Will Commodity ETFs Really Go Up?

I was recently reading Gary Gordon's article on ETFs here on Seeking Alpha, which basically said that the commodities ETFs are going to eventually see a rise. No prediction of the timing was advanced – frankly speaking, this would be quite impossible, given the current volatility of the markets.

There are indeed some strong arguments behind this potential trend. First of all, the history of 2008 shows that there was a huge rise in raw materials (commodities prices). To exemplify, I can use oil (LON:OILB), which started from around $60/barrel in 2007 to climb as high as $120 in July last year and then started a fast descent to the recent $30s:

The same happened with most of the raw materials, especially those in great demand from China (phosphates for the chemicals industry, steel for the consumer durables etc.). Looking at the charts, it is obvious that the prices are very depressed and they cannot go too much lower. (Unless the current market crash is complete, which does not seem to be the case.)

Another argument in favor of raw materials price increases is inflation. With $1.8 trillion to be pumped into the economy, the Obama administration has set not only the scene for a huge budget deficit, but also for a large increase in the Fed money supply. This action will generate price increases, and the first impacted will for sure be raw materials, acting as price translators in the whole economy supply chain.

Unfortunately, inflation has some other nasty effects, such as the dilution of the value of shares or commodities. In other words, the fact that the share prices will go up will mean nothing if interest rates also go up, diluting investors’ purchasing power. To me this looks like a closed-loop game, whereby you get a price increase, but not a purchasing power increase. And after all, all the commodities’ costs are derived from raw materials prices, which means that prices for all the goods will increase – although with a delay which might allow some profits to be made in the meanwhile.

Will these objective factors generate an increase in the ETF prices anytime soon? Here I think we should be patient – the speed of transfer to the raw materials prices varies from industry to industry. After all, we all have to eat and travel and buy goods, which means that the demand (now faltered by the stock market crash) will recover sometimes in the future. The issue here is that in order to see raw material price increases the demand for those have to rise. Which might generate an interesting “chicken and egg” dilemma – which investments will grow first? Those of the consumer goods companies or those of the raw materials ones? And where will most of the profits be made?

And last (but not at least), ETFs are (like any respectable low risk investment) relatively safe placements. As such, it is sure that they will come back in the near future, so if you don’t have a very aggressive strategy I think it is worth waiting.

Comments

[donzelion:]

I like commodities other than gold as a hedge against inflation - but limit my exposure to 5% of my portfolio, split evenly between oil and minerals. In general, I'd prefer to hold equities for good companies that produce the commodity, but at the moment, I've closed those positions.

Mar 15 09:10 AM

[chleoku:]

Do you the Stagflation situation worried by Warren Buffett would help?

www.wealthalchemist.co.../

Mar 15 09:57 AM

[chleoku:]

Sorry for the typo. I meant do you think the 'Stagflation' situation which Warren Buffett is worrying about would happen?

www.wealthalchemist.co.../

Mar 15 09:59 AM

[kelm:]

Price can rise on increased demand and reduced supply. It is the latter that is at work at the moment.

Raw material prices can go up because demand increases or because supply decreases. Supply is decreasing because the combination of economic contraction and credit crisis is forcing companies to close mines and smelting operations world wide. One of the world's largest nickle mines has been closed in Australia, most of the copper mining and smelting operations in the Congo have been closed, Opec has cut production multiple times, and we are told farmers cannot get credit for fertilizer and seed. So supply is contracting but as yet, not much faster than demand.

Once we see an uptick in economic activity we will quickly get into a squeeze. Closing a mine is a lot easier than re-opening one. Further, production at many mines and all oil fields is dropping naturally year on year. Without new investment into those operations production drops. The credit crisis is ensuring that not only are we reducing supply now, but we are failing to keep the supply we have producing at maximum levels due to lack of investment and we are not putting the investment into exploration. So when a real uptick in demand occurs we will quickly find prices soaring.

Having said that, I do not see the evidence from looking at the major metals that we have formed a solid base yet.

Finally, a word of caution. Look at the price charts of the underlying commodities (i.e. $copper, $alum etc, on Stockcharts.com) and then look at the ETF price action.

Mar 15 12:17 PM

[Ron Rowland:]

Perhaps they are just typos, but I am having trouble understanding the points trying to be made here because they appear to be contradicting. For example:

Do you really mean "impossible" or should it be "possible" in the following?

"...commodities ETFs are going to eventually see a rise...frankly speaking, this would be quite impossible, given the current volatility of the markets"

Do you really mean they can't go lower if the crash is "complete" or do you mean "incomplete"?

"...it is obvious that the prices are very depressed and they cannot go too much lower. (Unless the current market crash is complete, which does not seem to be the case.)"

Because your conclusion seems to imply that you think they are going to go up.

"...ETFs are...relatively safe placements. As such, it is sure that they will come back in the near future..."

Mar 15 12:24 PM

[bigmoney:]

>> To me this looks like a closed-loop game, whereby you get a price increase, but not a purchasing power increase.

from a macro-economics perspective, if commodities rise that's not necessarily inflationary if other asset classes continue to decline. If Joe the Plumber has to pay $5/gallon of gas, that leaves him less money to bid up the price of housing, stocks, college educations, etc. Chances are, his boss isn't going to give him a fat pay raise to boost his purchasing power. Maybe the government will give him money.

Either way, I imagine commodities could rise in a supply constraint, what they call cost-push inflation, I believe.

Mar 15 12:46 PM

[Analyste de...:]

Did anyone else laugh at the opener "I was recently reading Gary Gordon's article on ETFs..." ?

Prattle.

Mar 15 12:50 PM

[Obed Butuk:]

Since it is not clear where profits will be made why not hedge yourself in both the raw material and the goods industries depending on where the fundamentals indicators lead profit risk is minimized.

Mar 15 02:30 PM

[T.Stamps:]

Gold will not make you rich. It's an insurance policy.
It'll just hold the line against hyper-inflation.

Mar 15 05:24 PM

[donzelion:]

Kelm - in a single currency world, the following statement is almost certainly true: "Raw material prices can go up because demand increases or because supply decreases."

A modest exposure to commodities seems prudent given currency fluctuations, but in general, equities will probably outperform commodities, UNLESS
(1) technology is relatively static,
(2) management is relatively irrelevant,
(3) access to technology is independent of management or capital,
(4) one person can determine future supply'n'demand with better certainty than others, and
(5) supply and demand applies to raw materials, but not to currencies

Bear in mind, in 1750, cotton (pre-cotton gin) was 1/3 the price of silk, now it's less than 1/10. In 1820, opium was a major global commodity. In 1850, aluminum was more valuable than gold; by 1875, it was as valuable as silver. And in 2000, gold was certainly one of the worst performing assets of all time. In 2009, that's no longer so "self-evident."

Mar 16 03:02 AM

[Radu Haraga:]

Hi there Ron,

I meant this is very possible in the incoming future to see a rise in the raw materials prices, even probable. Noone can predict when and for what raw materials. Some analysts point at the oil, others at the chemicals, others at the foods/cereals. This is why ETF's are good at limiting the risk (and also the goods of course). So yes, my conclusion is that they will go up, I just cannot figure out when - before or after the economy will take off?

Mar 16 10:38 AM

[Radu Haraga:]

And I was not even trying to advertise this :(


On Mar 15 12:50 PM analyste de boston wrote:

> Did anyone else laugh at the opener "I was recently reading Gary
> Gordon's article on ETFs..." ?
>
> Prattle.
>

Mar 16 10:40 AM

[Analyste de...:]

Radu,
If you look back over the past year, Gary Gordon's calls have been positively atrocious. We do all make mistakes, but you don't flatter yourself with that opening reference.

A number of more credible commentators have suggested the same thesis, for longer and without the baggage of so many bunky calls.

Mar 16 01:03 PM

[Mad Hedge F...:]

This is a no brainer! Traders looking for the Next Big Play are keeping a laser like focus on two key commodities. Chinese stockpiling prompted copper to break out of its recent trading range to the upside to $1.70, taking lead producer Freeport McMoran (FCX) up 30% on the week. Crude rose 15% to a high of $46. These impressive moves happened during a week when global equity markets were in complete freefall. This suggests that the bulk of the world’s growth will be in emerging economies, and that the next round of commodity buying will be even more ferocious than the last. Since I believe that the future is all about the ascent of hard assets over paper ones, this is music to my ears.

Mar 16 04:46 PM