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The Quest for Value in Commodity Trading

March 20th, 2009 · No Comments

I have to believe that the mighty bear of 08 is coming to an end for commodities, at least some commodities anyway. Commodity trading for the past 8 years has offered pretty easy sailing. You could have picked a commodity out of a hat and probably found yourself a heck of a winner. But moving forward investing in commodities may be a little more difficult. Let’s take a look at a few of the external factors weighing on all markets:

 

-Lingering recession
-Massive government bailouts and money creation
-Fearful investors
-Tight finances and access to credit for institutions and investors alike
-Demand for stocks and commodities has dropped precipitously

Let’s look at a few of the positive elements:

-Energy costs have been cut drastically
-Commodities in general are cheap
-The dollar has had a nice 8 months, giving dollar holders some extra purchasing power in the short term
-If we haven’t reached the market bottom, we’re damn close
-The global growth story should receive another boost when inefficiencies and slack are flushed out and cheap commodities offer low input costs (at least in Asia)

An article on oil the other day (sorry, forgot the source) discussed the global build up of oil reserves as a result of the sharp decline in demand. This is something that could weigh on oil prices for some time to come, as the last time we saw a sharp increase in oil prices, the Iran oil crisis, US oil consumption fell sharply and took 20 years to reach levels it had been in the early 70’s, due not only to changes in driving habits, but also to more energy efficient cars. Oil will have its day again, but my guess is we have some time before we need to rush back in.

This development in oil I believe will be consistent for most industrial materials and perhaps some agricultural commodities for the near term. But there are many commodities where demand is less discretionary; certain agricultural and soft commodities, and investment metals like gold and silver. What sets these apart from the rest when the world seems to be coming to an end? Let’s review a few lessons from the 1970s, the last time the US had a long drawn out recession which held a pillow over stocks and pushed commodities to new all time highs throughout the decade.

When recessionary pressures took hold in the 70’s, our government responded the same way it is today, by printing money, tightening lending standards, and raising business standards and trade regulations. All of these things, while perhaps a step closer toward ethical business practices certainly don’t benefit businesses and economic growth as a whole in the short term. And the government, to win friends and punish poor business practices makes a whole bunch of new money for itself from nothing to make new things with. It produces jobs and public works projects and lends to large businesses that don’t like to exercise fiscal restraint. And this story always plays out the same way.

Recession strikes fear in the hearts of men…and women. Fear stimulates government spending to appease the masses. Government spending requires money creation, because a recession is an economic contraction where less money is produced through value creation. This new money flows in in tremendous quantities, creating more supply for dollars than exists demand, and consequently depreciating the value of all dollars in existence. This is inflation, and inevitably results in higher interest rates and the dollar cost of ‘real things’ rising considerably.

What kinds of real things turned out to be the best investments throughout the 1970’s? Commodities, most notably gold, silver, oil, real estate, and alternative energies. So in the midst of our little recession here, we are seeing a very interesting pattern surface. Gold and silver, while everything else has gone to shit, are up approximately 50% in the last 6 months. Real estate is dirt cheap, as are construction costs, while home builders are going out of business like building houses is going out of style. What does this mean? It means that should demand return, supply will take a long time to respond to the market. And from these prices, all those who own their homes will be sitting pretty when inflation pushes their home values higher over the coming years.

In addition to these three options, commodities, real estate, and alternative energies, all of which will prove again to be winners throughout the next 5 to 10 years, people need to eat. And at the rate the world is growing, and the rate at which China and India continue to grow, food is going to continue to be a hot commodity. So keep an eye on wheat, corn, cattle and hogs over the intermediate to long term. And in the short term, I believe we’ll see some impressive action from gold, silver and the soft commodities, most notably coffee, sugar, and cotton. The commodities bull is getting ready for its second leg up, and commodity trading is about to get very interesting.

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