How Much Should You Have in Commodities?

Alexander Green
by Alexander Green, Chief Investment Strategist, The Oxford Club
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I'm often asked how much of an investor's portfolio should be in commodities. If you're a trader or speculator, that's up to you.

But a long-term investor with a five-year-plus horizon? Virtually none. (The commodities allocation in our Gone Fishin' Portfolio, for instance, is zero.) Here's why...

It's not unusual to hear reports in the media from time to time about how human beings are "using up" the world's resources or that we are "running out of oil." Don't believe it. And certainly don't bet on it.

Price Pressure

Innovation and technology undermine prices for most commodities. We've seen this in agriculture, where irrigation, mechanization, genetic modification, and new pesticides and fertilizers all boost productivity.

Sure, you've seen coffee shoot up over 90% this year and hog futures climb nearly 50%. But these are one-offs. The spike in coffee is due to a drought in top exporter Brazil. And a virus that has killed millions of pigs is behind the run-up in pork bellies.

The same is true of "peak" theories of oil and gas. It seems like only yesterday that the national media was reminding us about our "addiction" to foreign oil. But new technologies like fracking and horizontal drilling have boosted production sharply. Last year we surpassed Russia as the biggest producer of oil and gas in the world.

The prophets of doom never foresee the new advances and increasing efficiencies that undermine future scarcity. When whale oil began to run out, we started using petroleum. When farm yields stalled, new fertilizers were introduced. When glass fiber debuted, demand for copper fell.

Yes, raw material prices had a good run from 2000 to 2010. The Dow Jones-UBS Commodity Index more than doubled. Copper gained 417%. Cotton jumped 184%. But that was when China - which consumes 40% of the world's commodities - was growing at more than 10% a year. That's not the case today.

And commodity prices - which had a lousy three decades in the run-up to 2000 - are back under pressure. Yes, they're up a bit this year, but they plunged 9.5% in 2013, lagging stocks, bonds and real estate badly.

Not a Diversifier

Some pundits - especially those who sell commodity products for a living - insist that raw materials are a good diversification. They're not. To own them, you have to take money out of stocks and bonds, both of which have handily outperformed commodities over the long haul.

Moreover, 17% of the market value of the S&P 500 consists of companies in energy, utilities and basic materials. So you likely have exposure to commodities - and these companies often turn a profit even if prices stagnate.

How about as an inflation hedge? There hasn't been much inflation to hedge lately. Sure, you can point to higher prices at the pump or the doctor's office. But I'll point to lower prices (and far superior quality) on homes, cars, electronics and more.

Even if inflation does raise its ugly head again, raw materials are hardly the only - or the best - inflation hedge.

Your home is an inflation hedge. Treasury Inflation-Protected Securities (TIPS) are an inflation hedge. And, unlike gold or commodities, TIPS actually guarantee that your money keeps pace with inflation, something gold hasn't done over the last 35 years.

(I'm not arguing against gold, incidentally, something you should hold in your portfolio for the same reason you keep a spare tire in your trunk.)

But a substantial allocation to commodities? Only if you're a speculator playing with money you can afford to lose.

Good investing,

Alex

Editor's Note: Alex has developed a recommended asset allocation that helps guide many of The Oxford Club's recommendations. For a closer look, click here.

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Profit From the Fracking Revolution

Although investing directly in commodities is generally a game for speculators, investing in companies that drill for, mine, sell or transport commodities - or provide services to those who do - is another story.

In fact, the fracking revolution underway around the world (and especially in the U.S.) is offering a bounty of opportunities in the energy business. In fact, Alex has called this renaissance "the single biggest positive" in the domestic stock market today. "An especially big plus for the U.S. economy," he added, "is cheap, clean, readily available natural gas."

Alex explains further:

"Gas releases only about half as much carbon dioxide as coal when used to generate the same amount of electricity. But natural gas is not only cheaper and cleaner. When you factor in transportation costs, there is also the huge logistical advantage of manufacturing close to North American markets. In essence, our energy renaissance is igniting a U.S. manufacturing renaissance.

"Utilities and trucking companies are busy switching from coal or diesel to natural gas. (Exxon [NYSE: XOM] predicts that natural gas will overtake coal as a global energy source within five years.) Natural gas vehicles make up less than 0.1% of the U.S. fleet but this will soon change. Trains are other good candidates for gas conversion.

"And while we tend to think of oil and gas as fuels, they are also feedstock for making things. In plants called 'crackers,' natural gas is broken down into ethylene. From ethylene, we produce polyethylene, polyester, PVC - all the world's biggest plastics, which make up everything from soda bottles to computer cases to car bumpers. Today there are 10 new world-scale crackers being built on the back of all the new shale gas we've found.

"When natural gas is cooled to very low temperatures it reduces its volume sharply, making it practical to transport over long distances. As a result, a huge new market is developing for the export of liquefied natural gas (LNG). Petrochemical exports from the U.S. should hit $30 billion in less than five years.

"In short, natural gas is a central pillar of America's economic rebound. How are we playing this in our Oxford Trading Portfolio?

"With Range Resources (NYSE: RRC). Based in Ft. Worth, Texas, Range is a leading independent oil and gas company with a particular emphasis on gas. The company drills and produces shale tight gas, coal bed methane, conventional natural gas and natural gas liquids, primarily in Pennsylvania, Virginia and West Virginia. It owns more than 5,000 producing wells, approximately 3,400 miles of transportation lines and has 1.8 million gross acres under lease.

"Range controls 1.1 million acres in the Marcellus Shale play, a particularly attractive target for energy development in the Appalachian Basin, as well as hundreds of thousands of acres in low-cost, low-risk areas in West Texas, New Mexico, Oklahoma, Mississippi and Kansas.

"Over the last decade, Range has worked tirelessly to lower its cost structure, strengthen its balance sheet and upgrade its inventory. As a result, the company now finds itself in the best position in its history.

"I know, the stock looks crazily expensive at 122 times trailing earnings, but look forward not back. Thanks to sharply increasing production, earnings should rise from roughly $2 a share this year to more than $4 next year. So Range is selling at less than 22 times next year's earnings.

"The stock is already a winner for us, up more than 20 points from our entry price. But there is still plenty of upside potential here."

- Bob Keaveney with Alexander Green

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