around 750 nukes to replace the energy of oil. We have 100 today, so that too is a huge project. They run around 20 sq miles in size, smaller than the huge solar farms, and producing more output at a lower cost. Waste is not a problem, since the industry would prefer to hold the waste on site and recycle it.
Suffice to say that if we are at Peak Oil, we may not have a politically acceptable and practical solution to cheap energy. Energy will go up in price, and with it the cost of about everything else. In that world commodities cost more.
This is not a today issue, but should be watched as the Great Recession crests and we start to really recover.
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