commoditiesWhile reading a finance forum, I saw the comment that commodities are destined to increase with inflation and therefore a good long-term investment. I found this comment so ridiculous that I had to write a quick post about it. So before you go invest your entire portfolio in oranges or corn, take a look below.

First let’s talk about what a commodity is —  a commodity is a basically any marketable item, usually fungible and are usually in some sort of “raw” form. Some examples would be milk, meat, wheat, tomatoes, grapes, eggs, beans, olives, wool, copper, and oil.  There are many types of commodities, but I’ll give a common example a commodities transaction.

Image you are General Mills and you need a large amount of wheat for your products, and you have enough for wheat for this year and want to also make the product next year– You may want to pre-buy your wheat for the for-seeable future, but you don’t really want to store it in a giant container (for various reasons) you just want to pre-buy what will be later farmed, so you buy a commodity future with the market (who is ultimately backed by the actual suppliers). If wheat was trading for $263.45 per metric ton ($7.17 a bushel) today and you needed 100,000 tons a year for production of your product you are going to need about $26,345,000 worth of wheat. If something were to happen to the supply chain such as a shortage, the prices could increase.

wheat

To be safe you buy the right to purchase that $26,345,000 worth of wheat, (at today’s prices) that you will need next year for a premium that is based off factors of how likely it is to increase (the higher the risk – the higher the premium). For example you might pay $1,155,000 million  for a guaranteed future purchase of that 100,000 tons of wheat 1 year from now at today’s prices (spending $1.115 million today and paying $25.345 million when you actually execute that right for a grand total $27,500,000) From there it is pretty basic math. If the price would have went up 10% it *would have cost you* $28,979,500 so you saved $1,479,500 by pre-buying the right. That being said – you could decide that it would be better for your company not to make the product and to simple sell the rights to that commodity for a $1,479,500 gain.

So let’s go back to that forum post. The idea he presented is this – We usually have inflation and commodities are affected by inflation so in other words it’s free money. This statement is ridiculous and here is why.

1. “Commodities go up by inflation” — Your Net Gain – Zero
Hate to burst your bubble here, but if something is increasing by just inflation it is a stagnate investment. You have no more money today than yesterday.

2. “More population, more demand — thus prices increase”
More people means more demand.. sure it does, but it also can mean more production. More farms, orchards, mining operations, etc. that result in an increase in supply.  Not to mention that even with more people, there can be other factors (such as a recession or depression) that can change how these people buy. If half as many people buy from a population 50% larger, you still are selling less than before. (1.5 population * .5 = .75)

3. “XYZ is in shortage and prices have to increase”
Temporarily – maybe. Long-term – Maybe not.
I love cuties (little clementine’s) and if there was a massive demand for these little guys this year – odds are the prices might increase – but then you would have something else occur, more people would start growing them (because demand has gotten high). All of the sudden – next season — there is plenty of inventory and prices are back to normal or maybe even lower than the start.

GasDepositDiagram

4. “You only have a set amount of area you can produce XYZ”
This maybe true but there are few things to consider. For things such as crops limited to a region – technology is getting better and some crops are even genetically modified to have higher yields. If science suddenly finds a way to yield 20% more fruit in a particular crop, it’s going to quickly be in surplus. As for non-farm commodities such as natural gas – if the price does actually go up, it can open new areas up for exploration. Maybe natural gas isn’t worth mining out of shale drilling because of cost – but if prices double, the shale drilling might become viable and provide resistance to prices.

Conclusions:

Do I think all commodities are a bad investment? Not at all. In fact, if I had a lot of money (millions or billions) I would consider investing in commodities such as copper because the world demand could make these prices go berserk in the foreseeable future with the rest of the world developing. The point of this post is that people who say “commodities will increase with inflation making you rich” (or something to this effect), simply smile and nod – but do not encourage such crazy talk. Remember – it’s your gain ABOVE inflation that is truly a gain.

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