Part V: Going Down to the Farm: Trading Agricultural Products
Chapter 2: Earn, Baby, Earn! Why You
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Never invest in something you don’t understand. If you hear someone on TV or the radio mention an investment, make sure you perform your due dili- gence to get the ins and outs of the potential investment. (I talk about due diligence in Chapter 3.) Not understanding an investment before you invest in it is one of the easiest ways to lose money.
In this chapter, I go through the reasons why commodities have been doing so well so that you have an investment framework to follow in your own port- folio. I also argue that the recent run-up in commodities is only the tip of the iceberg — most of the gains still to come!
The 21st Century Is the Century of Commodities
Since the fall of 2001, commodities have been running faster than the bulls of Pamplona. The Reuters/Jefferies CRB Index(a benchmark for commodities) nearly doubled between 2001 and 2006. During this period oil, gold, copper, and silver all hit all-time highs (although not adjusted for inflation). Other commodities also reached levels never seen before in trading sessions.
1000000 1800000
2005 Volume 1266228.00 Open Interest 331122.00
2004 2003 2002 2001 2000 1999 1998
300 350 400 450 500 550 600 650
Figure 2-3:
The price of Gold (COMEX) doubling between 1997 and 2006 (Dollars per Troy Ounce).
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Many investors wondered, what is going on? How come commodities are doing so well when other investments, such as stocks and bonds, aren’t per- forming? I believe that what you and I are witnessing is a long-term cyclical bull market in commodities. Because of a number of fundamental factors (which I go through in the following sections), commodities are poised for a rally that will last well into the 21st century — and possibly beyond that. It’s a bold statement, I know. But the facts are there to support me.
Although I’m bullish on commodities for the long term, I have to warn you that there are going to be times when commodities don’t perform well at all. This is simply the nature of the commodity cycle. Furthermore in the history of Wall Street, no asset has ever gone up in a straight line. There are always minor (and, occasionally, major) pullbacks before the asset makes new highs — if in fact it does make new highs.
A case in point is that during the first few months of 2006, commodities out- performed every asset class, with some commodities breaking record levels.
Gold hit a 25-year high and so did copper. Then during the week of May 15, commodities saw a big drop. The Reuters/Jefferies CRB Index fell over 5 per- cent that week, with gold and copper dropping 10 and 7 percent, respectively.
Many commentators went on the offensive and started bashing commodities.
“We are now seeing the beginning of the end of the rally in commodities,”
said one analyst. “Is this the end of commodities?” ran a newspaper headline.
An endless number of commentators hit the airwaves claiming that this is a speculative bubble about to burst. A respected economist even compared what was happening to commodities to the dot com bubble: “There is no fun- damental reason why commodity prices are going up.” Nothing could be fur- ther from the facts. A couple of weeks after this minor pullback, some of these commodities that were being compared to highly leveraged tech stocks had regained most, if not all, of their lost ground.
There’s a story behind the rise in commodities — and it’s a pretty compelling one.
Ka-boom! Capitalizing on the global population explosion
The 21st century is going to experience the largest population growth in the his- tory of humankind. The United Nations estimates that the world will add a little fewer than 1 billion people during eachof the first five decades of the 21st cen- tury. This means that the global population will grow to about 9 billion people by 2050 (as of 2006, there are approximately 6.5 billion people on the planet).
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Also, consider the following statistic: According to the UN, the average number of years it takes to add 1 billion people has shrunk from an average of 130 years in the 19th century to approximately 13 years in the 21st cen- tury! This means the rate at which the human population is increasing has reached exponential levels. Check out Figure 2-4 for the expected population growth in the 21st century.
So how is this relevant to commodities? Put simply, significant population growth translates into greater global demand for commodities. Humans are the most voracious consumers of raw materials on the planet — and the only ones who pay for them. As the number of humans in the world increases, so will the demand for natural resources. After all, people need food to eat, houses to live in, and heat to stay warm during the winter — all this requires raw materials. This large population growth is a key driver for the increasing demand for commodities, which will continue to put upward pressures on commodity prices.
Brick by brick: Profiting from urbanization
Perhaps even more significant than population growth is the fact that it is accompanied by the largest urbanization movement the world has ever seen.
In the early 20th century, according to the UN, less than 15 percent of the world’s population lived in cities; by 2005 that number jumped to 50 percent — and shows no sign of decreasing. As a matter of fact, 60 percent of the world’s population is expected to live in urban areas by the year 2030.
Population (in billions)
9
1950 1970 1980 2010 2030 2050
8 7 6 5 4 3 2 1 0
PEOPLE ON THE PLANET
Figure 2-4:
Population growth in the 20th and 21st centuries.
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The number of large metropolitan areas with 5 million or more people (mega cities) is skyrocketing and will continue to for much of the century. In Figure 2-5, I list the number of cities expected to have 5 million inhabitants by 2015. When you compare that with the growth in the number of cities with 5 million people from 1950 to 2000, you quickly realize how staggering this growth really is.
Urbanization is highly significant for commodities because people who live in urban centers consume a lot more natural resources than those who live in rural areas. In addition, more natural resources are required to expand the size of cities as more people move to them (rural to urban migration) and are having more kids (indigenous urban population growth). More natural resources are required for the roads, cars, and personal appliances that are staples of city life.
Industrial metals such as copper, steel, and aluminum are going to be in high demand to construct apartment buildings, schools, hospitals, cars, and so on. Investing in industrial metals is therefore one possible way to play the urbanization card. Make sure to read Chapter 16 for more information on these metals.
As you can see from the map in Figure 2-5, the largest urbanization is taking place in the developing world, particularly in Asia. As more Asians move from the countryside to large urban areas, expect to see huge demand from that part of the world for raw materials to fuel this growth.
Size of Urban Population 5 million and over since 1950 5 million and over since 2000
5 million and over since 2015 (projected) Figure 2-5:
The number of cities with 5 million inhabitants in 1950, 2000, and 2015 (projected).
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One way to profit from Asian urbanization is to invest in indigenous Asian companies and countries that process natural resources. I present this investment strategy in Chapter 5.
Full steam ahead! Benefiting from industrialization
The first industrial revolution, which took place in the 19th century, was a major transformational event primarily confined to Western Europe and North America. Major industrialization did not spread to other corners of the globe until parts of the 20th century, and even then only sporadically.
A new wave of industrialization is taking place in the 21st century and it may be the most important one in history. This wave is transforming a large number of developing countries into more industrialized countries, and this transformation is fueled by raw materials.
The BRIC countries
Although a number of developing countries are on the fast track to industrializa- tion, four countries in particular need to be singled out as the frontrunners in this movement — Brazil, Russia, India, and China (known as the BRIC countries).
The BRIC countries, which are now on a path towards full industrialization, are scouring the globe to secure supplies of key natural resources such as oil, natural gas, copper, and aluminum — the raw materials necessary for a coun- try to industrialize. (See the sidebar “It’s déjà vu all over again: The great game 21st century style.”)
As demand from the BRIC countries for natural resources increases, expect to see increasing upward price pressures on commodities.
China
Although all four of the BRIC countries are rapidly transforming themselves, no other country is doing so as rapidly and dramatically as China. Actually, it is only very fitting that the saying “May you live in interesting times” is said to be an old Chinese proverb. The 21st century is undoubtedly going to be an interesting century, and China is going to play an increasingly important role in global economic affairs.
China’s GDP has increased by 9 percent each year from 2000 to 2006. To sus- tain this growth, China has been consuming all sorts of commodities. Some of the highs that commodities such as oil, natural gas, cement, copper, and alu- minum have experienced between 2003 and 2006 are a direct result of increased demand from China.
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For example, in 2004 China gobbled up half the cement, one-third of the steel, one-quarter of the copper, and one-fifth of the aluminum produced in the world. In 2003, China overtook Japan to become the second largest consumer of crude oil — right behind the United States. (For more information on global oil consumption, make sure you read Chapter 11.) In Figure 2-6 you can see the expected Chinese consumption of crude oil for the first quarter of the century.
China is going to have a tremendous impact on the global economy in the 21st century and is expected to be the largest consumer of commodities in the world. For more information on China’s emergence as a global economic power and the transformation of the economic playing field that this entails, I recommend the following titles:
The World Is Flatby Thomas Friedman
Three Billion New Capitalistsby Clyde Prestowitz The Silk Road to Richesby Yiannis Mostrous The End of Poverty by Jeffrey Sachs
China, Inc.by Ted Fishman
The Next Global Stageby Kenichi Ohmae 2001
Barrels per Day in Millions
CONSUMPTION 0
5 10 15 20
2010 2015 2020 2025
PRODUCTION Figure 2-6:
China is expected to increase its consump- tion of crude oil products to approx- imately 12 Million
Barrels a day by 2025.
Source:
Energy Information Administr- ation.
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It’s All about Me! Why Commodities Are Unique
As an asset class, commodities have unique characteristics that separate them from other asset classes and make them attractive, whether as indepen- dent investments or as part of a broader based investment strategy. I go through these unique characteristics in the following sections.
Inelasticity
In economics, elasticityseeks to determine the effects of price on supply and demand. The calculation can get pretty technical but, essentially, elasticity quantifies how much supply and demand will change for every incremental change in price.
Goods that are elastic tend to have a high correlation between price and demand, which is usually inversely proportional: When prices of a good increase, demand tends to decrease. This makes sense because you’re not going to pay for a good that you don’t need if it becomes too expensive.
Capturing and determining that spread is what elasticity is all about.
Inelastic goods,however, are goods that are so essential to consumers that changes in price tend to have a limited effect on supply and demand. Most commodities fall in the inelastic goods category because they are essential to human existence. There is no way around this.
For instance if the price of ice cream were to increase by 25 percent, chances are you’re going to stop buying ice cream. Why? Because it’s not a necessity, but more of a luxury. However, when the price of unleaded gasoline at the pump increases by 25 percent (as it has actually done during 2003–2006), you’re definitely not happy about the price increase, but you still go out there and fill up your tank. The reason? Gas is a necessity — you need to fill up your car in order to go to work, school, run errands, and so on.
The demand for gasoline isn’t absolutely inelastic, however — you won’t keep paying for it regardless of the price. A point will come when you decide that it’s simply not worth it to keep paying the amount you’re paying at the pump; and so you begin looking for alternatives. (Please read Chapter 13 for more information on alternative energy sources.) But the truth remains that you’re willing to pay more for gasoline than for other products you don’t need (such as ice cream); that’s the key to understanding price inelasticity.
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Most commodities are fairly inelastic because they are the raw materials that allow us to live the lives we strive for; they allow us to maintain a decent (and, in some cases, extravagant!) standard of living. Without these precious raw materials, you wouldn’t be able to heat your home in the winter; actually, without cement, copper, and other basic materials, you wouldn’t even have a house to begin with! And then of course, there’s the most essential commod- ity of all: food. Without food we would not exist.
Because of the absolute necessity of commodities, you can be sure that as long as there are humans around, there is going to be a demand for these raw materials.
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Chapter 2: Earn, Baby, Earn! Why You Should Invest in Commodities
It’s déjà vu all over again: The great game 21st century style
During parts of the 19th and 20th centuries, the global powers of the time were embroiled in a strategic geopolitical contest over control of the world’s precious natural resources, commonly referred to as “the great game.” The 21st cen- tury is experiencing a new great game, where the stakes are higher and the competition fiercer. The world’s industrialized and rapidly industrializing countries are prowling the invest- ment landscape in search of secure energy and raw material sources.
China, in particular, is becoming one of the most aggressive players on the world stage when it comes to securing energy sources. As natural resources such as oil become more scarce, expect more countries and companies to act more aggressively to secure whatever supplies are left. Because demand for raw materials is fairly inelastic (please see the “Inelasticity”
section) and supply is limited, there is double upward pressure from both the demand and
supply sides of the equation. (Yet another reason to be bullish on commodities.)
For now, the pie is large enough that most of the global players are able to participate and get something out of this contest. To profit as an investor, keep your eye out for new companies that are making deals overseas to secure raw materials. The companies that are able to do so efficiently and aggressively will generally tend to produce higher revenues and cash flows — key ingredients to the success of any company.
You should keep a particular close eye on com- panies from emerging China, India, South Korea, and Russia as well as the traditional players from the United States, Great Britain, Australia, Europe, and Japan, which have the technological and capital resources to close in on some big deals. (For more on how to identify and evaluate these kinds of companies, flip on over to Chapter 14.)
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Is it safe in here? Commodities as a safe haven
During times of turmoil, commodities tend to act as safe havens for investors.
Certain commodities, such as gold and silver, are viewed by investors as reli- able stores of value. And so investors flock to these assets when times aren’t good. When currencies slide, when nations go to war, when global pandemics break out, you can rely on gold, silver, and other commodities to provide you with financial safety.
For example, after the horrible acts of September 11, 2001, the price of gold jumped as investors sought safety in the metal. You can see a clear spike in the price of gold in Figure 2-7 right after September 11.
It’s a good idea to have part of your portfolio in gold and other precious metals so that you can protect your assets during times of turmoil. Please turn to Chapter 15 for more on investing in precious metals.
Hedge-hogging galore! Commodities as a hedge against inflation
One of the biggest things you need to watch out for as an investor is the rav- aging effects of inflation. Inflation can devastate your investments, particu- larly paper assets such as stocks. (I discuss inflation and other risks in
300
01–Sep
$U.S. per ounce 03–Sep 05–Sep 07–Sep 09–Sep 11–Sep 13–Sep 15–Sep 17–Sep 19–Sep 21–Sep 23–Sep 25–Sep 27–Sep 29–Sep 30–Sep
295
AM PM
290 285 280 275 270 265
Increased demand for gold on Sept. 11Increased demand for gold on Sept. 11 Figure 2-7:
Investors turn to gold for safety during and right after the tragic events of September 11, 2001 (Prices as measured by the London Gold Fix).
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Chapter 3.) The central bankers of the world — smart people all — spend their entire careers trying to tame inflation, but despite their efforts, inflation can easily get out of hand. This is why you need to protect yourself against this economic enemy.
Ironically, one of the only asset classes that actually benefitsfrom inflation is, you guessed it, commodities. Perhaps the biggest irony of all is that increases in the prices of basic goods (commodities such as oil and gas) actually con- tribute to the increase of inflation.
As you can see in Figure 2-8, for example, there’s a positive correlation between gold and the inflation rate. During times of high inflation, investors load up on gold because it is considered a good store of value.
One way to not only protect yourself from inflation, but also to actually profit from it, is to invest in gold. I discuss the inflation hedging opportunities that gold provides in Chapter 15.
$2,000
$1,800
$1,600
$1,400
$1,200
$1,000
Inflation picking up steam lately Gold and inflation are in lockstep
Gold price
$800
$600
$400
$200
$0
Jan–70 Jan–73 Jan–76 Jan–79 Jan–82 Jan–85 Jan–88 Jan–91 Jan–94 Jan–97 Jan–00 Jan–03
Inflation
Figure 2-8:
The relationship between gold and inflation.
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