The broad commodity markets have been uneventful over the past two years. While some commodities have outperformed others, and windows of volatility may have been good for trading, the broad commodity markets ended up down in both 2011 and 2012. That being said, commodities should be attractive from a long-term perspective. The reasons are straightforward. Natural resources like oil, metals, and even livestock and agriculture are ultimately finite. At the same time, global demand increases every year. That much is clear.
What may be less obvious is the extent to which global consumption imbalances exist. Using oil as an example, the United States has a population of about 315 million people and consumes almost 7 billion barrels of oil per year. That equals just over 22 barrels per person annually. Meanwhile, China has a population of over 1.3 billion and consumes about 3.4 billion barrels of oil per year. That equals about 2.5 barrels per person. On average, Americans consume about 9 times as much oil as the Chinese. The fact is that the US consumes more oil per year than China, India, and Russia combined. This happens despite the fact that the overall population of China, India, and Russia is more than 8 times larger than that of the US. Figure 1 shows a summary of these disproportionate population and oil consumption numbers.
This is an extreme imbalance, and it is only a matter of time before the billions of people in developing countries become developed enough to demand their own 22 barrels of oil. The same is true for just about every other commodity. Given our fixed supply of natural resources, it is reasonable to assume that long-term commodity prices have significant upside potential. Worth noting, countries like China that used to love accumulating US dollar reserves have gradually cut back their holdings in favor of hard assets like oil and gold. If this trend gains popularity, it could accelerate price increases and even push them higher. That brings us our final point about commodities – prices.
Commodities can be difficult to price and value. This is because, unlike other assets, commodities have virtually no cash flows (i.e. interest, dividends, earnings, rent, etc.). That renders standard pricing and valuation tools (like discounted cash flow analysis) ineffective. Since intrinsic value is hard to estimate, fair value is often replaced with whatever price the next greater fool is willing to pay. This is one of the reasons that commodity markets can be very volatile and highly speculative. Fortunately, by using some simple assumptions we can come up with a reasonably sound estimate of fair value.
For example, assuming commodity supplies are finite and that demand for them will continue, we can expect commodity prices to at least keep pace with inflation over time (all else being equal). Of course, there are plenty of variables we have not considered, however, at the most basic level this should make sense. With that being said, take a look at Figure 2 below. It plots the real price (inflation adjusted price) of the DJ UBS Commodity Index over the past twenty years (in blue). Also included, is a trend line (in red) which plots expected real prices based on a 2% inflation rate. Long-term average inflation is closer to 3% or 4%, however, 2% is a reasonable average for the period considered.
Notice that while commodity prices had wide swings, they generally reverted around the trend line. We can think of the trend line as being the “fair value when all else is equal” threshold. Looking at the chart, it appears that commodity prices have recently dipped below fair value. To be clear, I think there is more downside from here due to the huge run-up that ended in 2008 – corrections tend to overcorrect. Still, two important points remain. First, prices are not high relative to where they were in 2007. Second, prices have breached a key threshold. At this point, it’s worth watching commodities closely. Trying to time a bottom is futile, but I think it makes sense to build a long-term position over time, buying on weakness.
Victor K. Lai, CFA
This blog is for informational purposes only. Nothing on this blog constitutes investment, tax, or legal advice. You should conduct proper due diligence and / or consult with professional advisers before taking any investment action.
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