In general, there are four main factors that affect commodities prices:
Let's go down the list to best understand their harmony. We'll start in a tiny, isolated town of farmers and families.
Supply and Demand in Commodities
If supply and demand are in perfect balance (assuming no other factors affect the price), commodities prices would go nowhere. Take corn for example. If the demand for corn was exactly one ear each day, and a farmer could grow exactly one ear every day, supply and demand would be in balance and the price would not change.
With no external factors on this transaction, the farmer of the corn could not raise or lower his price because he must sell one ear each day or he loses money. (The cost of growing the corn.) By raising the price, he would drive the purchaser away to another farmer at a lower price. By lowering the price, he would increase demand for his corn. Still, he wouldn't be able to meet that demand; so, buyers would go back to the other farmers and the price would not change.
We're making huge, unreal assumptions about how the real world works because nothing in economics is devoid of external forces; but, you get the idea. If supply and demand are in balance and there are no external factors, prices can't change.
Inventories and Stocks
Let's assume that supply and demand are not in balance. Instead, there's a draught this year and half the farmers can't grow corn. The demand is still strong β the people have to eat. Supply and production are short β half of what it should be. And because nobody stocked up on corn, creating reserves for this very scenario, prices rise to drive demand down.
Ten years later, another draught hits. This time, however, the town was prepared. Half the farmers can't grow corn; but, those farmers had built silos and stocked them for emergencies. Though production has temporarily shut down, the supply is fine for the amount of demand. Inventories begin to fall; but, nobody is worried because the draught is a temporary problem. Prices don't change.
Of course, if production remains offline for too long, inventories will begin to fall to alarming levels. In that case, prices will rise to quell demand and preserve inventories until production can ramp up again.
Currency
We'll now expand our scenario. Rather than having a single, self-sufficient town, we have three countries β Import (the "Eaters"), Export (the "Producers"), and Investment (the "Investors"). All three countries have different currencies.
Sometimes, Investors believe that Export offers the greatest investment opportunities; so, the people of Investment convert their money into Export currency, driving the value of that currency higher. In Export, the Producers don't really notice, except that they have a little more coin in their pocket. Why? Let's explain.
When the people of Investment keep their currency at home, Import and Export are not affected. With supply, demand, and stocks in perfect balance, prices never change. The exchange rate between the two countries is one Import dollar for one Export dollar.
Enter the Investors, putting their money into the country of Export. When that happens, the currency of Export begins to rise against that of Import (and that of Investment). Without getting too technical, it comes down to supply and demand. As more people want Export currency and less people want the other two, the Export currency rises against the other two (or, the other two fall against that of Export).
Now that corn price has to change, not because supply and demand are out of balance, but because the farmer from Export still wants one Export dollar for an ear of corn but the folks in Import can't convert $1 Import into $1 Export because of the currency fluctuation. Instead, the conversion is now at, say, $1.50 Import to $1.00 Export, and for the people of Import, the price of corn (commodities) just went up 50%.
Ouch.
And Then There's Inflation
Now, let's assume that the world is perfect. Supply and demand are in balance, inventories are perfectly managed, and currencies never fluctuate. But, inflation chugs along at 3% a year. How will that affect the price of commodities?
If you said that they'd go up at 3% a year, give yourself a balloon β you now understand how commodities work. The corn farmer has to raise his prices 3% a year because his cost of living β electricity, fertilizer β is going up by 3% a year. People can pay that increase without feeling it because everything (including their incomes) is going up 3% a year.
This Is All Too Macro For Me
I know β Buffett says that investors should ignore the macro stuff. That's all well and good; but, this is one area in which Buffett's actions don't match up precisely with his words. Buffett doesn't ignore the macro stuff or commodities. In fact, he tends to have very strong opinions on both, and takes actions based on those opinions.
Take, for example, his 1997 purchase of silver. World mine production of sliver was 16,500 metric tons. World consumption was 857 million troy ounces. A quick math conversion (32,500 troy ounces = 1 metric ton) tells you that, in 1997, the world was producing 16,500 metric tons while demand for the metal was 25,163 metric tons. Warehouse stocks were being depleted, down about 40% through 1997.
More recently, look at his comments on ConocoPhillips. He bought assuming that oil would continue to rise. Regardless of what oil actually did, look at Buffett's thinking. A large part of his investment thesis on COP was a macro, commodity prediction. How large? Large enough that it drove him to take action on (sell) COP when the price of oil collapsed.
Buffett may tell people to ignore "the macro stuff" so that they don't overthink their investments because people could get blasted in commodities or overthink minor macro events. Still, you can't invest in a company whose profits are tied to an underlying commodity without some thesis on where that commodity is headed.
Why Base Metals?
The perfect storm for rising commodities prices would be:
All of this leads up to the decision to invest in zinc, copper, and aluminum through an investment in DBB. Walking through all three would be much too long a post; so, we'll look at copper and then you can look at aluminum and zinc, applying the same logic.
And it's important to remember two things
Why Copper?
I'll spare you my long-winded definition. From the CRB Commodity Yearbook:
Copper is one of the most widely used industrial metals because it is an excellent conductor of electricity, has strong corrosion-resistance properties, and is very ductile. It is also used to produce the alloys of brass (a copper-zinc alloy) and bronze (a copper-tin alloy), both of which are far harder and stronger than pure copper. Electrical uses of copper account for about 75% of total copper usage, and building construction is the single largest market (the average US home contains 400 pounds of copper). Copper is biostatic, meaning that bacteria will not grow on its surface, and it is therefore used in air-conditioning systems, food processing surfaces, and doorknobs to prevent the spread of disease.
In short, it's used almost everywhere. Compare that to gold, for example, which is hardly used any more but in some electronics, a few dental fillings, jewelry, and as a filler for underground vaults. Gold demand is nothing like what it was decades ago, when gold backed currencies and it had a much more practical application across the board.
Supply, Demand, and Production
It doesn't take a genius to figure out that production at virtually all levels of the economy has slowed. In metals, this means that mines have been shut down, employees have been laid off to slow the supply line (as demand had dried up), and operations along the line β from smelting to delivery β have been interrupted and scaled back.
This, of course, caused the crash in many commodities prices. While demand was slowing, supply was not slowing as quickly. Ultimately, supply exceeded demand, inventories began to rise, and prices began their freefall. To stop the drop, which would be a self-fulfilling prophecy of further maiming the industry (if prices dropped too much for too long, there would be no industry because there would be no profits β no producer makes money if copper is selling for $0.10), supply was intentionally interrupted and plants, facilities, and mines were taken offline, workers were fired, etc.
It's a lot easier to disrupt production than bring it back online. Think of it this way: You operate a copper mine with, say, 1,000 employees. Every day, they're digging, transporting, etc. Things are going swimmingly.
Along comes a global credit crisis. You can barely finance your receivables because credit has dried up. Demand for your product is waning. So, you take your mine offline to wait it out. On Friday, you fire everyone, shut down the power, and lock the security gates. Mine closed.
(Okay β maybe it takes a little longer than that.)
A year passes, and you decide to get your mine back online. Now you have a dilemma. You can't just flip a switch. It's fairly easy to walk out of a mine; it takes some careful planning, security checks, hiring, paperwork, financing, and more to get the mine back online. To put 1,000 people to work (or back to work) can't usually be accomplished in a matter of days. And the longer you're shut down, the longer it will take to get back online.
Need to see it in action? Take a look at Freeport-McMoRan's December 2008 press release concerning their planned interruption of copper production.
So, condition 1 is partially met β we've had a disruption in production.
Inventories and Demand
Throughout the second half of 2008, production was still in full force (more or less) while demand was falling (due in large part to the real estate crisis). Hoping it was somewhat of a temporary condition, producers didn't scale back operations much. By the end of 2008, it was clear that the slowdown was not a temporary hiccup in the economy; so, steps were taken to cut supply.
During this time, copper inventories were on the rise. It's simple math β if supply is high and demand is low, inventories (stock, warehouses) grow. Nobody's buying the stuff so it has to be stored somewhere.
In January of 2009, daily copper inventory levels (stocks) grew 44%, according to the London Metal Exchange (LME), from 342,000 to 491,000 (metric tons). By February 24, 2009, LME warehouse data showed almost 549,000 metric tons of copper in inventories, up roughly 60% from the beginning of the year.
Let's put this into perspective so that the above chart isn't taken out of context. Inventories were extremely low in the last five years, which helped push the price up as demand increased. At today's levels, inventories are still 25% or so below the average levels of 1999-2003, and are right around the LME levels of late 1993 and early 1994.
By the end of March 2009, the world began to draw down on inventories. Though demand isn't what it was two years ago, it still exists. With production interrupted, copper end-users began drawing down on inventories because the interrupted supply couldn't (can't) meet current demand.
(Of course, demand will change up or down based on how the world economy plays out.)
So, we have conditions 1 and 2: A disruption in production with increasing demand, and diminishing inventories without adequate production to replenish them.
A Falling Currency
Prior to the real estate boom which caused us to import copper as fast as possible, roughly 80% of the copper used in the United States was produced in the United States. In the grand scheme of things, the US is, or can be, somewhat self-sufficient when it comes to copper. In addition, copper prices are quoted in US dollars.
Because of those two factors, a rising or falling US dollar shouldn't have too much of an impact on the price of copper in the US. And that's a good thing, because I don't have a strong opinion on which way the dollar is headed. Some people insist that it's going lower β much lower. But to them, I ask: Against what? Currencies rise and fall against other currencies, and, quite frankly, I don't know where an investor would want to put money right now other than in US dollars in some fashion.
I don't know if we have condition 3 or not, but I don't think it would have a major impact on US investors owning copper in US dollars.
Finally, There's The Inflation Factor
Why will we have inflation? Though nothing is certain, one thing history has shown is that you can not increase your available money supply without some inflation. The more you increase it, the harder inflation hits.
That's why the fed plays so many games with interest rates β to keep inflation in check. When the printing presses are running and inflation rears its head, the fed raises rates to "tighten up" the money supply, making it less attractive to spend wildly and enticing foreign investors to take some of that supply in the form of investment. On the other hand, when the presses are slow, rates can be lowered and money can become "loose" because the money supply isn't increasing all that fast.
Right now, we have the printing presses on overdrive and very low interest rates β a condition that usually results in high inflation. It happened during World War II and again in the 1970s.
This would give us condition 4 for commodities β dramatically rising inflation.
During World War II, the price of copper was frozen at $0.11. No surprise there β we couldn't afford to have price manipulation while the world was engaged in a global war. World War II was very inflationary. So, in 1946, when the price of copper was no longer fixed, it began its climb to a higher, inflation-adjusted rate. Over the next ten years, copper would rise some 400%.
In the mid-1960s, just as inflation was coming back with a vengeance, copper was trading around $0.34. Over the next fifteen years, rising interest rates and rampant inflation caused stocks to do virtually nothing; but, copper prices rose more than 300%.
This wasn't all due to inflation; but, inflation helped fuel the fire.
Why would inflation help commodities? Commodities are "fixed assets" with no interest-bearing or cash flow value. If you recall from Part I of this article, in a world with no external forces on them, commodities prices would grow at the same rate as inflation.
People generally believe that gold is a hedge against inflation. They're partially right. In fact, gold, along with real estate, commodities, and other "hard assets" are all hedges against inflation (if purchased at the right price) because the cost to produce or extract the hard assets rises with inflation; so, the cost to sell them must also rise with inflation.
That's not to say that prices are always rational. In fact, they can get ridiculous, as we saw at the tail end of the commodities bubble of 2007 and 2008. And, that's not to say that commodities at any price are necessarily good hedges against inflation, just as individual stocks at great prices can beat the pants off of commodities, inflation or not.
Like with stocks, you have to pick your spot in commodities.
Continue to Part III of this article.
Joe Ponzio
www.fwallstreet.com
Supply & Demand Inventories & Stocks Currency Inflation
Let's go down the list to best understand their harmony. We'll start in a tiny, isolated town of farmers and families.
Supply and Demand in Commodities
If supply and demand are in perfect balance (assuming no other factors affect the price), commodities prices would go nowhere. Take corn for example. If the demand for corn was exactly one ear each day, and a farmer could grow exactly one ear every day, supply and demand would be in balance and the price would not change.
With no external factors on this transaction, the farmer of the corn could not raise or lower his price because he must sell one ear each day or he loses money. (The cost of growing the corn.) By raising the price, he would drive the purchaser away to another farmer at a lower price. By lowering the price, he would increase demand for his corn. Still, he wouldn't be able to meet that demand; so, buyers would go back to the other farmers and the price would not change.
We're making huge, unreal assumptions about how the real world works because nothing in economics is devoid of external forces; but, you get the idea. If supply and demand are in balance and there are no external factors, prices can't change.
Inventories and Stocks
Let's assume that supply and demand are not in balance. Instead, there's a draught this year and half the farmers can't grow corn. The demand is still strong β the people have to eat. Supply and production are short β half of what it should be. And because nobody stocked up on corn, creating reserves for this very scenario, prices rise to drive demand down.
Ten years later, another draught hits. This time, however, the town was prepared. Half the farmers can't grow corn; but, those farmers had built silos and stocked them for emergencies. Though production has temporarily shut down, the supply is fine for the amount of demand. Inventories begin to fall; but, nobody is worried because the draught is a temporary problem. Prices don't change.
Of course, if production remains offline for too long, inventories will begin to fall to alarming levels. In that case, prices will rise to quell demand and preserve inventories until production can ramp up again.
Currency
We'll now expand our scenario. Rather than having a single, self-sufficient town, we have three countries β Import (the "Eaters"), Export (the "Producers"), and Investment (the "Investors"). All three countries have different currencies.
Sometimes, Investors believe that Export offers the greatest investment opportunities; so, the people of Investment convert their money into Export currency, driving the value of that currency higher. In Export, the Producers don't really notice, except that they have a little more coin in their pocket. Why? Let's explain.
When the people of Investment keep their currency at home, Import and Export are not affected. With supply, demand, and stocks in perfect balance, prices never change. The exchange rate between the two countries is one Import dollar for one Export dollar.
Enter the Investors, putting their money into the country of Export. When that happens, the currency of Export begins to rise against that of Import (and that of Investment). Without getting too technical, it comes down to supply and demand. As more people want Export currency and less people want the other two, the Export currency rises against the other two (or, the other two fall against that of Export).
Now that corn price has to change, not because supply and demand are out of balance, but because the farmer from Export still wants one Export dollar for an ear of corn but the folks in Import can't convert $1 Import into $1 Export because of the currency fluctuation. Instead, the conversion is now at, say, $1.50 Import to $1.00 Export, and for the people of Import, the price of corn (commodities) just went up 50%.
Ouch.
And Then There's Inflation
Now, let's assume that the world is perfect. Supply and demand are in balance, inventories are perfectly managed, and currencies never fluctuate. But, inflation chugs along at 3% a year. How will that affect the price of commodities?
If you said that they'd go up at 3% a year, give yourself a balloon β you now understand how commodities work. The corn farmer has to raise his prices 3% a year because his cost of living β electricity, fertilizer β is going up by 3% a year. People can pay that increase without feeling it because everything (including their incomes) is going up 3% a year.
This Is All Too Macro For Me
I know β Buffett says that investors should ignore the macro stuff. That's all well and good; but, this is one area in which Buffett's actions don't match up precisely with his words. Buffett doesn't ignore the macro stuff or commodities. In fact, he tends to have very strong opinions on both, and takes actions based on those opinions.
Take, for example, his 1997 purchase of silver. World mine production of sliver was 16,500 metric tons. World consumption was 857 million troy ounces. A quick math conversion (32,500 troy ounces = 1 metric ton) tells you that, in 1997, the world was producing 16,500 metric tons while demand for the metal was 25,163 metric tons. Warehouse stocks were being depleted, down about 40% through 1997.
More recently, look at his comments on ConocoPhillips. He bought assuming that oil would continue to rise. Regardless of what oil actually did, look at Buffett's thinking. A large part of his investment thesis on COP was a macro, commodity prediction. How large? Large enough that it drove him to take action on (sell) COP when the price of oil collapsed.
Buffett may tell people to ignore "the macro stuff" so that they don't overthink their investments because people could get blasted in commodities or overthink minor macro events. Still, you can't invest in a company whose profits are tied to an underlying commodity without some thesis on where that commodity is headed.
Why Base Metals?
The perfect storm for rising commodities prices would be:
1. A disruption in production with increasing demand, and
2. Low or diminishing inventories without adequate production to replenish them, and
3. A falling currency, and
4. Rising inflation
All of this leads up to the decision to invest in zinc, copper, and aluminum through an investment in DBB. Walking through all three would be much too long a post; so, we'll look at copper and then you can look at aluminum and zinc, applying the same logic.
And it's important to remember two things
1. I have no idea when the pricing shift will take place (ie., this isn't a short-term swing or momentum trade); and,
2. We have very small positions in each metal (roughly 3.3% of the portfolio in each).
Why Copper?
I'll spare you my long-winded definition. From the CRB Commodity Yearbook:
Copper is one of the most widely used industrial metals because it is an excellent conductor of electricity, has strong corrosion-resistance properties, and is very ductile. It is also used to produce the alloys of brass (a copper-zinc alloy) and bronze (a copper-tin alloy), both of which are far harder and stronger than pure copper. Electrical uses of copper account for about 75% of total copper usage, and building construction is the single largest market (the average US home contains 400 pounds of copper). Copper is biostatic, meaning that bacteria will not grow on its surface, and it is therefore used in air-conditioning systems, food processing surfaces, and doorknobs to prevent the spread of disease.
In short, it's used almost everywhere. Compare that to gold, for example, which is hardly used any more but in some electronics, a few dental fillings, jewelry, and as a filler for underground vaults. Gold demand is nothing like what it was decades ago, when gold backed currencies and it had a much more practical application across the board.
Supply, Demand, and Production
It doesn't take a genius to figure out that production at virtually all levels of the economy has slowed. In metals, this means that mines have been shut down, employees have been laid off to slow the supply line (as demand had dried up), and operations along the line β from smelting to delivery β have been interrupted and scaled back.
This, of course, caused the crash in many commodities prices. While demand was slowing, supply was not slowing as quickly. Ultimately, supply exceeded demand, inventories began to rise, and prices began their freefall. To stop the drop, which would be a self-fulfilling prophecy of further maiming the industry (if prices dropped too much for too long, there would be no industry because there would be no profits β no producer makes money if copper is selling for $0.10), supply was intentionally interrupted and plants, facilities, and mines were taken offline, workers were fired, etc.
It's a lot easier to disrupt production than bring it back online. Think of it this way: You operate a copper mine with, say, 1,000 employees. Every day, they're digging, transporting, etc. Things are going swimmingly.
Along comes a global credit crisis. You can barely finance your receivables because credit has dried up. Demand for your product is waning. So, you take your mine offline to wait it out. On Friday, you fire everyone, shut down the power, and lock the security gates. Mine closed.
(Okay β maybe it takes a little longer than that.)
A year passes, and you decide to get your mine back online. Now you have a dilemma. You can't just flip a switch. It's fairly easy to walk out of a mine; it takes some careful planning, security checks, hiring, paperwork, financing, and more to get the mine back online. To put 1,000 people to work (or back to work) can't usually be accomplished in a matter of days. And the longer you're shut down, the longer it will take to get back online.
Need to see it in action? Take a look at Freeport-McMoRan's December 2008 press release concerning their planned interruption of copper production.
So, condition 1 is partially met β we've had a disruption in production.
Inventories and Demand
Throughout the second half of 2008, production was still in full force (more or less) while demand was falling (due in large part to the real estate crisis). Hoping it was somewhat of a temporary condition, producers didn't scale back operations much. By the end of 2008, it was clear that the slowdown was not a temporary hiccup in the economy; so, steps were taken to cut supply.
During this time, copper inventories were on the rise. It's simple math β if supply is high and demand is low, inventories (stock, warehouses) grow. Nobody's buying the stuff so it has to be stored somewhere.
In January of 2009, daily copper inventory levels (stocks) grew 44%, according to the London Metal Exchange (LME), from 342,000 to 491,000 (metric tons). By February 24, 2009, LME warehouse data showed almost 549,000 metric tons of copper in inventories, up roughly 60% from the beginning of the year.
Let's put this into perspective so that the above chart isn't taken out of context. Inventories were extremely low in the last five years, which helped push the price up as demand increased. At today's levels, inventories are still 25% or so below the average levels of 1999-2003, and are right around the LME levels of late 1993 and early 1994.
By the end of March 2009, the world began to draw down on inventories. Though demand isn't what it was two years ago, it still exists. With production interrupted, copper end-users began drawing down on inventories because the interrupted supply couldn't (can't) meet current demand.
(Of course, demand will change up or down based on how the world economy plays out.)
So, we have conditions 1 and 2: A disruption in production with increasing demand, and diminishing inventories without adequate production to replenish them.
A Falling Currency
Prior to the real estate boom which caused us to import copper as fast as possible, roughly 80% of the copper used in the United States was produced in the United States. In the grand scheme of things, the US is, or can be, somewhat self-sufficient when it comes to copper. In addition, copper prices are quoted in US dollars.
Because of those two factors, a rising or falling US dollar shouldn't have too much of an impact on the price of copper in the US. And that's a good thing, because I don't have a strong opinion on which way the dollar is headed. Some people insist that it's going lower β much lower. But to them, I ask: Against what? Currencies rise and fall against other currencies, and, quite frankly, I don't know where an investor would want to put money right now other than in US dollars in some fashion.
I don't know if we have condition 3 or not, but I don't think it would have a major impact on US investors owning copper in US dollars.
Finally, There's The Inflation Factor
Why will we have inflation? Though nothing is certain, one thing history has shown is that you can not increase your available money supply without some inflation. The more you increase it, the harder inflation hits.
That's why the fed plays so many games with interest rates β to keep inflation in check. When the printing presses are running and inflation rears its head, the fed raises rates to "tighten up" the money supply, making it less attractive to spend wildly and enticing foreign investors to take some of that supply in the form of investment. On the other hand, when the presses are slow, rates can be lowered and money can become "loose" because the money supply isn't increasing all that fast.
Right now, we have the printing presses on overdrive and very low interest rates β a condition that usually results in high inflation. It happened during World War II and again in the 1970s.
This would give us condition 4 for commodities β dramatically rising inflation.
During World War II, the price of copper was frozen at $0.11. No surprise there β we couldn't afford to have price manipulation while the world was engaged in a global war. World War II was very inflationary. So, in 1946, when the price of copper was no longer fixed, it began its climb to a higher, inflation-adjusted rate. Over the next ten years, copper would rise some 400%.
In the mid-1960s, just as inflation was coming back with a vengeance, copper was trading around $0.34. Over the next fifteen years, rising interest rates and rampant inflation caused stocks to do virtually nothing; but, copper prices rose more than 300%.
This wasn't all due to inflation; but, inflation helped fuel the fire.
Why would inflation help commodities? Commodities are "fixed assets" with no interest-bearing or cash flow value. If you recall from Part I of this article, in a world with no external forces on them, commodities prices would grow at the same rate as inflation.
People generally believe that gold is a hedge against inflation. They're partially right. In fact, gold, along with real estate, commodities, and other "hard assets" are all hedges against inflation (if purchased at the right price) because the cost to produce or extract the hard assets rises with inflation; so, the cost to sell them must also rise with inflation.
That's not to say that prices are always rational. In fact, they can get ridiculous, as we saw at the tail end of the commodities bubble of 2007 and 2008. And, that's not to say that commodities at any price are necessarily good hedges against inflation, just as individual stocks at great prices can beat the pants off of commodities, inflation or not.
Like with stocks, you have to pick your spot in commodities.
Continue to Part III of this article.
Joe Ponzio
www.fwallstreet.com
