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All About COMMODITIES
By TOM TAULLI
The McGraw-Hill Companies, Inc.Copyright © 2011The McGraw-Hill Companies, Inc.
All rights reserved.
Introduction to Commodities Investing
Look at the main drivers of commodities prices
Understand the benefits of investing in commodities
Discuss the risks
Commodities are pervasive throughout the world economy. Every day we buy food and energy. We drive our cars, which are made out of an assortment of metals and other materials. We live in homes and apartments, which are also made out of various commodities. Without these valuable materials, civilization would vanish. It's that simple.
On a global basis, commodities markets are massive and trade in trillions of dollars on a daily basis. There is also much diversity. For example, investors can invest in the following categories:
Agriculture: Includes corn, wheat, soybeans, cotton, sugar, cocoa, orange juice, coffee, and oats.
Livestock: Includes live cattle, feeder cattle, pork bellies, and lean hogs.
Precious metals: Includes gold, silver, and platinum.
Industrial metals: Includes copper, palladium, aluminum, tin, nickel, zinc, lead, and cobalt.
Energy: Includes crude oil, unleaded gasoline, natural gas, coal, heating oil, uranium, ethanol, and electric power.
There are also a variety of ways for investors to participate in these markets. For example, these include buying and selling futures and options. There are also exchange-traded funds (ETFs), mutual funds, hedge funds, and managed futures. And yes, you can even buy the physical commodity, such as gold or silver, and put the metals in a vault.
Over the past decade, there has been a major bull market in commodities. In fact, it has become a popular topic on cable business channels like CNBC and even mainstream websites. Perhaps one of the most interesting signs of the fervor is that even criminals are focusing on stealing commodities. For example, copper has seen a spike in thefts. After all, the high prices could mean substantial profits. It also helps that you cannot trace copper back to the source.
Criminals are stealing power lines and cooling pipes. Unfortunately, this poses serious problems to communities. Because of this, law enforcement agencies have been putting more resources into combating this new crime wave. Consider that a criminal was able to extract the copper from an irrigation system in Pinal County, Arizona. There was about $10 million in damages. The theft even ruined a harvest. In 2008, a report from Electrical Safety Foundation International (ESFI) listed over 50,000 incidents of copper theft in the United States. The total damages were $60 million.
But for investors, is this a classic sign that the commodities market is in a bubble and will peak soon? Perhaps, but the fact is that bull markets can easily last 15 to 20 years, and some commodities experts believe that the commodities markets are in a bullish "super cycle" that could last for several decades. If you don't believe this is possible just take a look at Table 1-1. It details the bull markets in commodities that have taken place since the beginning of the twentieth century.
During the first three periods, the biggest commodities bull market was actually during the Great Depression. Even during bad times, people still buy commodities. Also, because of the difficulties in raising capital, there were continued difficulties with entrepreneurs to find new sources of commodities (this also happened during the 2008–2009 global recession). In other words, a drop in supply could have a huge impact on prices.
Why consider the long trends? A key reason is the difficulty of extracting commodities. To understand this, let's take a look at an example. Suppose that copper prices have surged and are likely to increase for some time. To capitalize on this, you decide to start up a copper mine. To do so you will first need to explore for a large deposit. This requires sophisticated scientific equipment. It also probably means you will need to focus on areas of the world that are treacherous, in terms of the geography and politics. The exploration process can easily take several years. Assuming you find a rich deposit, you will then need to negotiate the copper rights and get the necessary governmental permits. To do this, you will likely need to raise a substantial amount of capital from investors. This process can take several years. After you lock up everything, you will then need to hire miners and purchase expensive equipment to extract the copper. It can take a year or two to get any substantial amount of the commodity.
As you can see, it takes a great deal of time to find new sources of commodities. Thus, price increases can last a long time because the supply will lag. But, when the supply hits the market, there can quickly be an overabundance. The excess could also last 10 to 20 years. But over this time, there will eventually be an underinvestment in the commodity and the supply will slowly contract, which will set the stage for the next bull market.
In the case of the current bull market, there are some major demand forces that are likely to keep prices robust. The main one includes the growth in emerging markets.
COMMODITIES IN BRIC COUNTRIES
The main players in emerging markets—Brazil, Russia, India, and China—are known collectively as the BRIC countries. Combined, these countries have 42 percent of the world's population and are responsible for about 23 percent of the world's output.
Brazil is a country that has had its share of turmoil. Until the mid-1980s, the government had military dictatorships and populist leaders. The country also experienced severe bouts of inflation and economic slumps. But over the past decade, Brazil has made great strides. Then again, the country has rich natural resources and a large workforce.
Because of its tropical climate, it is possible to grow crops year-round in Brazil. Some of the key crops include coffee and sugarcane.
Oil is another big commodity. Over the years, there have been major discoveries off its shores. Brazil also has the second-largest mining company in the world, which is Vale. It produces nickel, coal, aluminum, and other commodities.
The gross domestic product (GDP) of Brazil is roughly $2.2 trillion and the economy grew by about 7.5 percent in 2010. Because of the strength of its economy, the country has been a popular destination for foreign investment.
Since communism was abolished in the early 1990s, Russia has undergone extreme changes. During 1998, the country defaulted on its foreign debt. The result was an economic plunge. Despite all this, Russia remains a major power. Besides being a big producer of oil and natural gas, the country also has large deposits of iron ore, bauxite, and gold.
The GDP is $2.2 trillion and the economy grew by 3.8 percent in 2010. However, there are still big challenges. Corruption is a big problem in Russia. Moreover, Russia has had difficulty in attracting foreign capital because of the uncertainty regarding property rights.
Because it was originally under British rule, India has a Western legal system and other institutions. This certainly makes international trade easier. But since gaining independence in 1947, India has seen lots of problems. The Gandhi and Nehru governments focused on a pro-socialist agenda, which had a dampening impact on the economy. Yet since the early 1990s, there has been a move t
Excerpted from All About COMMODITIES by TOM TAULLI. Copyright © 2011 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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