How, otherwise, was the analyst to differentiate himself from the pack, if not by playing Cassandra? After, all, he was probably a man who – seduced by the fictions propounded by the 'Death of Inflation' and the 'Platform Companies' schools – could never comprehend why commodities were actually becoming more expensive in the first place.
I mean, commodities? Actual physical entities?
Those dirty, smelly, s-o-o last century things not cooked up on a computer in a corporate finance department on Wall St., and not traded electronically on Nasdaq, but actually embedded in the earth and requiring large, hairy men and even larger, hairier machines to harvest, mine, and refine?
Cynicism aside, however – and ignoring the irony that, in seeking to be different, these naysayers are themselves displaying a certain uniformity of thought – the arguments variously being marshalled against commodities as an asset class do break down into a few common themes and it would be instructive to look at the merits of each, in turn.
Of these, the most rapidly disposed of is the idea propounded in some quarters that because commodities do not give rise to an income, they do not even merit being categorized as an asset in the first place! No cash flow, ergo, no value, runs the thread, but seeking to shoehorn everything into an equity dividend discount model is patently inadmissible as the sole criterion of valuation. Step away for a moment from the intangibility of financial assets and we can see that questions of physical supply, demand, existing stocks, and exploitable reserves might also have a bearing on the matter.
But, aside from the fact that the term 'asset' really is too broad to be at all meaningful – even in its less subjective form as a claim to property – this false distinction is also based upon the strange idea that since commodities represent finished products (akin, some say to washing machines) and do not therefore give rise to subsequent flows of goods or services, they cannot be 'assets'.
We can attack this misconception from each of three angles.
Firstly, we can deny the very basis of the definition. For must an asset, a claim to property, give rise to goods or services? If so, would our protagonist contend that a farmer's fallow land, or the connoisseur's Old Master, or the mistress' diamond ring were not 'assets'? If so, we should be more than happy to look over an inventory of such a man's private possessions, relieving him at no cost of anything to which he must therefore attach no value! But, even if we cede the point that an asset must give rise to further output, one should quickly realise that even the household washing machine gives rise to further services. After all, the reason it was bought was that it held out the prospect of several years' worth of clean laundry – which is to say, a schedule of services to be delivered.
Building upon this, we should also note that this whole approach confuses the concept of an asset with that of capital.
Though the word 'capital' itself may introduce just as many obscurities as it seeks to clear up – this being one of the rare instances where the usually rich vocabulary of the English language proves utterly lacking – a sensible economic definition of capital is the one propounded by George Riesman: namely, that a capital good is one which was acquired with the purpose of making a subsequent sale, perhaps, but not necessarily, in a physically-altered form. So, armed with this insight, we can see that our humble washing machine may be easily transformed into a capital asset, a categorisation which rests more on a functional distinction than on any physical attribute. For, if the machine is sold to the proprietor of a laundrette, everyone would have to admit that it belongs on the left-hand side of the business' balance sheet. Still more illustrative, let the machine's present owner decide to take in washing on the side, or even offer to swap a basket of clean shirts for day's labour from the local electrician, and it immediately becomes a capital good, rather than a durable consumer one – all without any change of form, ownership, or even location. But, we don't even have to delve deeply into such fundamentals to see the highly artificial nature of this attempt to exclude commodities from a definition of 'assets'.
For what other purpose do commodities primarily serve (we exclude here direct end-consumer use as food, or fuel, for example), if not that of inputs in productive processes? Does the coal which powers a steam turbine not give rise to electricity? Does the electricity not help transform bauxite into aluminium? Does the aluminium not make part of an aircraft fuselage? Does the aeroplane not carry freight from one continent to the next? Does that freight not contain components to assemble, say, an electronic temperature gauge? Does that sensor not help a washing machine function more effectively – and does that washing machine itself, as we have shown, not give rise to yet further services?
Inescapably, we are left with the firm conviction that only a crank, or someone who substitutes glib hand-waving and fine-sounding phrases for cool reasoning, could attempt to argue otherwise. That arch dilettante and master of the acerbic phrase, Maynard Keynes, must be pleased indeed with certain of his latter-day disciples!
However, leaving this intellectual Hall of Mirrors behind us, a much more serious charge levelled against commodities is not that they are not assets, per se, but that they are simply not very good ones to own, at least from the perspective of investment, rather than from that of intended productive use.
Those who hold this opinion do not think it inadmissible that Shell counts unexploited oil reserves, or Gold Fields unmined ore, on their balance sheets; they just aim to persuade us that we will go to the poor house if we seek to do the same by proxy. The first observation they usually make in support of this standpoint is that the real prices of most commodities have shown – and will therefore continue to show – long-term, secular declines. This they attribute to Man's ingenuity in advancing the technology employed both in wresting resources from the earth and in economising on their subsequent use. As a partial explanation this is indisputable, but like all such half-truths it can also lead to a dangerous (and potentially costly) misapprehension of the likely consequences. For a start, it does not consider the fact that under the admittedly Utopian conditions of genuinely free markets and unshakeably hard money, the continuous accumulation of capital equipment would be expected to increase the abundance – and so to decrease the real prices – of all goods and services, the capital kind included.
Under these ideal circumstances, one must grasp the fact that there would be no a priori reason to expect the aggregate prices of titles to the ownership of such productive assets to rise – at least not beyond the point discounted by an interest rate which would by then have fallen to the sustainably low level prevailing in such an earthly Paradise.
Some commentators may be weird enough to believe that the 'point of capitalism' is to 'produce asset price inflation' (sic), but, in reality, the overarching superiority of capitalism is that, left unhindered, it helps produce successively more and better quantities of final output for an unchanged input of labour and materials – i.e. it does so at ever lower real prices.
In fact, one might be tempted to reverse this whole line of argument and to ask whether such a process might not be expected to increase the overall availability of goods not only more rapidly than the hours of labour required to produce them – which is what a real increase in the material standard of living entails – but also more rapidly than any theoretical reduction in the per unit requirement of commodity input might take place. Under this hypothesis, the price of commodities would certainly decline in money terms (we have held money hard, remember), but it would rise in terms of the prices of final goods and so it would effectively be indeterminate in terms of those financial asset prices which are a function of the monetary profits accruing to those final goods' production. Certainly, we would have no basis for saying that we have any information about how the combination of the lower unit selling prices and lower per unit commodities inputs associated with final goods output would interact with an overall expansion of such output and, therefore, with potentially higher aggregate commodities use might set equity and resource prices in relation to one another.
Reluctantly quitting this economic Elysium, and re-entering our sorry realm of hampered markets, vitiated property rights, and degraded money, the only change in the interplay of these factors which is of importance is that much of the funny money we so effortlessly conjure can now be used artificially to inflate financial asset prices – and so these can and do occasionally rise more quickly than do the prices of almost everything else.
Strange as it may seem, this may be cold comfort, for we suspect that those decrying the market's belatedly rediscovered appetite for commodities would not be too eager to defend the equitydominated status quo by adopting the view that the stock market's supposed superiority is derived from its attributes as a quasi-permanent Bubble!
As for commodities themselves, the argument in favour of them undergoing long-term real price declines is best encapsulated in the famous 1980 bet between the indefatigable Green doomster Paul Ehrlich and the ever-optimistic (and intellectually-rigorous) Julian Simon. Exasperated by Ehrlich's wild pronouncements of the imminent end of civilization (for the Peak Oilers and Global Warmers are hardly a novel phenomenon), Simon bet him that any commodities he cared to name would be priced lower in real terms, ten years thence, in 1990. After some perfunctory research, Ehrlich and his co-Armageddonists picked what they thought were five key metals, absolutely bound to become exigently scarce. Simon smiled and waited – and duly collected his winnings. Simon's argument – one with which we would agree as far as it goes – is that Man does not require any natural resources for their own sake, but for the services they provide him and so increased scarcity, signalled by rising prices, eventually bring about their own solution.
We have a short-hand for this which is I2ES – Innovation, Investment, Economisation, and Substitution – one of which is far more crucial than the others and the direction of which requires a crucial additional factor which we will introduce in a moment. Before we do, you may now be wondering how it is that since we are broadly on Julian Simon's side, we have nonetheless not yielded the point to the commodities Doubting Thomases. How can we deny the charge any longer?
Well, firstly, one must be aware that even Simon himself admitted that, if he had renewed the wager over a subsequent period (which he offered to do, only to be rebuffed by the infuriated Ehrlich), he may well have lost heavily, for he only supposed he would be right over the balance of a sufficiently long series of such wagers and that he had no guarantee of success in any individual instance.
Clearly, had he still been alive to try, Simon would – retrospectively – have proven very ill-advised to have ante'd up in the past few years, but while that does not disprove the validity ofhis general argument, neither does his approach add to the case brought against us by the present prosecution.
The first point the defence must raise is an obvious one, but one which, nevertheless, bears repeating: that commodities may well tend to go down in real terms over long stretches of time, but what we are investing in them is a money which displays an even more constant proclivity to depreciate in real value over those same horizons. Indeed, we cannot resist the observation that if the modern model of the populist welfare-state could not have been consciously designed better to debauch the currency of its unfortunate citizens, its characteristic and unceasing attempts to suspend the eternal laws of economics in response to the politics of importunate focus groups is also singularly well-placed to frustrate, or at least to retard the Simonian process of secular, material advance.
In other words, politicians of whatever stripe and from which ever wing of the national assembly all have this in common: they can all activate the printing presses much more easily than they can conjure up the steel out of which such engines of inflation are fabricated.
Here, then, we must pause to flesh out the comments we made above about our I2ES shorthand, for it is the 'I for Investment' which is the dominant factor in the equation. Keynesian falsehood notwithstanding, there is nothing automatic about this investment occurring, for it presupposes two key things; both the ready availability of sufficient investible resources and the entrepreneurial awareness and empowerment to mobilise them and to inspire and guide the investment process as it unfolds. Sadly, in a world of interventionist governments, deluded by the consequences of economic ignorance, plagued by legalistic parasitism, echoing to the denunciations of morbid environmental cultists, and financed by means of wild monetary excess, the means and motivation of the entrepreneurs and their unfailing ability to spin gold out of dross is something upon which it would be foolish always to rely.
Moreover, another factor overlooked by the commodity critics is that even when, in any given instance, such multiple impediments to an increased supply are overcome, the final pre-requisite is Time itself, and Time will not be hurried, no matter what the spot price of palm oil or platinum futures.
Intriguingly, if the carpers will occasionally admit that the seeds of the heightened scarcity, so evident across a whole range of disparate resources, lie in the faulty investment decisions of the past, they will still refuse to accept that many of these strains are likely to persist for some good time hence – with only brief periods of intervening ease – given the inevitable lags involved in treating such an intractable and self-inflammatory ailment
Indeed, the very nature of the indescribably complex, highly-specialized division of labour upon which the miracle of capitalism is built is such that once a misdirection of efforts and a shared failure of vision occur, it can be mutually reinforcing to a very high degree. For, once a need finally does become pressingly evident, implementing the necessary changes to the structure of production can be far more problematical than simply changing a shop window display or running an extra shift on the assembly line, for vertical changes, not just horizontal ones, often then need to be undertaken to the productive structure as a whole. In this way, scarcity can exacerbate scarcity and costs can increase costs, as all too many producers of commodities and their immediate derivatives are finding out today.
Here we can pause to provide two contemporary illustrations of this principle, perhaps all the more pointed because they emanate from among the same people who are arguably the greatest beneficiaries of the current boom – the energy giants themselves. First to the rostrum, we have Christophe de Margerie, head of exploration for Total, who told the London Times that production targets were unrealistic not because of a lack of reserves, money, or will, but for reasons of logistics, skilled manpower, and infrastructure. Secondly, no lesser personages than two OPEC oil ministers were recently quoted on the wires, bemoaning the fact that spiralling construction costs were putting their ambitious expansion plans in very real jeopardy.
If the oil-rich find it a struggle to muster resources and exploit the current thirst for their product – even with crude at nearly $70 a barrel – what hope is there for the rest of us, you might ask?
Now, couple this with an environment where monetary profits are manufactured far more readily in the boardrooms of High Finance than in the ore bodies of the High Veldt and such secondary complications can become a source of near paralysis. This is because it all too easily happens that the resource company can be distracted into managing its stock price rather than its strip mine, and that it can divert effort into protecting itself from corporate raiders rather than prospecting for commercial reserves.
Commodities, then, may still outrun the money you are being asked to exchange for them, even if (the pale shade of the free market willing) they may one day cost less of your labour to acquire.
Still, the critics persist, real returns on commodities tend downward, even if this decline is punctuated by intermissions of rising prices – some of them, like today's, violent ones. Unspoken here, of course, is the insinuation that other assets can – perhaps even must – do better and so should continue to claim most, if not all, of your funds. But is this, in fact true? Moreover, even if it is true over the archetypal Keynesian 'long-run', is it inviolably the case over any more quantifiable investment horizon?
Clearly not, for it is all too easy to pick periods when any one asset class is outperforming and another asset is simultaneously struggling, especially vis-à-vis indices of consumer prices – and these periods have often endured for long years at a stretch.
For example, we can ask how wise it was to eschew all investment in commodities – as so many did – in favour of the universe of nondividend paying (indeed, frequently non-earning), options-grant dilutive, capital-intensive, lowvisibility, high-obsolescence, super-cyclical equities which was (and largely still is) the Nasdaq?
Is the evidence of the past five years or so enough of a representative sample to set against that of the previous fifteen?
But we do not just have to engage in hindsight, we can also look forward and wonder whether we will we turn out to be better served for giving up thoughts of chasing copper, or gold, or soybeans at today's highs, and to buy in their place Japanese government bonds at barely 1% nominal yields? We can wonder whether investing in agriculture, rapidly becoming both food and fuel, or whether we would be smarter to add to our holdings of 50-year UK government index-linkeds at less than 1% 'real' yields?
Anyone who thinks these latter offer genuine protection from 'inflation', when they are being drastically suppressed by a combination of regulatory hamfistedness, buy-side herding, and the global liquidity glut, has not asked himself a few basic questions.
Among these, he might ponder whether the highly-selective and statistically-massaged UK inflation indices (or, indeed those of any other country) really reflect the likely future purchasing needs of his clients -which will presumably be heavily weighted towards medicine and personal care, for example, as they pass into retirement. He might also consider whether such exiguous real yields are at all suitable for a country like the UK, beset as it is with a range of rapidly deteriorating internal and external fundamentals. Finally, he might muse upon whether staking out what is only a claim to a share of future tax exactions (payable in nothing but a printable paper money and in what may, in any case, be an externally-depreciating currency) is the best way to ensure for prosperity tomorrow.
Yet, we are told, while "commodity indexes may have been closer to an inflation hedge than any available alternative in the past … the advent of inflation-index bonds and inflation swaps [represent]… much more efficient inflation hedges…" We would beg to differ.
The wider point here is that it is, of course, the simplest of manipulations to choose just the right sample from a long-run series to give the appearance of a little empirical backing for one's case – whatever the nature of that case might be. In this way, the commodity critics tend to rely on data since the Great Inflation of the early Seventies – a selection which not only paints resource prices in the worst possible light, but which is the most flattering for stocks and, post-1982, for bonds.
However long such a duration might seem to the average trader, with his Mayfly-like professional lifespan, it cannot be over-emphasised that it does not suffice to reveal the cyclical waves unleashed by recurring 'Price Revolutions' and their intimately intertwined monetary upheavals.
But, roll the starting dates back a little further on the graph and we enter a very different world, one in which fixed income instruments were traditionally known as 'certificates of confiscation'. Though two decades of ever lower interest rates have dimmed the memories of those sentinels of monetary rectitude and fiscal prudence – the bond market 'vigilantes' who used to fret about such things – one cannot help harbour the suspicion that they are about to be taught the penalty for their lack of watchfulness.
But now, panning out even further, equities do not invariably beat increases in consumer prices (however flawed such measures may be as a measure of the ongoing monetary erosion of wealth).
Yet, even here, we are in danger of thinking too linearly, for, if we lay out the real price of equities, P(r), by the tautologous, but informative, relation P(r) = (P/E x E/R x R/CPI) (where E = earnings, R = revenues, and CPI = the consumer price index), we can start to see the impact which the price of commodities can have on each of these disaggregated terms.
For one, operational margins – E/R – can be adversely impacted by the relative stresses which both monetary inflation and real-side imbalances can exert on input costs and selling prices (something especially relevant to commodity producers themselves in a world of floating foreign exchange rates). Furthermore, price multiples – P/E – also tend to move in opposition to commodity prices. This observation may be explained by the heightened risk premia generally demanded in periods of rising prices, for these usually introduce greater macroeconomic volatility and firm-specific uncertainty.
Rising prices discourage the voluntary savings with which productive investment is funded and by means of which real profits are made. They also tend to confound entrepreneurial planning, not least by drastically impairing capital accounting. At the same time high and rising prices elevate and destabilize the interest rate structure with which those plans' outcomes are then discounted, again to the detriment of a high valuation ratio.
Finally, although we are in danger of entering into a case of monetary chicken-and-egg here, rising commodity prices may be most evident during periods of rising final goods prices, and hence real revenues – R/CPI – may be lower and thus much less healthy than their nominal values seem to suggest.
To round off this part of the discussion, let us also not overlook the implicit doctrine of the new Panglossians which is that every portfolio should unfailingly contain a sizeable proportion of equities: that it should be well nigh 'fullyinvested', no matter what these equities' valuations, and with no regard to the particular stage in the business cycle at which we might find ourselves.
One might think that those who rode the whole stock market roller-coaster of the past decade up, down, and part of the way back up again – all the while encompassing only minor variations of under- and over-weighting – are hardly the ones best place to throw stones at the greenhouse of commodities.
Of course, there are signs that this stomachchurning experience has begun to challenge the idea of passive and mechanical indexation, adhered to in the hope that sticking unimaginatively to a mix of, say, 65% equities, 35% bonds, and 5% cash will at least keep one inconspicuously in the middle of a mediocre pack and so immune to complaint. There is hope that the idea of such a hidebound approach as the ne plus ultra of investment is a vogue which is thankfully well past its zenith. Curiously, however, some critics try to pretend that those few avant-garde enough to season their portfolios with commodities are somehow still subject to the fallacies of this doctrine, even as they simultaneously accuse these investors of foolishly succumbing to what is only the latest of many market manias.
This truly goes beyond paradox and stoops into farce, for what would the doubters have us do instead, we might ask: crowd into one of the historically-rich emerging markets? Buy a batch of cyclically tight junk credits? Join those financing the tsunami of ever more leveraged buy-outs presently swamping our capital markets? Faced with such unattractive possibilities, can we honestly say that there is no room whatsoever for something different in one's portfolio, something with a direct connexion to the global phenomenon of burgeoning commerce and swelling industry, and to the rapid urbanization of a third of humanity?
The final class of arguments being deployed against making commodity investments is both more detailed and a deal more realistic, for these allude to the fact that the inconvenience of most commodities makes it impractical for most people to invest in them as physical entities and thus forces them to resort to buying futures instead. As a result, we are admonished, the trade is becoming increasingly unprofitable as the former backwardations (the lower deferred contract prices, especially in energy commodities, which add positive carry to such positions) are eroding, or indeed vanishing.
In part this is ascribed to the inevitable consequence of a greatly increased participation in commodity markets themselves. In greater part, this is the result of a recent period of inventory accumulation, albeit in some instances from severely depressed levels, which has served temporarily to calm fears of the possible appearance of actual shortages. Whether such a rebuilding will prove anything more than transitory relief is, of course, an open question, but in this regard, commodity critics seem to have access to a crystal ball denied to the rest of us in the business.
Naturally, as the roll returns become more scanty, or even turn negative where contangoes now apply, so performance is growing more and more dependent on rises in the underlying alone. How can you, the critics, now chorus, speculate on owning something, solely in the hope that it will be significantly more highly valued in the future?
What goes unsaid here, of course, is that even if buyers were to dispose of sufficient warehouse space, by buying spot and taking delivery, they would not only forgo earning interest on the value of their present futures collateral, they would still have to pay to store and insure their stockpiles of goods, much as they now pay custody fees to those whose vaults hold their gold bullion, or who house their 'alternative' investments in art, classic cars, and fine wines.
Again, the irony should not be lost on the impartial observer that the same pundits now turning antagonistic to commodities were cheering enthusiastically as foreign investors spent $300 billion over the past three years, betting on a rise in the Nikkei during a period in which its dividend yield has consistently languished well under 1%.
It should also be pointed out that many of these same analysts were happy, during a brief outbreak of collective insanity last summer, to encourage their customers to plough funds equivalent to 10% of the country's GDP into Iceland in under three months, at a time when the yield curve was steeply negative and when short rates were fully expected to rise further and so exacerbate the negative roll on offer. [It even worked for a while, until the enormity of the little island's excesses finally struck home and the krona plunged 25% in three months, more than erasing all the gains made while the buyers were stampeding into this soon-to-beburning theatre!]
Less dramatically, but equally telling, many such commentators also monotonously reiterate recommendations that their clients play for a resumed stratospheric rise in the silicon Yellow Pages which is Google, or that they should cling on, through thick and thin, to sizeable, index-determined stakes in companies like Dell Computer, whose penchant for issuing options to enrich its executives is only matched by its distaste for paying out anything to its less fortunate shareholders in hard cash.
But, besides pointing out the logical inconsistencies involved in this reasoning, one may adduce factors specific to the present market for commodities which are widely disregarded by the detractors.
In the first place, consider that, for several commodities – especially those related to energy – the risks and rewards associated with securing an adequate supply are asymmetric: that to have to shut a refinery down, for example, or to take a power station offline, for a lack of feedstock or fuel, would be to incur potentially debilitating costs.
Thus, such a commodity, especially where storage can only provide a partial backstop, is likely to command a premium up front.
We can grasp this by visualizing the refinery owner as an anxious suitor faced with a never ending succession of imminent Valentine's Days, or as an eager relative confronted by one accelerated Christmas after another. Naturally, both our lover and our doting uncle are well aware that the price of flowers and toys, respectively, will be lower for any series of deferred dates, but they each also know that the penalties for non-delivery on the special day in question will completely override the additional expense borne by paying up in advance. In this, lies the rationale for the persistence of backwardations, even in normal times.
However, these are not 'normal' times – not with the world showing the first signs of synchronised growth in getting on for two decades. Not with the system thus facing a clustering of remedial investment schedules, of a kind not seen for many a long year; ones whose undertaking is urgently needed both to supply an expanded fixed capital's requirement for more complementary goods and to build the logistical capacity to move these – and the finished products to which they give rise – around our humming international trading routes.
Thus, many supply lines are now stretched drum-tight and leave little or no room for producer shortcomings – whether these take the form of a storm in the Gulf; a flood in the mineshaft; a dry hole under the rig; an outbreak of disease in the crop; a failure of rainfall; a protracted labour dispute; or an act of military aggression.
If such an event were to occur, we can be sure of one thing: no-one, but no-one, would for long be reassured by the level of current inventories – and the missing backwardations would reassert themselves in an instant.
In accepting this, we can fairly state that the currently less favourable roll is therefore to be seen as something of an option premium; a call on the emergence of both increased demand and the accident of interrupted supply.
In addition to this, many producers – especially the many with costs in local currencies and revenues in US dollars – are actually far from flourishing in this environment (another counter to the equity-only crowd), by dint of their great sensitivity to the vicissitudes of our flawed global reserve currency. As rising commodity prices lead these producers' local units to strengthen – and as their interest rate differentials shift against the US as a result – hedging their forex risk becomes less advantageous even as their naked exposure becomes more and more threatening to their continued viability.
Add in the fact that many of these resource companies have been committing the double sin of high-grading and under-investing during the long years of famine and it is demonstrable that cash costs are, in many cases, beginning to rise – whatever long-term technological advances we are usually told to expect to mitigate this process.
Thus, there is a chance that higher US dollar prices of commodities especially where this originates in a falling dollar, rather than from a heightened physical demand – begin not to call forth supply increases, in classical fashion, but that they may even occasion a nasty, forcible curtailment of output. If so, anxieties about securing needed resources will rapidly intensify, not only supporting deferred futures prices, seen as outrights, but also potentially restoring backwardations, at a stroke.
In such a case – all too easily envisionable – the present cost of roll would then prove to have been nothing more than the payment of a very reasonable insurance premium.
So, to sum up, commodities are assets. They are valuable portfolio assets. They are economically scarce to a degree today's money is not now, nor will ever be. They do enjoy periods where they rise in all of nominal, real, and relative terms.
The currently diminished running returns are neither unique to this class, nor necessarily prohibitive when we allow for prevailing uncertainties. Notwithstanding this, commodities are not assets to be held unthinkingly or passively, over all horizons, under all conditions, and in all conceivable circumstances – but then the same stricture applies in spades to all competing outlets for an investor's funds, as only the most cursory glance at financial history will confirm.
Sean Corrigan is Chief Investment Strategist at Diapason Commodities Management