Saturday, January 16, 2010

Why commodities move the way they do

If we were to pick two words to describe the gist of Jim Rogers book Hot Commodities, it has to be demand and supply.
His explanation for ‘commodities' as an investment, rings a very simple tone that should resonate with any investor looking for an answer as to why his investments move the way they do.
The book is sprinkled with several historical anecdotes and simple intros to the modus operandi of a variety of industries including oil, gold, coffee and sugar.
The book also provides a glimpse into Mr Rogers' thought-process, one which has made him one of the world's most recognised commodities investors.
Jim Rogers is famous for co-founding the Quantum Fund with George Soros.
The fund racked up a index-whopping 4,200 per cent gain in the 1970s at the end of which he retired and focussed on his commodity holdings and travelling, the latter arguably providing an edge in his early insights into several markets such as China and India.
Rogers has dipped into politics, geology, economics, psychology and history, among other disciplines, to giving a well-rounded, albeit sometimes polarised, view on why commodities move the way they do. Here is a summary of what Rogers says:
If stock investors may have to pore over ratios that are numerous enough to fill a dictionary, commodity investors too have to understand numbers. Like the equity markets, a variety of opinions go into arriving at a market price, providing considerable scope for mis-pricing due to pessimism or optimism.
Unlike equity markets, however, the data pertaining to commodities isn't easy to manipulate. Once understood, commodities as an asset class are no riskier than stocks.


The range of commodities and the complexity of the contracts one trades them with can be astounding. Ranging from various grades of iron ore to varieties of crude oil and dairy products, commodity contracts could virtually cover everything we consume.
Figuring out the moorings of demand and supply are crucial to avoid being carried away by the bull and bear price runs of commodities, which can be protracted and painful on the wallet. The dot-com equity bull market of the late 1990s also marked historic lows for a variety of commodities, including oil and gold. However, Rogers made an early call that commodities were poised for a bull market.
By simply linking the fact that no major oil finds were made over the last 30 years and the rapidly growing demand from Asia, Rogers managed to capitalise on crude oil's big move from the sub-20 dollar prices of late nineties to levels of over 140 dollars in 2008. Lax demand with the sub-prime crisis and the subsequent loss of consumer confidence sent oil plummeting back to the sub-40 levels.
Supply considerations including OPEC, a consortium of oil-producing nations, which adjust production and geo-political factors such as a moody-Venezeulan dictator and unrest in Nigeria have all sent oil riding back close to the current 80 dollar mark. At the end of the day, while politics and trading may shape prices in the short term, the big picture of how much oil is left under the ground, how much time and money it takes to get new capacity up and the race to secure supplies between nations is going to shape long-term returns.
Trends in alternative fuel sources such as tar sands, fuel-cells and renewable energy may also decide the future of the crude oil market.
When Rogers explains to you the expense associated with extracting crude oil from Canadian Tar sands or the sheer inefficiency and controversies surrounding the oil business in regions of the former Soviet Union, you know they are his opinions and there is a chance the scenario could change very quickly. But rest assured, when they do change, having an approach like the one Rogers advocates — having your ears to the ground and your sights on the output numbers — will give you a perspective before news of the price move is actually flashed on a news channel.
Being aware of one Mr King Hubbert's 1956 much ridiculed prediction that the then dominant American oil industry output was set to decline, enables you to cast a critical eye on claims made by several oil-producing nations on how large their reserves are.

Inverse relationships

Rogers' ideas such as inverse relationships between commodity markets and equity markets may not be hard and fast rules. However, they do give you a starting point to figure out links between various companies or commodities which may be poised for good returns.
By digging into the science of commodities much like the fundamentals of business, you gain an edge over the person fixating on the price or trying to outguess a trader's next move. By giving a good argument for the term investing in commodities instead of the more popular ‘trading' or ‘speculating' in commodities, Jim Rogers gives you a framework to tilt the odds of a commodities bet in your favour.

Source: Hindu Business Line