Invest In Commodities – and Keep Your Shirt

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Recently,
at a party in New York, I mentioned that I had been talking to various
groups in the United States and Europe about investment opportunities
in commodities. Before I could get out one more word, a woman interrupted
me. “Commodities!” she exclaimed, with the kind of incredulity in
her voice that Manhattanites reserve for people moving to Los Angeles.
“But my brother invested in pork bellies and lost his shirt. And
he’s an economist!”

Everyone seems
to have a relative who took a beating in the commodities market,
and this fact (or fiction) is considered sufficient reason that
no sane person would ever risk playing around with such dangerous
things. That this particular victim was also a professional economist
makes the warning seem even more ominous. I, however, couldn’t help
laughing.

Billions of
dollars are invested in commodities every day. Without the commodity
futures markets, many of the things that you depend on in life,
from that first cup of coffee in the morning to the aluminum in
your storm door to the wool in your new suit, would be either scarce
or nonexistent, and certainly more expensive.

To be sure,
investing in anything has its risks. A lot of Ph.D.s in economics
lost money in the dot-com debacle, too. (On New Year’s Day in 2002,
the Wall Street Journal published its annual survey of economists
for the upcoming year. Although the economy had been sagging for
almost a year, not one of the 55 economists thought that it was
in for a serious decline. One hundred percent were wrong – and proof
that Ph.D. economists are as prone to mob psychology as the rest
of us.)

There are several
other bromides out there for why “ordinary people” should not invest
in commodities, and I want to lay these myths to rest, once and
for all, so that we can get on with the more interesting business
of how you can begin to make some money investing in the next-generation
asset class.

About That
Relative of Yours Who Got Wiped Out – He was inexperienced. You
can learn. Most likely, he was buying on thin margin – the minimum
deposit a broker requires to take a position in a particular commodity – and when the market went against him he lost big-time.

Here’s how
it happens: Like stocks, commodities can be bought on margin. Unlike
stocks, however, where by law you have to put up at least 50 percent
of the price of the shares, the margins on commodities can be even
lower than 5 percent: You can buy $100 worth of soybeans for $5.
If soybeans go up to $105, you’ve doubled your money. Beautiful.
But if soybeans go down $5, you’re wiped out. Not so beautiful.

Experienced,
smart speculators can make tons of money buying on margin. They
also know that they can lose tons, too. But they can usually afford
it. Your relative was in over his head. If he had bought $100 worth
of soybeans in the same way that he can buy IBM – for $100 (or maybe
even $50) – he would be happy when it goes up $5 and a lot less
sad should it go down $5.

“But What About
Technology?”

Whenever I
mention commodities in public, someone always points out that we
now live in a high-tech world where natural resources will never
be as valuable as they were when we had a smokestack economy. But
if you read your history you’ll discover that technological advances
are as old as history itself: The introduction of the sleek and
beautiful Yankee clipper ship dazzled the world in the mid-nineteenth
century, loaded with cargo, sailing down the trade winds at 20 knots
and more, averaging more than 400
miles in 24 hours and able to make it from U.S. ports around Cape
Horn to Hong Kong in 80 days; within a decade, the clippers had
been replaced by the steamship, no faster but not dependent on wind
power; and before long the next big thing in transport had taken
over, the railroad, which, of course, was the original Internet
– and prices in commodities still went up.

In the twentieth
century came electricity, the telephone, and radio (three more Internets)
and then television (a fourth Internet). There was also the automobile,
the airplane, the semiconductor – and in the midst of all of these
truly revolutionary technological breakthroughs came periodic, multiyear
commodity bull markets.

Even a revolutionary
technological breakthrough in a particular commodity-related industry
will not necessarily lower prices. For decades, drilling below 5,000
feet or offshore was virtually impossible. Then in the 1960s the
Hughes diamond drill bit was invented and an explosion of technological
advances in oil drilling and exploration followed. Drilling efficiency – and oil deposits – were available that had been unthinkable before
this technological breakthrough. Soon there were wells 25,000 feet
deep and offshore oilrigs multiplied around the world. Yet oil prices
went up more than 1,000 percent in the 15-year period between 1965
and 1980.

When the supply
and demand in raw materials is seriously out of whack, the emergence
of new technology will not necessarily restore the balance quickly.
To be sure, changes in technology, for example, have made the economy
less dependent on oil. But we still use plenty of it, and whenever
there isn’t enough prices will rise. Computers or robots may do
amazing things, but they cannot find oil or copper where there is
none or make sugar, cotton, coffee, or livestock grow faster than
nature allows. We can put in orders all day long on our computers
for lead, but all that Internet technology will be in vain if there
are no new lead mines. Technology can neither feed us nor keep us
warm, and the demand for commodities will never disappear.

“But Isn’t
It Only Speculation and the Lower Dollar That Are Inflating Prices?”

Certainly,
speculators who jump in and out of commodities can push up prices.
And the dollar has been a pale remnant of itself – down against
the euro almost 40 percent from the beginning of 2002 until the
start of 2004 and at a three-year low against the Japanese
yen. Since commodities are traded in dollars, a weak dollar will
make prices appear higher. Crude oil rose 64 percent in dollars
over that two-year period, but only 16 percent in euros.

But the dollar
strengthened in the spring of 2004, and a funny thing happened:
Commodity prices kept going up. The global recovery, particularly
in Asia, was for real. We are now watching a fundamental structural
shift in commodities markets, and it is called “supply” – and “China,”
a nation that will be consuming extraordinary supplies of all kinds
of commodities for years to come. I will explain why in more detail
in a later chapter. For now, however, here’s the story: dwindling
supplies and increasing demand.

And the dollar
has nothing to do with either. Let me also remind you of the 1970s,
when inflation in the U.S. was about 10 percent a year, the dollar
wasn’t buying anywhere near what it used to, and the economy was
in a major recession – and commodity prices kept rising. We’re
talking another long-term bull market in commodities, and neither
speculators nor a weak dollar can make that happen. Speculators
can have a short-term effect only. For example, if they drive up
the price of oil artificially, oil producers with excess supplies
will gleefully dump their oil on the market driving the price back
down. Both the dollar and speculation can have a marginal effect,
but the market itself is bigger than they are.

“But My Stock
Broker Tells Me That Investing in Commodities Is Risky.”

Tell me again
about all those Cisco shares you owned back in 2000. Or JDS Uniphase,
or Global Crossing? So many risky stocks made the turning of the
new millennium a not so happy time for many, who watched their portfolios
evaporate.

If you do your
homework and remain rational and responsible, you can invest in
commodities with perhaps less risk than playing the stock market.
You don’t need me to emphasize that investing in anything is a risky
business. But let me point out something that you might not have
realized: There has been more volatility in the NASDAQ in recent
years than in any commodities index. Cisco, Yahoo!, and even Microsoft
have been much more volatile than soybeans, sugar, or metals. Compared
with the risk record of most tech stocks, commodities look safe
enough to be part of any organization’s “widows and orphans fund.”

According to
“Facts and Fantasies About Commodity Futures,” the Yale study cited
in the first chapter, the “high risk” of investing in commodities
does not square with the facts. Comparing returns for stocks, commodities,
and bonds between 1959 and 2004, the authors found that the average
annual return on their commodities index “has been comparable to
the return on the SP500.” The returns from commodities and the S&P
500 beat those from corporate bonds during that same period. They
found that the volatility of the commodities futures under analysis
was slightly below that of the stock in the S&P 500. They also
found evidence that “equities have more downside risk relative to
commodities.”

How about buying
shares in commodity-producing companies instead of buying commodities
themselves? That’s about as far as some financial advisers will
go in the direction of commodities. But investing in commodity-producing
companies can turn out to be an even riskier bet than sticking with
buying the things outright. Supply and demand will move the price
of copper, for instance, while the share prices of Phelps Dodge,
the world’s largest publicly traded copper company, can depend on
such less predictable factors as the overall condition of the stock
market, the company’s balance sheet, its executive team, labor problems,
environmental issues, and so on. Oil skyrocketed in the 1970s, but
some oil stocks did not do that well. The Yale study found that
investing in commodities companies is not necessarily a substitute
for commodities futures. The authors found that from 1962 to 2003,
“the cumulative performance of futures has been triple the cumulative
performance of ‘matching’ equities.”

And let me
remind you of one more important difference between commodities
and stocks: Commodities cannot go to zero, while shares in Enron
can (and did).

November
23, 2006

Jim
Rogers has taught finance at Columbia University’s business school
and is a media commentator worldwide. He is the author of Adventure
Capitalist
and Investment
Biker
. See his website.
He lives in New York City with his wife, Paige Parker, and their
18-month-old daughter, who is learning Chinese and owns commodities
but no stocks or bonds. This article originally appeared in The
Daily Reckoning and is reprinted with permission.

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