The End Of Ordinary Commodity Cycles: ETFs To Play This Emerging Trend

by: Patrick Young

There is a widely held view that the price of commodities is cyclic, and that this cycle is well balanced by supply/demand forces. As demand eats up existing resources, prices increase, which leads to new supply coming online, driving prices down. Additionally, Malthusian predictions about the limited supply of essential resources have historically been proven false. New technologies fundamentally change the game.

This will essentially always be true for energy. Already there are ideas and technologies that could fully replace fossil fuels. The most promising energy source among these ideas is solar power, but improved nuclear and even fusion reactors may provide all our energy needs in the future.

Theoretically, energy could be used to synthesize food from inorganic compounds and fresh water by desalination, so even agricultural land and fresh water sources are destined to find competition from new technologies.

That leaves only one commodity class that is practically irreplaceable: elements. There is simply no practical way to produce Zinc from say, saltwater, or anything else, except ores containing large quantities of Zinc. Furthermore, with the exception of iron, we are continuing to find new and unexpected uses for nearly every element on the periodic table. Alchemy truly is a fool's errand except when breeding very high mass and unstable isotopes in a nuclear reactor (such as Plutonium).

Elements are also unlikely to be found somewhere else. Even if resources exist on other planets in our solar system, only our planet has plate tectonics and flowing water, which are the two processes most responsible for concentrating rare metals into economic ores. Furthermore, some mines on Earth are already exploiting ores at depths approaching 5 miles! Finding new sources of an irreplaceable resource will prove increasingly difficult.

Therefore, over the next century, fossil fuels could suffer the same fate as whale oil. Food production may continue to outpace population growth. But rare metals, like copper, zinc, molybdenum, tin, tungsten, rare earth elements, and platinum group metals (including gold), will not be significantly replaced from new resources. With more and more demand for high tech goods, the prices for these metals should at least be well supported. Ultimately, prices will rise enough in some metals to warrant much more aggressive recycling of metallic materials - something which is not possible for energy - which will provide a long life span for the element, but not increase the total supply.

There are several ways to play this long-term trend.

ETFs that track the price of an underlying metal by purchasing physical commodities currently only exist for the precious metals Gold (GLD, IAU, SGOL, AGOL), Silver (SLV, SIVR), Platinum PPLT and Palladium (NYSEARCA:PALL). Gold is a wonderful example of a rare metal commodity that is already aggressively recycled and for which there is growing demand and difficulty bringing significant new production online. Platinum should be no different, particularly given its important applications in industry.These are the safest instruments for tracking commodity prices because they cannot lose all of their value overnight or be mispriced. J.P. Morgan and iPath are attempting to create physical copper ETFs as well.

An alternative to paying a large bank to hold a physical commodity for you, is to buy the futures contracts that track the underlying index. This allows access to more metals, but also carries the risk that contango will erode the fund. However, given the possibility of continuing supply shortages for industrial metals, backwardation seems to be the more likely scenario, which the retail investor should not be concerned with, and in the case of copper, backwardation is well correlated with medium-term price rises. See this article for more on this.

Broad based ETFs that trade in futures contracts include the DBB and DBP (base and precious metals respectively). To help mitigate contango, the new CPER by US Commodity Funds, trades futures options on copper using a dynamic roll-over model.

An entirely different alternative is to buy an I.O.U. from the bank that tracks the price of the underlying commodity. This is called an ETN. While ETNs perfectly track the underlying commodity, they are riskier than futures funds because the bank issuing the I.O.U. could go bankrupt overnight and the ETNs would become worthless overnight. So the bottom line is that you shouldn't buy any ETN from a bank that you wouldn't buy shares in or loan money to.

One disadvantage of ETFs as opposed to the ETNs is that the ETF is always taxed at a higher rate than ETN when held for longer than 1 year. This is because of the buying and selling of short term futures contracts in ETFs.

The (Barclays) iPath Industrial Metals Total Return ETN (NYSEARCA:JJM) tracks a basket of industrial metals, with a heavy weighting in aluminum.

The (Bank of America) ELEMENTS Metals Total Return ETN (NYSEARCA:RJZ) tracks a more diverse basket of metals, but still has a large weighting in aluminum.

The problem with aluminum is that it isn't actually very rare. Neither is iron. In fact, aluminum is the third most abundant element in the crust, after Oxygen and Silicon, it's just bound up in minerals from which it is hard to separate.

There are also numerous individual metal ETNs. Of all the industrial metals, copper (NYSEARCA:JJC) has the most direct uses as a pure substance. Zinc [LON:ZINC] , Nickel (NYSEARCA:JJN), and Tin (NYSEARCA:JJT) are also essential in many processes and alloys.

Rare earth metals have seen a huge spike in demand, but because exploration for new deposits of this type is in it's infancy, significant new supply may indeed come online in the near future.

The last way one can bet on the coming metal crunch is to buy a diversified group of metal miners. There are several ETFs that track the mining companies including XME (US companies), EMT (Emerging market companies), TSE: CMW (Global), and the CRBI (Global). This will allow you to reap dividends from companies that have relatively low P/E when compared to other sectors.

In any case, it looks like metals will be a very lucrative business to be in for a long time to come.

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

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here