Commodities: Great Expectations

[ostap]

Investing in commodities has become very popular in recent years. Commodities are in a bull market, and commodity investors have great expectations. However, many a commodity investor will probably be disappointed by his commodity investment returns. In order to understand why, it is important to be aware of the difference between “flow” and “stock” commodities.

Flow commodities flow more or less directly from producers to end users of that commodity. They cannot be stored, either because storage is too expensive or because the commodity is perishable. Most commodities are, to a large extent, flow commodities, with negligible amounts of stockpiles available. Electricity is a classic example of a flow commodity: once produced, it cannot be stored at all. Most sources of energy are flow commodities, among them crude oil: worldwide above-ground oil stocks amount to only a few weeks of annual supply.

Stock commodities, by contrast, can easily be stored and stocks are plentiful. Gold is a classic example of a stock commodity: storage is cheap and above-ground gold stocks are many times larger than annual mine supply.

Investing in a flow commodity means buying futures contracts, as taking possession of the physical underlying is not possible. When delivery date approaches, investors in flow commodities roll over their contracts. As investors never take delivery, they do not represent physical demand for that commodity. Therefore, the spot price of a flow commodity is unaffected by investment. Contrary to most other assets where investment demand increases the demand and thus the price of that asset, investment demand for a flow commodity does neither increase physical demand nor the spot price of that commodity. The only effect of an increase in investment demand is an increase in the contango, i.e. an increase in the amount by which prices for future delivery are higher than the spot price. As futures prices tend towards spot prices with approaching delivery date, the higher the contango, the higher will be the losses for investors from rolling over their futures positions.

With stock commodities, things are different. Futures prices and spot market prices cannot diverge by too much. An increase in investment demand in the futures market spills over to the physical spot market, as arbitrageurs seek to profit from the contango by selling futures and hedging their long position by buying the underlying commodity on the spot market. With stock commodities, investment demand in futures markets is therefore equivalent to physical demand in the spot market and does indeed affect the spot price of that commodity.

Despite the bull market in commodities, prices of flow commodities will therefore probably not grow into the sky, because demand, which consists from end users only, is quite price-elastic. If prices of orange juice, electricity or pork bellies rise too much, end users will switch to apple juice, alternative sources of energy and chicken meat. Prices of stock commodities, by contrast, are more likely to grow into the sky, as their prices are not only determined by end-users, but also by investment demand, which is less price elastic.

For this reason, I expect gold to soon outperform most other commodities as the bull market in commodities progresses. I also expect investors in flow commodities and in commodity funds to fare less well than investors which invest in precious metals only.

[jk]

Re: Commodities: Great Expectations

helpful clarification. thank you.

[grapejelly]

Re: Commodities: Great Expectations

I think that gold is not really a commodity.

It can be a speculation, as can silver, and much of the time it may resemble a commodity but it isn't.

It really moves counter cyclically to paper. It is a form of money.

Specifically, it appreciates when there is a negative real interest rate on paper.

Notice how the gold market bull started after the 2000 market crash and resultant drop in US$ interest rates. We have been in a negative return situation vis a vis real interest rates (compared to growth in M3 broad money, say, or its proxy on nowandfutures.com).

In 1981 and thereafter, there was a very high return on paper. On bonds through interest and capital gains, and on stocks. Gold went nowhere until the climax in Spring of 2000.

I expect gold and silver to do very well for a number of years because real returns will be negative for a long time. This is due to the enormous debts that have built up and the inability for the economy to sustain a positive real rate of interest.

[Finster]

Re: Commodities: Great Expectations

I think that gold is not really a commodity.

Sure it is. A commodity is anything that is the same from one batch to the next.

[Finster]

Re: Commodities: Great Expectations

Interesting comments about differentiating between flow and stock commodities, Ostap. In spite of the excellent points you make, however, there is one crucial issue that you overlook. And that is that these price increases do not constitute merely a bull market in commodities, but a bear market in currency.

As the market value of the dollar falls, it simply takes more of them to buy anything. This is equally true of all goods, whether stock or flow commodities. It may well be that the prices of flow commodities don't rise as much as stock commodities, but that could also be due to the fact that turnover makes the impact of reduced real production cost more significant in the former. Also, the commodities themselves may be of inferior quality to those of prior years. If we, for example, merely compare the price of corn today to corn 25 years ago, we are not comparing the same thing. While we could quibble as to whether today's gene-spliced product is inferior, it undeniably is different. For an apples-to-apples comparison, we have to compare the same commodity today with the same commodity of before. Substitution of the kind you cite is just a more extreme example of the same.

You are correct to note that stock commodities may be impacted by investor demand, and probably in none may that be more significant than with gold. But a large part of that is that gold remains the prime form of money that cannot be inflated. As people looking for a store of value flee government currencies, gold presents itself as the main alternative. Yet this further underscores my basic point - that this is not so much a bull market in commodities per se, but a bear market in government currency.