As the current secular bull market in commodities enters the next phase of its life, it is worth reflecting on the different ways to play the market. There are, in essence, 3 distinct possibilities to enhance your portfolio with commodities plays: 1) Invest in futures contracts, 2) invest in companies that are involved with mining, energy, and agriculture, and 3) invest in the stock markets of commodity based countries.
If we count 1999 as the start of the bull market in this commodities cycle, all three possibilites would have beaten the S&P500 hands down. However, all three have distinct advantages and disadvantages associated with it. Let us examine the concept of investing in companies versus the futures market.
Recently, two professors at Ivy League institutions studied the benefits of investing in futures contracts versus buying companies involved with the commodity industries. What Dr. Rouwenhorst and Dr. Gorton found was that investing in the futures contracts themselves were three times more profitable than investing in the average commodity company. While as a general rule, this may be true, a good investor must understand the exceptions to these rules. Let us take the example of the gold market since 2001, when gold bottomed around $350/oz. Since that time, an unleveraged investor in the gold futures market would have earned a 90% return in 5 years. Better than the S&P500 for sure, but paltry returns compared to investing in gold stocks. During that time, the XAU gold stock index is up over 300%. And if you count only the unhedged producers, the HUI index, their returns have been nearly 1000% in just 5 years time!
Seemingly, this information contradicts the conclusion obtained by Rouwenhorst and Gorton's study. But rather than disproving their conclusion, The Commodity Investor believes this is one of the major exceptions to the rule. Take company X, which produces gold at a cost of $100/oz and sells it at $101/oz, earning a profit of $1/oz. If the price of gold simply rises $1/oz to $102/oz, investors in gold futures only gained about 1%. But company X now earns $2/oz, doubling their profit, and likely gaining 100% on the value of their stock. Hence in the early stages of a bull market, investors in commodity companies are likely to have greater returns then investors in the futures market. This explains why, up until now at least, mining companies have outperformed other investments. As the bull market matures however, this is likely to change. If company X is now selling gold at $1000/oz, thus making a profit of $900, it will take much larger moves in the price of gold for them to double their earnings. As we enter the second leg of the bull market, The Commodity Investor believes investors in futures contracts will begin to see higher returns than commodity companies. Unless of course, the investor can find the second exception to the rule.
Exploration companies are the proverbial canary in the coal mine in the entire process. Pick the right one, and an investor can retire in style. Pick any of the thousands which will end up fruitless, and many will lose all their value. Thus, picking exploration companies is the most time intensive of all the possibilities. For those who have the time and knowledge to assess these companies and who have lady luck on their side, their outcomes could be extremely profitable. For those who lack the time, the knowledge of geology, or who are cursed in investing, this could prove to be disastrous. The Commodity Investor recommends most investors stick with futures contracts for the next stage of the bull market. Or at the very least, read the articles on www.thecommodityinvestor.com for information on the most promising exploration and development companies.
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