How to value commodities?

[Lucky C]

Anyone know of any good resources out there online, or in book form, on commodity valuation? If I want to buy a commodity ETF, how do I know if the underlying commodities are currently a good deal?

Of course there is always a chance for commodities to spike up during a crisis, and that's a big reason why they have historically made a good 10-20% diversified portfolio slice. However, I would ideally only want to buy them when it's likely they would appreciate in price, even if the economy is running smoothly.

Or am I asking the wrong question... if goods are made from commodities and the change in price of goods = inflation, is the real return of a diversified commodity index simply 0% over the long term? Even if that is the case, can we expect to earn real returns over the long run from buying only the cheapest commodities and avoiding the overpriced ones, or are commodity prices too hard to reliably predict even over a long time horizon?

[Dragline]

Well, there's a lot of questions. First, whether you are talking about a basket of them or individual ones. Every one of those markets are different and peculiar in their own way. Some of them like coffee and orange juice are extremely subject to weather.

But even if you want to buy a basket, they are extremely tricky and unpredictable. I think the only reason to own them in basket form (and I do in a way) is to diversify a much larger portfolio, because they are like that little girl with the curl in the middle of her forehead. "When she was good, she was very very good, and when she was bad she was horrid."

[Lucky C]

To narrow down the question: Is there a "Security Analysis" or "The Intelligent Investor" equivalent for petroleum commodities, and/or precious metals, and/or agricultural commodities? To at least learn more about commodity markets even if they are unpredictable?

[JL13]

Read Buffett's essay on gold before digging any deeper on commodities. It sufficiently turned me off on the entire concept forever. You may decide otherwise, but it's a necessary read either way.

http://fortune.com/2012/02/09/warren-bu ... and-bonds/

"You can fondle the cube, but it will not respond."

[Dragline]

To narrow down the question: Is there a "Security Analysis" or "The Intelligent Investor" equivalent for petroleum commodities, and/or precious metals, and/or agricultural commodities? To at least learn more about commodity markets even if they are unpredictable?

Not that I am aware of -- at least not that I would trust. Most of what is out there is charlatans trying to sell you something. My experience in trading futures back in the day (1990s) was that the oil market was completely impenetrable as to what was going on and the metals markets were completely uncertain. Agricultural markets were usually a little more predictable, but punctuated by occasional and extreme dislocations.

Read/listen to anything by Jim Rogers you can find on this subject, though.

[jacob]

The word "currently" throws me and I don't have any book recommendations.

For relative valuations, marginal extraction costs are a good starting point. They can vary widely. Compare e.g. Saudi Arabian gas with shale gas. Having that isn't the end of the story since different companies will be using different levels of debt leverage, so a low cost producer can suffer more if they have higher debt.

As for absolute valuations ... I think we're talking "a glass of water for thirsty man in the desert" stuff. However, these considerations are worthwhile in a systemic sense. For example, knowing that Egyptians commits 40% of their budget to food, it stands to reason that the coupling becomes rather stiff should food (wheat) prices double resulting in significant consequences. These can either be market based or revolution based in the stronger sense... which happened in that area. Conversely, Americans commit 20% of their budget to food and a lot of the calories are wasted by turning it into meat. Hence a doubling of prices simple resulted in cattle owners prematurely slaughtering their livestock thus resulting in cheaper meat prices. A 10x in food prices would probably have had Americans shooting at each other, just like the ME.

The other issue in valuation is value relative to what? Money? One wonders why the world economy is not taking off like a rocket with sub $50 oil? Perhaps because that paper money doesn't have the same value in terms or churning out commodities as we are accustomed too. Apparently if the oil prices go higher, shale companies start going bankrupt. This is a bit analogous to having a parachute market for falling economists --- whenever they try to write a bigger check they find that the supply "mysteriously" vanishes until a few more craters on the ground.

[Tyler9000]

Read Buffett's essay on gold before digging any deeper on commodities. It sufficiently turned me off on the entire concept forever.

Every time Buffet trashes gold and other commodities, I'm reminded of the time he bought 130 million ounces of silver and cornered over a third of the world's supply.

[Lucky C]

Hey Tyler, with your Start Date Sensitivity tool we can see that Commodities have never had a worse 10 year span in your data set than 2006-2015. Not surprising seeing as how poorly they've done up until the start of this year. So even without a decent way to "value" commodities, from a contrarian/reversion perspective 2016 looks like it could be a great year to buy commodities funds and hold them for a decade or so!

[JL13]

Every time Buffet trashes gold and other commodities, I'm reminded of the time he bought 130 million ounces of silver and cornered over a third of the world's supply.

IIRC that was because the market price dropped below the industrial value of silver. It was more of an inventory purchase.

[toto123]

Before digging into valuation, I'd start looking at what instruments you can trade to access the commodity markets. Futures are IMO your best shot. I'm not sure how liquid are ETFs/ETNs these days, but if all they do is roll into the December contract once a year I'd rather hold futures anyway. Now if you decide to go with futures, pay attention to the term-structure. For example, recently crude oil was apparently "cheap" yet the front month's roll yield was expensive. I seem to recall that the annualized roll yield (cost of holding the front month assuming all else remain equal) was in the double digits.

A rule-based methodology to define cheapness from futures prices can be:
- select a market (eg, crude oil, coffee...)
- build a continuous contract from raw prices that represents what you would trade (just splice individual contracts together by rolling from/into contracts)
- divide prices by the point-in-time CPI index to get comparable prices across time
- calculate a rolling or an expanding average of prices
- the proxy for cheapness is the ratio of CPI-adjusted prices/historical average

[BlueNote]

Most valuations use a discounted cash flow formula. Most, if not all, commodities do not throw off cash flows and therefore cannot be valued in the academic sense. Their value is what the market is willing to pay at that moment based on supply and demand. Therefore value = price.

That makes investing in raw commodities inherently speculative and unique. There's a good case to be made that commodities will never provide a long term return higher then inflation. You can buy safe bonds that guarantee the same $0 real return or better over any term , these can be valued easily through DCF.

I have read that strategies like mean reversion and trending/momentum have worked well in the commodity market for some people (google Paul Tudor Jones for example).

There's also roll yields as previously mentioned which I have read a little about but I'm no expert. I think that one could apply a DCF to futures with roll yields.

I've never heard of anyone achieving and sustaining an early retirement by investing in commodities but there are a ton who have done so with traditional stock/bond/real estate type strategies.

[toto123]

Not exactly about valuation, but IASG.com provides a free access to a large database of track records from a variety of CTAs (from super small to some of the largest funds in terms of AUM in the industry). Some of them have over 30 years of actual trading performance in the commodity space (Dunn Capital Management & Tactical Investment Management come to mind, with net CAGR around 15%). It's a great place to find out what (some) people have really achieved over the years trading commodity futures and futures options.