Commodities: Future ETFs Worth Investing In

by: Todd Sullivan November 20, 2008 | about stocks: DBC / USO    
Todd Sullivan

Todd Sullivan

About this author: Subscription newsletter:
Become a Contributor Submit an Article
  • Font Size:
  • Print

I have been getting a bunch of emails lately about commodities. The following excerpt from Roubini's RGE Monitor was emailed to me yesterday:

Today we turn our attention to commodities, which have been badly battered by the global financial crisis, deleveraging and a worsening economic outlook, with commodity indices having lost 50% of their value since the July peak. With the G10 in recession and many emerging economies slowing sharply, further demand destruction is likely, and it may continue to outpace production cuts. Once the price adjustment filters through to producers, they may account for another source of slower aggregate output.

Despite the steep price declines so far, commodities as a group have only fallen halfway to their 2001-02 trough, meaning they may have farther to fall. Among individual commodities, those that grew the most expensive in the shortest period of time have suffered the sharpest and fastest price drops. In fact, some investors are pricing in a temporary drop in the price of oil below $30 per barrel, far below marginal production costs.

Metals and energy led recent declines, after breaching nominal and inflation-adjusted highs earlier this year. Agricultural commodities took smaller hits as their price climbs were not as excessive – their peak prices this year remained 2-3x below their inflation-adjusted highs in the 1970s. Only newsprint has yielded positive returns this year as of November but its resilience seems unsustainable in the medium-term. Across the commodities group, inventory buildup and falling demand creates conditions ripe for a continuing current bear market despite the fact that some commodities, such as oil, seem to have fallen below production costs.

WTI crude oil futures have fallen from a peak of $147/barrel in mid July to around $55/barrel, well below the 2007 average price. U.S. government data suggest that demand for oil products is about 6-7% lower than last year, with the sharpest declines in jet fuel. Despite the fact that gas prices are now hovering at $2 a gallon and energy costs fell 18% nationwide in October, demand continues to fall. Forecasts from the EIA and OPEC suggest that 2009 might mark make the largest contraction in oil demand in decades, despite the recent price correction. EM oil demand will be insufficient to offset growing declines in the OECD countries. For now, financial market trends and macro fundamentals might point in the same direction, towards weaker energy prices.

Yet, output cuts are reducing supply, removing the surplus reached earlier this year, even as OPEC’s surplus capacity increases. Non-OPEC supplies continue to disappoint. Oil production has declined in Russia, the North Sea and Mexico while new production in Kazakhstan and Brazil has yet to come on stream. In the short-term, it might take a major supply shock - say one that cuts off Iran’s oil supply or major output from the GCC - to really boost prices.

The Somali pirate hijacking of a Saudi tanker might raise transport costs as insurance premiums rise and routings increase, and reminds observers of the energy supply chain’s vulnerabilities, but it may not have a major affect on oil market fundamentals. OPEC’s willingness to comply with current (and future?) production cuts may be the most significant supply side factor. Yet the elevated cost of new oil supplies may lead to future supply crunches. Canada’s oil sands are woefully expensive at today’s prices and projects are being deferred if not canceled.

Lower global energy demand, in the face of increasing supply, is also affecting current and expected natural gas prices. EIA has noted that the Henry Hub natural gas spot price projection for 2009 has fallen from $8.17 per Mcf to $6.82. The front month contract price of natural gas on NYMEX has steadily declined and the futures curve has sloped downward. Demand for alternative energy tends to move inversely to fossil fuel prices, so the deep cuts in oil and coal prices could pose a headwind for alternative energy, unless counteracted by climate change mandates. Fortunately for producers, falling grain prices will help relieve the profit margin squeeze, even if the credit crunch impairs borrowing for expansion.



Oil (USO) was insane at $147 and may fall to equally insane levels on the lower end. Long term, the trend is definitely higher, but when it happens is another story. I think the food commodities will rally first as the demand for them will not fall nearly as much due to a global recession. Wheat, corn, soy beans should all continue to rise as demand does. Folks do not stop eating in a recession.

My feeling is the way to play this is the DBC (DBC). The DBC seeks to reflect the performance of the Deutsche Bank Liquid Commodity index. The fund will pursue its investment objective by investing in a portfolio of exchange-traded futures on the commodities comprising the index, or the index commodities. The index commodities are light, sweet crude oil, heating oil, aluminum, gold, corn and wheat.

I like it because all the components of the index are high demand items. I do not see how demand for any of them drops significantly for a prolonged time. That being said, supply of all is somewhat limited. There is only so much oil and land to grow corn and wheat. That bodes well for the fundamentals of it going forward.

Would I buy it now? Not yet. I think early next year might be the time to do it. There is a glut of items now and it will take time for production cuts to take the slack out of the system. That means short term price decreases..

Long term the story stands....short term...not so much.

Disclosure: None

Related Articles

This article has 4 comments:

  •  
    Nov 20 04:43 PM
    I cant think of a worse buy then commodities in deflation. Buy bonds. They may pay little but will pay even less interest in the future.
    Reply | Link to Comment
  •  
    Nov 21 10:26 AM
    I think its worth monitoring these commodity ETFs. Even with chronic asset deflation, some market sectors can easily inflate. Oil (the premier fossil fuel) is a good candidate because its getting increasing expensive to dig out of the ground, and since energy consumption is tied to "the good life", it seems reasonable that the world will always be striving to consume more and more.
    Reply | Link to Comment
  •  
    Nov 25 01:10 AM
    When the people controlling the monetary system warn you of deflation and use that as an excuse to PROMISE they will drive inflation instead - you better listen up - inflation is what you will get and you'll get plenty of it. Commodities might be a good area to keep an eye on.
    Reply | Link to Comment
  •  
    Nov 25 01:24 PM
    You forgot to mention in this article that there are numerous commodity ETFs that SHORT commodities. There are many of them, and I won't name them here. I have written about several on my ETF blog. Thus, investors can benefit financially from the decline in commodity prices and demand as well. There is also one that takes both long and short positions in a single ETF. It is the Elements Long & Short commodity ETN, and the symbol is LSC. LSC has continued to make money for me even while commodity prices have declined by as much as 50% over the past 4 months.
    Reply | Link to Comment
More Comments on USO ยป
Top Rated Comment Streams:

Numbers are net rating-

See all Top 100 »
More by Todd Sullivan

Investment Resources
Money Management
Research
Seeking Alpha provides these ads as a service to its leading contributors
Articles on related themes
Long Ideas
Commodities
Oil Price
Commodity ETFs