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Not all Commodities are Treated Equal (Part 1)

Commodities / Resources Investing Feb 19, 2009 - 02:06 PM GMT

By: Oxbury_Research

Commodities Best Financial Markets Analysis ArticleI wouldn't be letting the cat out of the bag if I mentioned that I'm a commodity bull in both the near and long terms. It's no secret as I've spent a number of issues of Bourbon and Bayonets writing on the driving fundamentals behind resource markets. That's not what I'm here to do today and if you'd like to hear some of the market commentaries refer to prior articles. Identifying the fundamentals is one thing. Investing to profit is another. Regardless of your investment medium, there are a number of different strategies and notions to keep in mind in playing the rest of this commodity bull run.


Call it what you want: commodity, tangible asset, or raw resources. Across the board, I believe that if we eat it, build with it, or heat our homes with it, it's going to rise in price. If someone (like me) is a commodity bull they essentially believe that monetary inflation is going to outweigh the deflationary effects of a global recession. In my opinion, “outweigh” is an understatement, but it does speak to the notion that the underlying fundamentals of the commodities market are pulling in opposite directions.

With that in mind, it would be beneficial to expose your portfolio to the commodities that have the most exposure to the bullish fundamentals and the least exposure to the bearish ones. All commodities are susceptible to both monetary inflation and global supply/demand fundamentals. It's just a question of, to what extent does the underlying fundamental affect price.

Cyclicality Decides Which Commodities will Shine

Gold is a good example of a commodity that is used mostly for monetary means as a medium of exchange and store of value. Gold's cousin silver on the other hand, has a host of industrial and commercial uses that make up its demand; therefore, silver is more cyclical than gold. Comparing the two, gold's monetary uses accounts for about 30% of demand (WGC-Gold Demand Trends), while silver's monetary uses is only 7% of aggregate demand (Silver Institute-World Silver Supply and Demand). With that in mind, I expect gold to outperform silver going forward even though the historical price ratio is way out of whack. Be careful of these historic ratios. Just because something is different than it has been over the last couple of decades does not mean it will converge back. I'm all for reversion to the mean, but this period may redefine certain means. So personally, I prefer a naked long gold position over a naked long silver position. If a naked position is too much risk for your taste, you might consider a long gold short silver position. Take your time in setting these up. Accumulate your position when the ratio is weak.

The agricultural sector is another segment of the commodities markets to look at. The agricultural commodities used for general consumption around the world are significantly less cyclical than industrial metals or energy. Simply put, people have to eat. Even within the agricultural sector there are commodities that are less cyclical than others. Corn for example doesn't see its demand fluctuate very much with changes in global GDP. Coffee on the other hand is a different story. Think about it on the margin (marginal consumers). Coffee is a minor luxury good. It's an easy cost to cut (not for me) when paying the rent/mortgage and feeding the family come into question. Basically, it's a “really want” good and not a “really need” good. For that reason, it has a cyclical nature. Degree of cyclicality is relevant. Coffee is more cyclical than corn or beans, but it's still significantly less cycle than oil or copper. The agricultural sector is a good tool to use if you plan on taking advantage of the commodity bull market. A lower risk trade here would be a long corn/soy beans short coffee/orange juice.

[Note: If you use a long corn position you also give yourself exposure to energy market through bio-fuels. I don't care what your stance is on ethanol; it's here now and ethanol and gas prices have a strong correlation. Corn is a great way to give yourself cross sector exposure.]

Commodities for You

I could go on and break down these markets, but it's all about what you like and when you like it. If you like the fundamental need for energy sector, wait for governments to allocate funds and look into the copper and aluminum markets. If you're a peak oil person (I am indeed one of those people), then oil may be your cup of tea. Like I said, all commodities are not equal.

t's important to understand the fundamental discrepancies between commodities markets if you want to maximize returns on your capital. Using ETFs, futures, and options on futures, combined with strong patience and proper due diligence, is a great way to make some of the above mentioned trades, but I understand that that these vehicles aren't for everyone. Many investors/traders, myself included, use stocks of commodity producers to give themselves less leveraged (but still leveraged) exposure to commodity markets. We have a host of readers here at Bourbon & Bayonets who fall into that category. Just like commodity markets, commodity producers within their given sectors are not equal. The second part of this two part series will look into some of the important notions of commodity stocks that must be considered in order to maximize returns.

By Nicholas Jones
Analyst, Oxbury Research

Nick has spent several years researching and preparing for the ripsaws in today's commodities markets.  Through independent research on commodities markets and free-market macroeconomics, he brings a worldy understanding to all who participate in this particular financial climate.

Oxbury Research originally formed as an underground investment club, Oxbury Publishing is comprised of a wide variety of Wall Street professionals - from equity analysts to futures floor traders – all independent thinkers and all capital market veterans.

© 2009 Copyright Nicholas Jones / Oxbury Research - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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