Commodities are known to be a very volatile asset class with the potential for large gains and losses.
In the past, they were sometimes referred to as ‘widow makers’ given the catastrophic losses suffered. Little has changed, they remain as risky as ever and this is borne out by declines across the board over the last year. Data for a selection of commodities highlight these declines: Decline
Oil 48% Gold 17% Copper 37% Corn 8% Sugar 42% Coffee 40%
The strengthening US dollar and slowing Chinese economy are touted as the main reasons for the falling prices. A stronger dollar makes commodities less affordable in many markets which undermines demand. At the same time, Chinese demand for commodities, particularly metals and construction materials was waning. This had a big impact as China was a huge consumer of a wide range of commodities. For example, in the space of 5 years (2005 -2010), China consumed more cement than the United States used throughout the whole of the twentieth century.
The share prices of companies involved in the production or extraction of commodities have also suffered. This can be clearly seen when one looks at the annual share price declines of Exchange Traded Funds (ETFs ) that invest in companies in the oil, mining and agricultural sectors.
ETF Symbol % decline Global Oil IXC 28% Global Mining PICK 44% Global Agriculture VEGI 4%
So there has really been nowhere to hide for the investor bullish on commodities. One can blame the strong dollar and China but the simple fact is that supply exceeds demand and prices have faltered.
When will prices recover? As the saying goes ‘low prices are the cure for low prices’. When prices are depressed, investment in new supply ceases and high-cost production operations are shut down leading to a fall in supply. At the same time, low prices make the commodity more affordable leading to an increase in demand. Over time, supply continues to decline and demand grows until eventually demand exceeds supply; prompting prices to recover. It can take years for this to occur as it takes time to terminate exploration projects, decommission mines or change crops planted.
For the long term investor, commodity related stocks are now ‘on sale’ with prices in the miners starting to look particularly interesting. It may well be that they will be discounted further so there is no need to rush to buy. A gradual build up of a position is the way to go as it will take time for demand to catch up with supply. In the meantime, those advanced economies who are big consumers rather than producers of commodities should do well – Europe and Japan look like the main beneficiaries.