Wednesday, July 13, 2011

The Commodity Assumption

There appears to be a prevailing market belief that commodity prices can only rise over the next several years. Inelastic demand from developed countries and unremitting demand growth from emerging markets are the most commonly cited reasons for this. As a result, investors are putting companies in this space on a pedestal, taking recent earnings growth of such firms for granted. Value investors must be careful not to get caught up in this game of rising commodity prices leading to rising earnings expectations; it can result in portfolio disaster.

One commodity in particular that well-represents the general consensus of that of commodity bulls is the oil market. Demand for oil is indeed inelastic in the short-term; one cannot design a more fuel-efficient car overnight, and nor does one upgrade his car overnight in response to a change in the price of oil. But over the long-term, the market for oil is like any other market in that it responds to price signals.

To see this in action, consider US oil imports over the last several years (click to enlarge):

In the chart above, it is clear that oil consumers react to high oil prices, it just takes them time. In both the early 80's, and in the last five years or so, high oil prices resulted in down-trending consumption in the ensuing years. Though it may be argued that part of the reason for the fall in consumption is thanks to the recession, it is worth noting that US GDP today is around 50% higher than it was in the mid to late 1990's, which was the last time the US was importing so little oil according to the chart.

Of course, making up for this demand are emerging markets like China and India, where economic growth is strong. Despite this, however, global "proved" oil reserves are actually increasing despite these draw-downs.

But what happens if these emerging markets have not conquered the business cycle? If growth slows or a recession is experienced in these economic behemoths, expect there to be a lot of oil for sale without a lot of takers.

Furthermore, as oil prices currently remain high, a number of new technologies are about to make it possible to consume less oil without lowering our cushy living standards. For example, hybrids and electric vehicles continue to improve in fuel efficiency and price. Since transportation fuels make up more than 70% of oil consumption, expect technology changes in this space to meaningfully reduce oil consumption in the coming years.

Though I am clearly a long-term bear on oil, the end result of all this may very well be that oil (and other commodity) prices will continue to rise as they have over the last decade. But hopefully it is clear that whether this will happen or not is not clear at all. The future is uncertain, and considering the cyclical nature of this industry, it would be very dangerous to extrapolate the last ten years into the future.

For example, can you really predict what an oil services firm will earn five or ten years from now with any reasonable standard of deviation? Probably not. But if you pay 10 times earnings for such a company, you are implicitly saying that you can.

Commodity prices are volatile and difficult to predict over the next week, let alone over the next few years. As such, it is best for investors to stay away. Why place a bet when the odds are uncertain? Place your bets when the odds are in your favour.


Anonymous said...

I completely disagree. Commodities are generally easier to understand and invest in than stocks. Companies earnings and cash flows are very uncertain also. Apparently RIMs eps and cash flow cannot be predicted even a couple months out! Plus you have to know mgmt won't do anything stupid or what competition might arise that you cannot envision. Commodities just require supply/demand analysis. People who do the due dili in this space do very well. One doesn't always have to be long. If one just spent all of their time studying the corn or soybean market, they'd probably make a fortune. How long have you been bearish on oil? since 2003? of course you might be right eventually, but if you're wrong for 15 years thats not something to hang your hat on.

Anonymous said...

You are right in saying that oil prices are harder to predict. But the increasing demand from the emerging world points to higher oil prices in the future. But the conundrum for the value investor is the ability to buy low and sell high, which is very hard to duplicate over and over again. I believe the investment thesis behind buffet's purchase of BNSF is to capitalize on higher oil prices without the downside risk of oil price volatility.

Anonymous said...

One big reason for popularity that you haven't mentioned is the fear of currency devaluation for reasons not related to oil fundamentals.

Anonymous said...

The electricity that is used to charge electric vehicles is generated by oil burning power plants.

Anonymous said...

Anonymous from 7:44AM: How can supply and demand ever tell you the current price is correct? When gold costs $500/oz to pull out the ground, how are you so sure $1500 is the correct price? If demand will decrease by 5%, how much will the price change by?

While one cannot accurately predict a company's earnings, one can look at the value of its assets and make conservative assumptions about earnings.

Please show me how you can calculate the correct price for any commodity.

Zachary said...

Once again I don't think reserves are going up from discoveries except in remote and costly locales. Mostly, they are going up because marginal deposits are being reclassified as reserves as a result of rising prices.

Anonymous said...

In response to one of the anonymous commenters: the electricity used to drive electric cars usually does NOT come from burning petroleum (although it depends on your utility company). The may getting powered indirectly by fossil fuels (including natural gas or coal) along with other source, but the point is really that they can get their energy from any source of electricity.

If you're an investor, this means that demand for gasoline (and thus petroleum) would become much more elastic if/when electric cars become more prominent. In other words, petroleum may have to compete more directly with other types of energy when fewer people have to put it directly into their car in order for their car to work.