These days, there is little doubt that commodities are in a bullish super cycle. The question is, how can an individual investor take advantage of the greatest opportunity of the next decade?
In one of my previous articles about investing in commodities, I explained in detail why commodity ETFs are almost always the worst way for individual investors to play commodities, even though they're the most common choice. So now I'm going to get to the good stuff -- the best strategies for individuals who want high-quality and effective commodity exposure.
I've done a lot of commodities investing in my day. I even run my own advisory firm to help clients get exposure to commodities. One of many things I've learned from the recent market turbulence is that all strategies are not created equal.
We'll cover a few of the most common ways of investing in the commodities market, but by the end of this tutorial, you'll know why I think commodities futures are the single best way for individuals to get exposure to the commodities super cycle -- with less risk. I'm not going to hide my bias.
Before we get there, let's back up a bit to discuss the fundamental behind the commodities market.
Even prior to the unprecedented monetary binge that the Fed began in 2008, the fundamental case for commodities was compelling. Famous investor Jim Rogers points out in his book, Hot Commodities, that half the world's population didn't partake in the last great commodity super cycle from the late 1960s through the mid-1980s because during that time, the governments of China and India put a lid on any economic growth in the region. Today, China and India are full participants, and it's likely this new super cycle will blow up for another four to ten years -- minimum.
Secular trends in the commodity space typically last for 15 to 20 years, which means we have many more years to go. And given that the most explosive gains occur at the end of bull markets, there is still ample opportunity to take advantage of the trend.
Let's get started.
In my previous article, I made it very clear that I hate most commodity ETFs (exchange-traded funds). That said, there's another type of exchange-traded security my clients always ask me about: exchange-traded notes (or, ETNs).
[InvestingAnswers Feature: The Absolute Worst Way to Invest in Commodities]
Let's take a second to address the differences between ETNs and ETFs, because they're important.
An ETF is a fund that invests in the securities of an index. The SPDR S&P ETF (NYSE: SPY) holds all the stocks of the S&P 500 Index in the same proportion as the index. If the fund does a lousy job tracking the index, the investor absorbs the loss. If the fund does a lousy job tracking the index, the investor absorbs the loss. The fund isn't required to match the index -- it just has to give it the good old college try. For a good example, see my chart of the performance of the United States Oil Fund (NYSE: USO) versus the crude oil index it's supposed to track.
ETNs, on the other hand, are obligated to pay investors the exact performance of the index. Technically, an ETN is a debt instrument issued by a bank and the interest payment owed to the investor is tied to the performance of the underlying commodity index.
ETNs are better than ETFs for a few reasons. First, ETNs should theoretically not be subject to 'roll yield,' a majorly problematic phenomenon that I covered in my commodity ETF article. Second, a wide range of ETNs can be easily purchased from practically any broker, even for small accounts and IRAs, which should allow you to achieve diversified exposure to the entire commodity space.
That said, there are some serious disadvantages to ETNs. First and foremost, ETNs are a liability of the issuing bank. If the bank goes bust (as many have since the financial crisis), you will be a creditor of a busted bank. ETNs can also be subject to front-running and other forms of market manipulation -- especially in thinly traded commodities like cotton, cattle and coffee.
In my mind, there are only two justifiable reasons to buy ETNs for commodity exposure:
1) You have insufficient capital to buy commodities futures, and/or,
2) Your money is with a broker that won't permit you to trade commodities futures.
The key factor to remember when considering ETNs is to do your homework on the bank backing the notes. ETNs will provide you decent commodity exposure as long as the bank is around to pay the note. But if the bank goes under, then your investment will likely end up worthless and you'll be part of the investing club whose members were right on the trade, but wrong on the execution.
Stocks of Commodity Companies
Perhaps the most popular way to play the emerging commodity space is through stocks exposed to the underlying commodity. Stocks like ExxonMobil (NYSE: XOM), Caterpillar (NYSE: CAT) and BHP Billiton (NYSE: BHP) have been some of the best performers of the past decade.
Buying stocks with exposure to commodity prices has its advantages. Here are a few:
1) Leverage: A gold mining company will often see its profits grow exponentially when the underlying commodity (gold, in this example) takes off. If it costs $400 to extract an ounce of gold from the ground, gold mining is futile at $250 an ounce (like it was in 2000). But as the following table illustrates, a linear price move in gold creates a disproportionate increase in profits for a mining company:
As the price of the underlying increases, the price of the stock should increase to reflect the mining company's enhanced profitability.
2) M&A activity: Practically every week, CNBC will cover some unheard of stock that was bought out by a larger competitor for multiples of what the stock was trading at. When this happen, similar names will rise alongside the acquisition target, just in case they are 'next in line' to be purchased. This is one of the many reasons small cap stocks have outperformed large cap stocks over time.
By buying small cap stocks, one might take advantage of increasing M&A activity in the commodity space. When ExxonMobil offered to purchase XTO Energy, Inc. in 2009 for a 25% premium, similar companies jumped alongside XTO.
3) Upward equity market bias: If you spend more than five minutes talking to a stock broker or financial adviser, you are sure to hear them utter something about how the stock market has always gone up over time (I agree that due to a debased currency, the stock market has a tendency to go up in nominal terms over very long periods of time, but that's a topic for another article).
But buying stocks is not always a winning proposition, and here are a few of the distinct disadvantages your broker won't tell you about:
1) Over time, many more stocks go to zero than not. It's interesting to note that of the Dow's original 12 components, only one -- General Electric (NYSE:GE) -- has survived the numerous mergers, business failures and deletions from the index that have altered the composition of the Dow since 1896. Many of the high-flying oil, gas and gold miners from the 70s are now long gone, but the underlying commodity never went to zero. And just as natural gas was embarking on a historical run, Enron, a giant in the natural gas space, collapsed and wiped out all of its equity investors.
2) Geopolitical risks: Many commodity companies have operations in developing countries where governments have a propensity to change the rules without notice. Invariably, these changes result in the confiscation of profits through taxes or outright control of the companies' assets. The examples are too many to list, but one of the most prominent examples was Russia's termination of many of their contracts with western oil and gas companies when oil moved over $40. Gold miners are continually dealing with such issues, and it's one of the most critical components in analyzing a mining stock.
3) Environmental risks: Unfortunately, we have two perfect examples of this risk in the past 12 months. British Petroleum's (NYSE: BP) stock still hasn't recovered from the Gulf oil disaster (and I'm not suggesting that it should.) And TEPCO, Japan's largest utility provider, saw its stock drop to all-time lows after the recent nuclear crisis there.
4) Hedging risks: It is terribly ironic that the very nature of inflation can benefit a commodity company and at the same time be its downfall. Just talk to feedlots in Texas about how the price of cattle has not increased in line with the price of feed corn, their primary input. Oil and gas companies had a heck of a time managing their materials costs as metal prices went parabolic in the middle part of the last decade.
5) Capital market risk: While stock markets do tend to appreciate over time, today's sky high valuations are destined to decline when interest rates increase. If interest rates rise, stocks decline become less attractive. If an investor wants to go the equity route to achieve commodity exposure, I might suggest (not recommend, just suggest) hedging interest rate risk by shorting bonds (and actually shorting bonds by buying interest rate futures or shorting bonds, not by buying inverse ETFs) to take advantage of the inverse relationship.
6) Management risk: Enron didn't go to zero because natural gas went to zero. Enron went bust because of unadulterated greed and overly inflated egos. One of our nation's proudest companies, General Motors (NYSE: GM) went bankrupt not because they made really lousy cars for a really long time, but because they decided to get into the home mortgage and commercial mortgage business through their finance arm, GMAC (now, Ally Financial). And in the 80s, they came within a hair of going bankrupt when they decided to get into the emerging IT business.
For every justification for buying equities tied to the commodity business, there seems to be two reasons not to.
And, here's the kicker. Academic research supports the idea that commodity stocks are not the ideal means of achieving commodity exposure. In 2004, Gary Gorton, economics professor at University of Pennsylvania, and Geert Rouwenhorst, economics professor at Yale School of Management, published a white paper titled, 'Facts and Fantasies about Commodity Futures.' Here's what they discovered: 'Over a 41-year period between 1962 and 2003, the cumulative performance of futures tripled the cumulative performance of 'matching' equities.'
In the recent years since this report was published, equities have not necessarily underperformed the futures of an underlying commodity. But I expect that when interest rates inevitably increase, equity valuations will collapse and stocks will go back to underperforming commodities.
Which leads me to…
The Underlying Commodity
Every once in a while I'll receive a cold call from someone trying to sell me ownership in an oil and gas partnership. Ownership in oil and gas partnerships is a great way to buy oil and gas in the ground -- theoretically. But while I know some of those investments are very lucrative, they can also end up as a complete loss. If you ever get one of these calls, it is critically important to do your homework to make sure that the people offering these deals are competent, have strong track records and, most importantly, are not highly leveraged.
[Thirty years ago, the Hunt brothers were destroyed by leverage when they tried to corner the silver market. Learn more here -- The Three Lessons From the Biggest Silver Bust in History.]
There are other opportunities to buy physical commodities. I'm assuming nearly half of the people reading this article have some physical gold or silver stored somewhere safe. If you wanted to, you could call up a feedlot in the Texas panhandle and buy physical cattle at $1,000+ per head. You could invest in partnerships that own farm land in the Midwest. So there are definitely ways to achieve direct commodity exposure; it just takes a little bit of homework and a propensity to take some risk.
The downside to these deals, typically organized as partnerships, is that they can lack liquidity and diversity, plus they are subject to management risk. The people managing partnerships may or may not be competent or ethical. And even if they are competent and ethical, it's easy to get caught with too much leverage. During an inevitable downturn in prices, highly leveraged ventures go bust. Our nation's history is littered with once successful men and women who made wise investments but were foolishly overleveraged. The lesson is simple -- buyer beware!
I've saved the best for last. In my opinion, and in the opinion of legendary investor Jim Rogers, the best bet for playing rising commodity prices is to buy commodity futures. Though they may seem confusing and risky, commodities futures are actually highly appropriate for individual investors. Their many advantages include:
- Direct dollar for dollar exposure to commodities
- Low transaction costs and no management fees
- Tax advantages
- Partial control over roll yield and market manipulation
- Liquidity (in most cases)
- No equity market risk
- Partial control over volatility via longer-dated contracts
- Highly diversifiable
- Require a relatively small amount of capital, especially for mini-contracts (click here for information on trading mini contracts in a brokerage or IRA account)
- Effective hedge against crazy monetary policies, and
- Last but not least, if done properly, Goldman Sachs, JP Morgan and Merrill Lynch won't make a dime off your trade (you may not care about this but I do)
If you decide to go the futures route, then you have a choice to make: Either go it alone or hire a specialist.
Futures Investing On Your Own
Going it alone is not as intimidating as it might seem. There are a lot of nuances to trading commodity futures but nothing that cannot be overcome with several hours of homework.
The first step is to open an account at a brokerage firm that allows for commodity futures trading. While many of the big boys do not permit individual investors to do this, there are well established online brokers who do.
For my commodity business, I use Interactive Brokers. I would also suggest (not recommend, just suggest) checking out Think or Swim, which is now owned by TD Ameritrade (Nasdaq: AMTD). Think or Swim does a very good job of educating and servicing their customers, but I trade with Interactive Brokers for a few reasons -- the main one being they allow my IRA accounts to trade futures. It doesn't hurt that their commissions and execution are highly favorable as well.
Depending on the size of your account or the amount of exposure you desire, you might consider clicking here to learn more about trading mini-contracts. Mini-contracts trade at a fraction of normal futures contracts, which makes them almost perfect for individual investors with smaller pools of capital.
If you are going to trade commodities yourself, it is absolutely critical that you understand the impact of leverage. If I were sitting with you in person, I would use a host of colorful and R-rated words to describe how leverage can utterly destroy you. I do not currently leverage my clients' accounts. If you decide to do it on your own, then I can't emphasize enough that you should spend a few hours to figure out margin requirements and leverage on the contracts before you dive in.
Hiring a Specialist
Given the many nuances of the commodity market, you might decide to hire either a Series 3 commodity broker or a fee-only adviser competent in trading commodity futures (I'm the latter, FYI). To illustrate why you might want to outsource this part of your portfolio, here are just a couple of the pitfalls that a neophyte in the commodity futures business might come across:
Timing: For practically every commodity futures sector, there is a different expiration date, as well as different trading hours and different contact months. Jim Rogers' book, Hot Commodities, has a really useful appendix that is a great resource for keeping track of trading times for all commodities, but the complexity of the commodities calendar can sometimes be lost on beginners.
Seasonality: The supply and demand for a commodity ebbs and flows throughout the year, which causes prices to ebb and flow throughout the year. For example, the demand for natural gas (NG) and other commodities tied to electricity will fall in the spring and autumn months when electricity demand falls. This is called the 'shoulder season.' Demand drops, but supply doesn't (it is not worth it for producers to cap wells for just a couple of months) and prices usually go down.
A novice commodity investor who just learned about contango (futures contracts trading higher than spot prices) may look at the NG contract for October, see it trading at a discount to the September contract and think he's stumbled across a great deal. But in reality, the October contract often trades at a discount because spot prices tend to fall between the September and October expirations.
Another example -- and one not as commonly known -- is the price fluctuation of live cattle (LC) in the late fall and winter months. Prices for LC typically run up in October and then fall off in January and February. This is because wealthy ranch owners buy most of their cattle during this part of the year for tax purposes. Because taxes are primarily accounted for on a cash basis, they can make the purchase late in the year, write off the purchases and then turn around and dump the cattle on the market after the beginning of the new tax year. This year was no different -- prices dipped in January when ranchers started selling (I bought them at around $1.07) and they have gone up ever since.
For almost every commodity there strange idiosyncrasies that impact prices. I'm not going to give away all my secrets here, but I will say that a seasoned commodity specialist should be aware of these trends in prices, and this specialized knowledge may justify the fee or commission they will charge you.
The Investing Answer: If you decide to go the futures route and would like professional assistance, my firm is focused on offering solutions for retail investors. We manage several strategies that are dominated by commodity themes, but we can also invest according to an index or to specifically hedge against the rising prices of gasoline or foodstuffs.
In my experience, futures contracts are the best way to get exposure to the commodity space because they are simple to trade, inexpensive to trade, give you direct exposure and can easily be diversified. If you want to learn more about investing in commodities, I suggest you check out my other article, The Absolute Worst Way to Invest in Commodities, as well as these other InvestingAnswers features:
Everything Beginners Need to Know About Commodity Investing
3 Simple Ways Everyone Can Hedge Against Inflation
This is a guest post from Matthew McCracken, a Texas-based Registered Investment Adviser (RIA) and founder of McCracken & Company.