Commodities -- What Are They Worth

Commodities are becoming scarcer, and in general I buy the argument for investing in them. But is it enough to be in broad agreement with that trend, or do I need more concrete data before investing?

Take uranium, for example: Energy prices are soaring, and climate change has put nuclear energy back on the agenda for many countries. At first glance, I can imagine how this could push uranium prices higher. And it may. But if you'd invested in uranium last summer you'd have lost more than half of your money, and regardless of the long-term story, that would have hurt.

Admittedly, uranium is not the easiest metal to trade, but I think it illustrates my point -- I need more than just qualitative arguments, I need quantitative models.

And that's a problem, because so far I haven't found any. I've found data, and lots of it. And I've found acres of theory on the pricing of futures, but these are all functions on the spot price -- that's great if you're a hedge fund looking for arbitrage opportunities, but that's a different type of investing. What I need is something to indicate whether the underlying spot-price is worth buying, or selling.

Depending on the type of commodity, there's an array of factors that may be relevant to varying degrees. To mention just a few:

    *   the trend in demand;
    *   production volumes, and capacity;
    *   processing and transport capacity;
    *   known reserves;
    *   expansion plans.

And that's before considering more nebulous issues like geopolitics, and the weather.

For any particular commodity, I could try to determine the most significant factors, see how these factors relate to previous price trends, and devise some indicators of the price. In doing so, my model would be competing against models developed by large industrial producers and consumers of the commodity, as well as by professional traders and hedge funds, and they often get it wrong. What competitive advantage do I have to enable me to win in that game?

In that sense, commodities are very different from small-cap shares; there are no small-caps in commodities, and even the more obscure traded commodities are huge industries; since commodities are now in fashion, I can't imagine that any of them are under-researched.

One possible solution might be to take a pound-cost averaging approach, ignoring the short-term fluctuations and investing an amount monthly or quarterly, just as you might in a FTSE tracker. Buying Exchange Traded Commodities (ETCs) is as easy as buying shares, and there's no stamp duty, so this could be an efficient strategy. And rather than selecting specific products, the risk can be spread by buying ETCs that represent a general basket of commodities.

I intend to look into specific commodities in more detail, but I may have to accept that attempting to determine a 'fair' value may be futile.

http://www.fool.co.uk/news/investing/2008/06/13/commodities-what-are-they-worth.aspx

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Commodities -- What Are They Worth