The Little Book of Commodity Investing

John Stephenson, John Stephenson

• Publisher: Wiley
• Year: 2010
• Print ISBN: 9780470678374
• eBook ISBN: 9780470679340
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

The world has changed and so too has investing. The market is shell shocked and yesterday's momentum stocks are today's slow-motion stocks. But in the new reality of low-growth investing, commodities are hot and getting hotter. A rapidly industrializing and urbanizing Asia will be demanding lots more copper, zinc, iron ore, coal, fertilizers, gold and oil to transform their societies. Commodities are it and that's great news for investors who want to profit from the next great bull market in commodities. In fact, commodities may be about the only asset class that is likely to outperform the broad market in the future.

Although they are without a doubt important to the global economy, commodities are among the most misunderstood of all asset classes. Stocks, bonds and real estate all have legions of followers and plenty of experts agree on their importance within an investment portfolio, but venture into the world of commodities and you are into an area that's intimidating to the average investor, where suspicions run deep and understanding is limited. As a result, commodities get short-shrift in most investment accounts and investors miss out on some important opportunities.

The Little Book of Commodity Investing is an indispensible guide to learning the ins and outs of commodity investing. It's about identifying opportunities to profit from the coming bull market in commodities. It explains the benefits of commodities as part of a well diversified investment portfolio; covers all of the major commodities markets; what makes commodities and the companies that produce them tick; why commodities sometimes zig and then zag; what to buy and when to buy it; and why commodities are the next big thing.

Today's world is a very different world-a world where an understanding of commodities is a prerequisite for investment success. And The Little Book of Commodity Investing is the roadmap you need to discover where the opportunities of the future lie, and what to do about it.

Chapter One

Calling on Commodities

Why Commodity Investing Is a Savvy Bet

A MASSIVE BULL MARKET IN COMMODITIES is about to wash up on our shores, powered not by the stagnating West, but by a surging Asia. The big money of the next decade won’t be made in bonds or real estate, and certainly not in the so-called U.S. blue chip stocks—it will be made in commodities. Savvy investors know that following global growth where it’s going—as opposed to where it’s been—is the winning bet. And as economic influence continues to shift toward the East, the smart money is investing in the basic raw materials that support economic growth—commodities.

A rapid reordering of the global economic pecking order is underway. In 1987, one-third of the world’s economic output came from developing economies and two-thirds came from developed economies. By the end of 2009, their contributions were evenly split. By 2020, two-thirds of the world’s economic activity will come from developing economies, while the so-called rich economies will be responsible for just one-third. The pace of economic change we are witnessing is both unparalleled and unprecedented.

By 2020, two-thirds of the world’s economic activity will be coming from developing economies, while the so-called rich economies will be responsible for just one-third.

Commodities are real things that we rely on every day. From the time we get up to the time we go to bed, we are surrounded by commodities. The coffee we drink and the sugar we sweeten it with are commodities, so too are the steel that holds our cars together, the oil that makes them run, and the natural gas that heats our homes.

Nothing about commodities is bush-league; in 2009, the production value of seven of the most important commodities was north of $3.6 trillion. The value of the commodities traded on the world’s futures exchanges dwarfs the dollar volume of transactions on U.S. stock exchanges. Commodities and the exchanges that set prices and marry up buyers and sellers of these crucial raw materials are so important to our way of life that the world as we know it just wouldn’t be possible without them.

The value of commodities traded on the world’s futures exchanges dwarfs the dollar volume of transactions on U.S. stock exchanges.

Plenty of experts will espouse the merits of stocks, the benefits of bonds, and the advantages of real estate. But when it comes to commodities, there isn’t much of a fan club, despite compelling evidence that when stocks and bonds are going down, commodities are usually going up. When inflation is heading higher and bonds and stocks are heading lower, commodity prices will be on fire. Commodities have been proven to boost returns and chop risk in an investment portfolio, but even sophisticated investors give them short shrift. For most investors, commodities just don’t figure.

Trading Places

Commodities trade on commodity exchanges, where they are bought and sold for future delivery. The first commodity futures trading can be traced back to 17^th century Japan, where farmers sold rice to local merchants who stored it year-round. Not content to just sit on their inventory of rice, the merchants raised cash to pay for their costs by selling “rice tickets,” which were receipts against the stored rice. Over time, the rice tickets became accepted as a form of currency and rules were established to manage their trade.

Almost 200 years later, in 1848, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT), a member-owned organization that offered a centralized place for trading a wide range of goods. With its convenient location between Midwestern producers and the east coast market, Chicago was a natural hub for cash trading in commodities.

As time went on, buyers and sellers negotiated directly with one another to sell crops at an agreed upon price not only on that day, but also on a future date. These negotiated transactions, known as “forward contracts,” are still a fixture in the world of commodities. As trading in forward contracts increased, the CBOT decided that most details could be standardized to streamline the delivery and trading of the contracts. Under this new system, price and delivery date would be the only variables.

The standardized contracts the CBOT ushered in were America’s first futures contracts. All bids, offers, and transactions were published by the exchange, which increased the transparency and popularity of these marketplaces. With standardized contracts, it was easy to trade commodities. Investors who wanted to profit from a drought in the Midwest could easily use the exchange to buy futures contracts for wheat, and if their views changed, they could sell their contracts just as easily. Standardization was a boon to trading.

Commodity futures are standardized contracts that trade on commodity exchanges; price and quantity are the only variables.

Other futures exchanges quickly sprang up. The Chicago Butter and Egg Board, founded in 1898, later became known as the Chicago Mercantile Exchange. Kansas City, St. Louis, Memphis, and San Francisco all got into the act by forming their own commodity exchanges; yet today, Chicago still reigns supreme as the epicenter of U.S. futures trading. Globally, there are major commodity exchanges in more than 20 countries.

Yeah, But . . .

Commodities get a bad rap. In spite of their importance to the global economy, they are among the most misunderstood of all asset classes. Bonds, stocks, and real estate all have plenty of followers and universal agreement amongst experts regarding their importance within a well-diversified portfolio. But venture into the world of commodities, and you’re into a fringe area of investing where understanding is limited and suspicions run deep.

In the 1983 movie Trading Places, Eddie Murphy and Dan Aykroyd team up to turn the tables on their former employers, Mortimer and Randolph Duke, by placing a winning bet on commodities. In a single trading session, Louis Winthorpe III (Aykroyd) and Billy Ray Valentine (Murphy) become fabulously wealthy while destroying the Dukes financially. To skeptics, reversals of fortune like that are all too common in the world of commodity investing, where volatility and complexity are the order of the day.

But peek behind the curtain, and most of the criticisms of commodities just don’t hold water. While commodities are more volatile than bonds, their volatility is about the same as that of stocks. Commodities have no funky accounting, scandalous behavior by management, or incomprehensible off-balance-sheet items that can skewer your finances overnight. The problem with commodities—if there is one—is the amount of leverage investors can employ.

Leverage is a double-edged sword. It can boost your returns when prices are heading higher and tank your investments when prices are sinking. “Leverage,” using other people’s money, is quite common. For example, when you buy a house and take out a mortgage, you’re using leverage. Both stocks and commodities can be bought on margin, but by law a stock buyer needs to pony up at least 50 percent of the purchase price. In commodity investing, margin requirements are skinnier—sometimes as little as 5 percent.

Suppose you decide to buy crude oil contracts when oil is trading at $50 per barrel because you think it’s moving higher. You open a futures trading account, slap down the minimum margin of $5,000 per contract and—presto—you’re instantly controlling $50,000 worth of crude oil ($50 per barrel times 1,000 barrels per futures contract). If oil moves from $50 per barrel to $55 per barrel, your position is worth $55,000 ($55 per barrel times 1,000 barrels) and you’ve doubled your money and are no doubt feeling pretty smart. But if oil goes from $50 to $45 per barrel, you’ve lost your whole investment. Still feeling so smart? I don’t think so.

Wait a Minute

The Yale International Center for Finance, in their working paper Facts and Fantasies About Commodity Futures,¹ concluded that an unlevered basket of commodity futures gave as much bang for the buck as stocks. Not only did futures offer similar returns to stocks, but they tended to perform well when stocks and bonds were doing poorly. By adding futures to a well-diversified portfolio, the researchers found you could chop risk while boosting returns—a nifty trick. Because the value of commodities is tied to tangible assets, they performed well in inflationary periods, or times when prices were rising. Including commodities in your portfolio can not only help diversify it, but may also help you preserve wealth when inflation is gobbling away at the value of your stocks and bonds.

Including commodities in your portfolio can not only help you diversify it, but also help preserve wealth when inflation is gobbling away at the value of your stocks and bonds.

In a separate study on commodity returns, Ibbotson Associates² found that adding commodities to an investment portfolio helped to reduce risk and increase diversification by generating superior returns when they were needed most. The researchers concluded that all portfolios could be improved by the addition of a healthy dollop of commodities.

Ricochet

Shell-shocked investors watched in horror as the commodity markets tumbled with the collapse of Lehman Brothers in September 2008. Executives at commodity-producing companies nearly went into cardiac arrest as their share prices cratered, forcing them to slash expenses just to keep their companies afloat—mines were closed, oil fields were capped, and steel mills slammed shut.

However, as the global economy picks itself up off the mat, the demand for commodities—the stuff that economic recoveries are made of—will soar. Commodity production is a time- and capital-intensive undertaking requiring extensive engineering, environmental, and permitting procedures before work can begin. Lead times for obtaining most major pieces of equipment are measured in years, not months. In addition, a severe shortage of well-qualified people and investment capital means new sources of commodity supply will be a long time in coming. Sluggish supply and voracious demand have set the stage for our next bull market—one that won’t be in North American real estate or blue chip stocks, but in commodities.

Sluggish supply and voracious demand have set the stage for our next bull market—one that won’t be in North American real estate or blue chip stocks, but in commodities.

A Bulging Middle

An exploding global middle class, fueled by global trade, is supplying the liquid hydrogen to the commodity rocket. Over the last 30 years, hundreds of millions of people have been lifted out of extreme poverty and transformed into global consumers. According to a recent World Bank report, between 1990 and 2002 some 1.2 billion people joined the ranks of the developing world’s middle class. These people are not rich by Western standards, but are rich enough to leave a subsistence-level life behind and begin to spend. More remarkable, the report noted that four-fifths of this emerging middle class were from Asia and half were from China.

Others have predicted that the pace of this middle class expansion will accelerate, likely reaching its zenith around 2018. Goldman Sachs estimates that by 2030 a further two billion people could join the global middle ...

Table of contents

• Little Book Big Profits Series
• Title Page
• Copyright Page
• Foreword
• Introduction
• Chapter One - Calling on Commodities
• Chapter Two - Gettin’ Goin’
• Chapter Three - Gusher
• Chapter Four - Drilling for Dollars
• Chapter Five - Going for Gold
• Chapter Six - Digging It
• Chapter Seven - Betting the Farm
• Chapter Eight - Ordering the Breakfast Special
• Chapter Nine - Gaining in Grains
• Chapter Ten - Bulk Up
• Chapter Eleven - Capitalizing on Commodities