Updated: May 19, 2022
Unlike equities, bonds or property, commodities cannot be valued on the basis of the income they generate. This makes it hard to feel comfortable investing in them, as without yield it is hard to predict future returns. In fact, when you invest in commodities, one way or another you have to pay for storage, which makes them even less attractive as investments. For this reason, our core allocation to commodities is zero for all our funds other than our Growth Fund where it is a low 2.5%, and this more for their diversification benefits than their return characteristics.
Asimov was staggered to learn that the pessimist had lost the bet
The only reasonable method I can think of to value commodities is to consider their inflation-adjusted prices then compare them with their long-term price trends. But this throws up another problem – what should the trend real price appreciation of a particular commodity be? Should the real price of a commodity be rising, falling or staying the same over the long term? Should nominal prices be rising in line with inflation, in which case trend growth is zero? Or falling, in which case trend growth is negative?
This question brings to mind an article written by the great Isaac Asimov. The piece in question was entitled The Dismal Science, and it somewhat obscurely constituted the editorial in his 1991 science fiction magazine (Asimov was a polymath and would write on any number of subjects).
Asimov began his editorial by saying that he could not understand economics. “People may say they understand it and economists even win Nobel Prizes, but I think it’s all a fake,” he wrote. He then went on to note a New York Times article in which the story is told of a bet made by two economists, one who thought the prices of certain industrial metals would rise – because of rising populations – and one who thought they would fall – because of advancing technology. Asimov was staggered to learn that the pessimist had lost the bet.
If we look at a broad index of commodities over the last 15 years, we capture in that period the great bull market of the noughties. This means that trend growth over that period was substantially positive, +8.9% real in fact, and thus that current prices look very cheap relative to trend (see chart).
Look further back however and you get a different picture. In the case of gold, oil, copper and lead, longer term trend growth in real prices has been 2-3% per annum (see charts below). In other words, Asimov was right! Trend growth over the longer time frames is nowhere near the 8% per cent or so registered in the last decade and a half, but it is nonetheless positive. I would guess that the explanation for the 2-3% growth lies in real prices tracking growth in real incomes (GDP ) and thus the fact that the world can afford to pay a bit more each year for these raw materials in real terms.
Nevertheless, 2-3% real is still not particularly attractive given that commodities prices are very volatile and that as an investor in commodities you will a) be paying for a storage and b) not be using the commodities to manufacture things and make a profit. Looking at the charts, it would appear that a sensible approach to commodities investing would be to buy them when real prices are well below trend and to have a long-term – 5-10 years – investment time horizon, selling when real prices are well above trend.
So, where are prices currently in relation to their trends? While the oil price is still well below its trend, 26% in fact, the others are either close to it (copper and lead) or above it (gold), making them in my view unattractive.
Is it time to buy oil? I’d say not. In 2001, prices fell to 53% below trend, and in 1970, 54% below (that these are so similar is instructive!) In other words, prices can fall much further if history is any guide which it often is. True, there are forces that might drive the price up (a prolonged period of heightened political risk or the fact that the world is using up its fixed reserves) but there are also forces that might drive it down further (the shift to renewables and lowered political risk, the recent Iran deal being a good example of the latter). At $30 I might be interested.
Published in Investment Letter, August 2015
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.