Fundamental Analysis Is The Smartest Way To Play Commodities

by: Philippe Casey

As investors scrambled to exit long commodity positions en masse in May, I could not help but marvel at the flawed psychology which fueled the aggressive sell-off. The problem is one of perspective. In the never-ending quest for profit, the important distinction between trading and investing is often breached.

Fickle as ever, Mr Market is once again riding the wave of macro concerns (not least of all the Eurozone debt crisis) to impose a bearish view on commodities. Adopting a long-term perspective, an examination of underlying fundamentals leads to a different– and far more optimistic – conclusion on this underappreciated asset class.

Despite the increased interconnectivity of global finance, commodity markets retain little correlation to the performance of broad equity and fixed-income indices. This seems intuitive enough. After all, can yields on European sovereign debt really influence the price of Brazilian sugar? Does the quarterly performance of Japanese REITs affect a farmer in Indiana trying to lock in a selling price for soybean oil? Geopolitical developments, while remaining significant, tend not move commodity markets in the same manner that tangible factors like harvested acreage, crop yields, and weather patterns can.

As such, commodity exposure offers investors the dual benefits of portfolio diversification and downside protection. Managed futures funds (also known as Commodity Trading Advisors, or ‘CTAs’) outperformed all other asset classes during the 2008 financial crisis. In a year when many stock indices dropped 50% or more, CTAs returned +17% on average.

For those who can stomach the inevitable ebb and flow of commodity price fluctuations, the long-term outlook for base metals, staple crops, and ‘softs’ remains remarkably strong. Continued demographic growth and economic development in the emerging markets will further increase the demand for natural resources like crude oil and copper for the foreseeable future.

Additionally, as disposable income rises in the emerging markets, the local population may acquire a taste for meat – a food item oftentimes too expensive for frequent consumption in developing nations. If high-quality meat successfully transitions from a luxury food item to a dietary staple, look for holdings like the Barclays’ IPath Pure Beta Livestock fund (NYSEARCA:LSTK) to skyrocket.

Meanwhile, US government mandates on ethanol production pushed corn prices to an all-time high in early June at nearly $8/bushel. Since then, fears of slowed global economic growth have dropped corn prices to below $6/bushel, despite USDA predictions that corn production relative to global demand will be the lowest in decades. For this reason, the Teucrium Corn Fund (NYSEARCA:CORN) seems like a strong value buy for longer-term investors, especially since it is currently trading below $40, well off its all-time high of $50.69 achieved in late August.

Disciplined investors with a long-term perspective can appreciate the sweet simplicity of the bullish argument on commodities: given the earth’s finite supply of resources (and, at present, no viable alternatives on the horizon) it holds logically that prices can only increase in the long-run. Take for instance, the IEA’s decision to release 30 million barrels of strategic reserves of crude oil. The impact of the move – while hitting speculators hard – was hardly noticeable to the average person. Although Brent Crude futures fell over 10% in the period between June 13th and June 24th, the market rallied impressively the following week, rising 5.27%. All in all, the deflationary pressure resulting from this unexpected supply increase – while temporarily effective – barely lasted two weeks. As we learned in economics, demand for crude oil is relatively inelastic; consumers may not be happy (they may even kick and scream) but in the end they will line up to pay at the pump as always, whether $2.50 or $5.00 per gallon.

Investors interested in gaining exposure to crude oil should closely consider Barclays’ IPath Pure Beta Crude Oil Fund (NYSEARCA:OLEM). The fund looks to replicate the performance of West Texas Intermediate (WTI) crude oil by tracking the Barclays Capital WTI Crude Oil Pure Beta TR index. As recently as mid-October, the spread between WTI and Brent Crude reached an all-time high of $28.07, with the heavier North Atlantic Brent Crude oil trading at a premium to its higher-quality North American cousin. This counterintuitive pricing discrepancy is mainly attributed to logistical issues at Cushing, Oklahoma – the main storage and delivery point for WTI. Recent weeks have seen strong price convergence as the spread between the two crude oils has rapidly narrowed to under $9. This can be attributed to the fact that US legislators are currently considering approval for the construction of the Keystone XL Pipeline, a massive project undertaken by TransCanada that would remove many of the logistical problems at Cushing.

Copper provides another interesting case study. On June 5th leftist Ollanta Humala won the race to become president of the world’s second largest copper producer, Peru. During his campaign, he hinted that he would increase corporate tax rates on miners by as much as 15% (from 30% to 45%), potentially crippling future excavation projects. Despite this, copper prices inexplicably dipped 1.77% (from 412.25 USc to 404.95 USc) in the week following his election. Considering the current global economic slowdown and growing Eurozone debt concerns, however, investment in copper funds like the Dow Jones-UBS Copper Subindex (JJC) seems too risky and slightly premature.

This example of a counterintuitive price movement suggests that fundamental analysis – rather than technical – is the smartest way to play the commodity markets for most investors. Indeed, who can forget Goldman Sachs’ late May prediction that Brent Crude would hit $135 a barrel by mid-July? With commodities, short-term unpredictability is willingly absorbed for long-term certainty. Many analysts believe US copper reserves will be entirely depleted within 50 years. Barring the discovery or creation of an innovative alternative, the red metal can only rise in price. Unfortunately, in a global society that emphasizes instant reward, this sort of long-term investment philosophy has become difficult for us to accept.

So how does one jump into this game? Short-term volatility, high leverage, and complex technical language can make commodity investing seem intimidating. Thankfully, the advent of ETFs and ETNs means that exposure to this unique asset class no longer requires a blind leap into the much-maligned and highly obscure derivatives markets. Pure-play commodity ETFs – still a new concept for many of us – have gained traction recently. These handy investment vehicles can make anyone’s first foray into the commodity markets a pleasant learning experience. Just remember: in the end, long-term commodity bulls will win the day.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.