INVEST IN COMMODITIES
Updated: Jan 18
First, lets quickly understand what “commodities” are. Commodities are things like oil, copper, soybeans, and other materials found in everyday life. It’s important to know that commodities are priced in the United States dollar (USD). This pricing pedestal is what makes the USD the world reserve currency. Please know that these commodity prices fluctuate constantly based on supply and demand. Real world events have very real effects on these price fluctuations. The connection from a country cutting their oil production will immediately have a dramatic effect on the price of oil. These commodities are traded via “futures contracts” on the Chicago Board of Exchange and the New York Board of Exchange. Traders essentially are betting whether or not they think the future price of a commodity will be higher or lower next month or several months down the in the future. Please know, I have absolutely no experience in trading futures contracts and have no desire to. There is a much more simple and stable way to invest in commodities.
At J.A. Lawrence Wealth Management we invest in commodities by owning companies (via public stock) that operate in certain commodity markets. Our current clients certainly know this and are reaping the rewards. It’s a simple process. When done correctly investors can find themselves in positions with limited downside and maximum upside. This strategy isn’t for “traders” but the long-term investor. We believe this strategy is the best for an investor to generate market-beating returns over the long haul.
PROTECT THE DOWNSIDE: First, protecting the downside is the only way you can invest and get a good night’s sleep. How do we protect the downside? Find yourself in a winning position with this combination:
OWN A COMPANY WITH A STRONG BALANCE SHEET WHEN THEIR COMMODITY HAS BEEN BEATEN TO HELL.
FOR EXAMPLE: The gold sector in 2018 was at about a six-year low. Gold was trading at $1,200 an oz. Through extensive research we were able to find a handful of gold companies that were still profitable in this environment (although barely). The companies we owned had little to zero debt. The important thing to understand was these companies weren’t going anywhere. They didn’t have any debt. This environment began the scratching of the surface for a great investment.
UNDERSTAND THE COMMODITY: For simplicity, I will continue to use gold as the example, but these “rules” apply across the board in all commodities.
WHAT IS THE BREAKEVEN POINT FOR COMPANIES IN THE SECTOR TO PROFIT? For gold, the average breakeven point in the sector is $1,200. As this breakeven point is breached companies can’t afford to mine gold anymore. By operating their business, they will go out of business. Similar to when oil companies start pulling rigs out of the ground- gold companies will simply stop mining. Over time the price of gold begins to rise as the supply is drying up. Commodity prices are legally manipulated. What happens when the price doesn’t rebound as expected? Drying up the supply doesn’t work as hoped? Well, those highly indebted companies go out of business. Then the healthy companies in that sector get a bargain on an asset sale. The strong companies feast on the carcass of the weak-true capitalism at work.
In 2018 the precious metals market was depressed. It was the most hated sector out there. When something is hated- prices on spectacular companies become depressed. When a sector is loved and all over CNBC the price soars. The stupid money is on a buying frenzy. In 2018, the gold market had the lowest gold prices the sector could sustain before shutting down production. There were zero debt companies everywhere. This was a ticking time bomb to make a lot of money.
In August of 2018, the gold price was $1,200 per ounce. The metal traded to almost $1,700 per ounce just before Covid-19 took the world by storm in March 2020. This increase in the commodity price reflected greatly in stocks operating in this space. The price of gold surpassed $2,000 per ounce during Covid-19-but I don't like pointing to a black swan event for examples. If investors had the patience to see the obvious tailwinds to jump into this space market beating returns were just waiting for them.
Currently in 2021 other commodity sectors offer the same opportunities as gold did in August of 2018.
UNDERSTAND THE CASES FOR COMMODITY UPSIDE
Consolidation: This is the simplest rule to understand in commodity markets. When companies begin to consolidate it typically means they couldn’t survive on their own. Nonetheless there is a situation created where more control of material is in less hands. There is less competition. Since competition lowers prices then less competition overtime will begin to raise prices. When the consolidation begins to happen, this is often the beginning of a bull market for that sector. This is a huge BUY signal and typically the end of a bear market.
The United States Dollar: Remember, commodities are priced in the USD. This is a very important piece of the pie to understand.
The equation is simple: When the USD weakens, commodities become more expensive. Simply due to the fact our dollar isn’t able to buy as much. The flip side is when our dollar is strong, commodities become less expensive. Currently the average oil price in the United States is $2.50/gallon. The current average oil price is Mexico is $3.50/gallon. The Mexican peso is a weaker current currency and can’t buy as much oil in the open market. If the USD weakens and the Mexican peso gains strength- the Mexican people will see an increased standard of living. This is a perfect example of currency risk (currency risk can be both positive and negative).
Between 2005-2009 we saw dollar weakness and prices at the gas pump were in the $4-$5 range. Our American standard of living was nosediving into the ground. I remember waiting in lines for gas and people were selling their SUV’s for bargains. After the financial crisis of 2009 we saw dollar strength and commodity prices plummeted. This allows Americans to purchase less expensive oil, food at the market, and other basic materials. The United States imports the majority of our goods. When the dollar is strong, we get more bang for our buck and our trade deficits shrink. As our dollar weakens, we have ballooning deficits because we need to spend more to get the same amount of goods as previously before.
DO WE HAVE A WEAKING DOLLAR TODAY?
We certainly have a weaker dollar today. Take a look at the USD index https://www.marketwatch.com/investing/index/dxy. Over the last year we have seen a 13% drop in the value of the USD against other currencies. This means our dollar has lost 13% of its purchasing power. In this article I won’t get into why we have dollar weakness. That is a topic for another article involving the federal reserve. However, anyone can see the effects in the prices of our commodities this year. The prices have absolutely soared. The end result are the companies operating in these commodity space’s are seeing their profits increase dramatically.
WHAT IS AN INVESTOR TO DO?
Take advantage of these bullish signs in the commodity space. Do you remember, or have heard, about the high oil prices in the 1970’s? People were waiting in long lines for gas and were paying extremely high oil prices. Instead of suffering the price squeeze, invest with the price surge! An investor has to protect their purchasing power. Investing intelligently in the commodity space is the best play to protect your purchasing power and adding collecting an additional profit.
It’s simple- invest in best of breed companies in their sector with little to no debt. As commodities increase in price the shares of the company will perform accordingly. This is the safest way investors can minimize their downside and maximize their upside.
If you enjoyed this article please subscribe!