By Sumit Roy
Tim Rudderow discusses why the old way of looking at commodities is wrong.
Tim Rudderow is CEO and chief investment officer at $1.5 billion asset manager Mount Lucas Management. He has been in the investment business since the late 1970s, when he worked at Commodities Corporation. Rudderow specializes in the design and management of technical trading systems applied to the futures, equity and fixed-income markets. HardAssetsInvestor Managing Editor Sumit Roy recently caught up with him to discuss why a buy-and-hold investment strategy doesn't work for commodities and other ways investors can approach the asset class instead.
HardAssetsInvestor: Recently you said you thought the end of the "commodities dream" was here. Can you elaborate?
Rudderow: I've held a commodity position every day for the last 30 years. I've traded a lot of commodities, and I've traded in a variety of different formats-mostly futures over that time-but commodity stocks as well. I have a decent amount of experience in this area.
The idea of commodities as an asset class was a dream that began in 1991, when Goldman Sachs rolled out the Goldman Sachs Commodity Index. It was at the Pierre Hotel in New York City, and I was there.
What was interesting about that event was that the notion commodities would go up in value over time was never part of the discussion. What they thought they had created was a way to think about commodities that was different. It was called the roll yield-this idea that if you bought commodity futures, there would be yield to be had if you held them for a certain period of time.
But the yield was created by the fact that producers sold down forward prices, and you earned the yield by the fact that you rolled up the spot. We thought then, and we still think now, that is completely nonsensical. The roll yield that they showed in the pre-1991 data was largely a function of how they weighted the components of the index. If you looked at the median roll yield, it was zero or negative.
It had everything to do with the construction of the index. And that actually has been borne out over time. The roll yield has been tremendously negative. But they created this juggernaut, where people started to think about commodities as an asset class.
Over time, the roll yield began to get less press, and many people began to think about the idea of commodities as a supercycle. We were fed the idea that the prices of commodities would go up because of burgeoning demand and the whole scarcity argument that has been bandied about for many years.
We thought that that was nonsensical as well. People missed the idea that commodity prices are not like stock market prices or equity prices. They enter the production function of real businesses, and they matter.
I can recall in 2008, when people were saying oil was going to go to $250 or $300 a barrel, our notion was that it was never going to happen because people would just stop using it. Moreover, people would change their habits in a way that they wouldn't use as much of that particular commodity over time.
In the next part of the commodities dream, we were told that commodities were a financial asset. They told us that because the money supply continued to expand dramatically, prices of commodities had to go up. This was a monetarist argument that has been largely been discredited, and in fact, we're seeing the opposite. Central bank balance sheets are expanding at a wild rate, but gold prices are falling, for example. Other commodities are under pressure as well.
The last part of the dream was the geopolitical risks. There was always geopolitical risk. If you have tumult in an area of the world that was sensitive to commodity prices, those commodity prices are likely to go up.
But in the case of oil, for instance, you've had rising prices that have brought on additional supply, which has offset a lot of that geopolitical risk. We've had pretty significant geopolitical risk in the former Soviet Union and in the Middle East, and yet oil prices have collapsed over that period.
Institutional investors are now getting frustrated. They're starting to question the commodities dream and think about other ways to approach the commodity markets.
HAI: We have seen extremely poor performance in a lot of these broad-based commodity funds. Do you have any views on these newer indices that try to improve returns by buying commodities in backwardation and avoiding the ones in contango?
Rudderow: As we've been saying for 25 years, commodities are a trade. There are various ways to trade them and there are profits to be made on the long and the short side-and perhaps even through a backwardation model like you described.
But I want to emphasize that they're not an asset class that you buy and hold. It's more likely that you're going to earn positive returns if you take advantage of why these markets exist in the first place. Futures markets, in particular, exist for the transfer of risk. If you're taking the other side of that risk on a systematic basis using some trading methodology, be it discretionary or algorithmic, there are profits to be made. There is a risk premium, but it's not a buy-and-hold risk premium.
HAI: You're saying you have to look at each of these markets individually, not as a whole, and trade them that way?
Rudderow: That's absolutely correct. One of the beauties of commodities markets, from my experience, has been that they're driven by their underlying microeconomics. One of the hard parts of recent commodity trading has been that baskets of commodities have created correlations where there shouldn't be. If we get away from that, and the basket trading becomes less prevalent, we'll get back to trading each individual commodity based on its underlying fundamentals, which would be a big positive.
HAI: Could you go into some of the commodity positions that you hold right now?
Rudderow: We trade both discretionary and quantitative in our macro fund, MLM Macro-Peak, and we also trade commodity equities. Our two largest discretionary commodity positions are short gold and short soybeans.
In my mind, the gold price is a function of the condition of the reserve currency and the level of real interest rates. When the dollar gets stronger, gold gets under a lot of pressure. And if real interest rates begin to rise, gold will succumb to a lot of pressure. We're going to see both of those things. That's why I see more downside, and I'm targeting gold at about $1,000 over the next couple months.
On soybeans, you have a situation where you've had a tremendous expansion in production in the United States, which has taken prices down. But it's still economic right now to plant beans over corn in the U.S. even at these prices. We're looking for expanded bean acres next year into the teeth of the surplus.
Moreover, the Brazilian currency has been relatively weak, which makes bean economics in South America, Brazil in particular, very strong. Thus, barring a weather shock, you're in for two years of oversupply of soybeans. We could get to an $8-handle over the next few months.
HAI: Do you own commodity-related equities as well?
Rudderow: Yes. We run a value equity portfolio mutual fund, MLM Focused Equity (Ticker: BMLEX), and a macro fund, MLM-Macro Peak. In those spaces, we like Valero (NYSE:VLO) and Marathon (NYSE:MPC) on the refining sector. In the deep value space, we own Nobile Corp. (NYSE:NE) and Transocean (NYSE:RIG). Oil prices are probably in the neighborhood of a bottom. By that I mean that we're within $5 of a bottom.
The other stock that we own is the other side of that trade, Delta Air Lines (NYSE:DAL), which is a great value stock with great earnings. It got absolutely demolished during the Ebola scare and has since rallied very dramatically through the month of October. That's obviously a company benefiting from low oil prices.
HAI: Touching on oil a bit more, do you see any significant upside to prices from here? Or do you just see it range-bound for now?
Rudderow: Probably range-bound. This decline is not a huge surprise.
The question becomes: What is the cost of production on the margin? The biggest surprise in the world right now is that the marginal cost of shale production in the U.S. might actually be as low as the marginal cost of production of traditional wells, when you factor in that the countries in OPEC with conventional wells depend tremendously on oil revenue for their government budgets and social concerns.
In my mind, the Saudis are using the fact that they have excess foreign reserves to push the price down and test what the supply elasticity is. Perhaps they'll find out, but what I've heard about shale is that production won't fall off dramatically until we get a good deal lower.