Avoid the Commodity Trap

China and other emerging nations need more raw materials—ranging from oil to copper to lumber to grains. As these countries’ economies continue to grow at a rapid clip, they’re stepping up their purchases of commodities. Commodity prices, particularly for oil and gold, have soared—and many individual investors are tempted to join the party.

My advice: Be careful. Dozens of exchange-traded funds (ETFs) now allow you to invest in commodities. (ETFs are mutual funds that you buy and sell through a brokerage the same way you buy stocks.) But investors, both large and small, have pushed the prices of many commodities far higher than is justified by the fundamentals of supply and demand. Too many people, I fear, have already chased what was a good idea too far.

While economies of many emerging nations surge ahead, most of the world is still trying to crawl out of the deepest economic hole since the Great Depression. Demand for industrial commodities, particularly, has been much lower than normal in most of the developed world—as a huge percentage of factories stay idled and countless millions of people remain unemployed.

Earlier studies found that putting 5% or 10% of your investments into commodities could net you good returns—especially when stocks and bonds headed south—and reduce your portfolio’s overall volatility. But that strategy failed utterly last year, as commodities plunged almost in lockstep with stocks. I think it will fail again because a key factor that drove commodities’ returns has disappeared, at least temporarily, thanks to the hordes of new commodity investors.

“It’s whole a new ballgame,” says Charles Ober, the veteran manager of T. Rowe Price New Era, which invests in stocks of commodity companies. “A lot of the studies that justified investing in commodities were based on data through 2005. If you look at data through 2008, it turns those studies on their ear. Price movements of stocks and commodities were so correlated it was pathetic.”

Those who are in the commodities markets to hedge today represent only a small fraction of all commodities investors. Hedging, of course, is the raison d’être for these markets. They allow, for instance, an oil company to lock in a price on its production months or even years before it can bring the product to market. A farmer can sell futures on his summer harvest to raise cash for spring planting. “Investors are now a multiple of the people who need a hedge,” Ober says. “I can’t tell you if it’s five times or ten times, but it’s a big number.”

Almost none of this has happened before—not even in the 1970s, the last time the price of oil blasted off, even as stocks suffered through a horrid decade. The futures markets in commodities weren’t nearly as active then, and ETFs didn’t exist. So few people and institutions invested in commodities.

The broken case for stuff

Investors in commodities, in essence, provide insurance to companies that need to lock in a commodity price in advance. As the seller of that insurance, you’re entitled to a premium. That’s why futures that don’t come due for many months generally trade for less than those coming due in a few weeks.

But the market doesn’t work that way these days. Instead, the market currently prices near-term futures at a lower price than those expiring months in the future. Light crude oil for December delivery closed at $79.65 on November 11, but the same barrel slated for delivery next April closed at $82.12. For investors, the insurance premium—which constituted much of their returns—has evaporated. Instead, it’s the investors who pay the premium.

Whether you’re concerned about a falling stock market, a decline in the dollar or a pickup in inflation, I think you should look elsewhere to insulate your investments. T. Rowe Price New Era is one good choice. You’ll likely get almost as much diversification nowadays in stocks of commodities as in the commodities themselves. And a well-run company can make money even when commodity prices are flat.

As for the commodity markets, I’d give them a wide berth.

November 24, 2009

—Steven T. Goldberg