Apr

15

 How does one find value in commodity markets? In stocks you can hang your hat on P/E, Breakup Values, P/B, etc. Bonds have relative value in rate differentials. Currencies tend to be driven by carry differentials (outside of a crisis). But how do you ascribe value to a commodity? I would think interest rates and/or inflation would apply to commodities in general, but not individually. Nat gas dropping sub $2 on the May '12 contract sparks my interest in the topic.

Carder Dimitroff responds: 

Hi George:

You ask an interesting question. Dan Dicker wrote a book called Oil's Endless Bid on the issue of creating assets out of commodities. His conclusion is that indexed funds and ETFs based on, say oil is a mistake. It is was mistake to create them and it is a mistake to "invest" in them.
From my perspective, commodities have two types of investors. The first are hedgers. In the case of natural gas, they could be utilities locking in margin on future deliveries to retail consumers. They could also be drillers, who are monetizing future deliveries. They could also be independent power producers who have a fixed contract to deliver power. Until the ETFs arrived, I believe most transactions were from hedgers.

The second investor is the speculator. This is very tricky business because it has another dimension to their bet. Prices can differ by geography. Frankly, I do not know how speculators make money in the natural gas. I am hearing many aren't and are leaving the business.

One issue in commodities is that prices can go negative. You frequently see this is electric power. Just a couple of weeks ago, I captured a screen shot of power in West Virginia at -$25 at the same time it was $80 in New Jersey. If you send me a request off list, I would be happy to send you the picture.

I've been thinking natural gas prices could go negative. The problem is producers must produce, no matter what. You can see the issue in Ohio. Chesapeake is working the Utica Shale for oil. A byproduct of their oil production is natural gas, and a lot of it. Also, to maintain hold on leases, producers must produce during the contract period or lose the lease.

If prices go upside down, it would likely occur in the spring or the fall when overall demand is light.

There are more knowledgeable people on this list, but I thought I would start the conversation.

Bruno Ombreux states:

In my opinion, commodities are not meant to be invested in. They are meant to be traded.

A stock or a bond can be invested in, because it produces a future stream of cash-flows. This is what an investment is.

A commodity is meant to be consumed. Ultimately it vanishes: in a stomach, in a turbine, in an Atmospheric Distillation Unit… It does not produce any future income stream. It is not an investment.
 

George Coyle writes: 

I disagree. I think a commodity is very much a viable investment and, on a long enough time horizon, nat gas will look like a home run at $2 in much the same way shorting bonds at current interest rates will. But the issue, in my mind, is the best means to express the investment. Futures require rolls, ETFs have contango priced in to the detriment of an investor, related equities are not pure plays. The lack of a pure play vehicle is the issue on trading vs investment. But that said, the original question is still valid if only hypothetical.

From November 26, 2004 to April 12, 2012 GLD is up 264% vs SPY up 16% (per Google finance).

Rocky Humbert writes:

I believe that it is with this statement, that Bruno's entire logical argument falls apart.

To wit, if gold is an exception, then so must be silver. Because silver has the same monetary characteristics.

And if silver, then so must copper…. And if copper, then so must platinum… And if platinum, then so must lead…

And then so must diamonds?

But what about the itinerant artist or court jester who provides a service to the king and is paid in room, board, food or a gold coin?

What about any merchant who uses his product in barter?

What about the farmer who stores his excess wheat over the winter and then barters his crop for some gold or silver? And then uses the silver as payment for a new pair of shoes for his kid ?

As I demonstrate linearly, all commodities can have monetary attributes. And historically did.

Hence Bruno's standard that only commods with monetary attributes are investments means all commodities are investments.

He may have other arguments, but this argument fails as illustrated in examples of barter. He also doesn't address art as an investment (which doesn't produce cash flow) but which clearly has investment characteristics. So cash flow is certainly important when valuing a piece of paper, but as illustrated commods have tangible value as well.

Craig Mee writes: 

What maybe of further consideration is that nat gas at these levels is a direct result of crude trading 150 approx, in 2008. What other "secondary markets" to the main event see capital inflow when the "majors" price goes parabolic, and the secondary "stuff" is so much easier to find than the major, and supply is lifted sharply thus collapsing price for some time. Possibly instead of trying to sell the "major" near the high or on the turn, a better strategy may be to take a long dated position short the "secondary".

An anonymous commenter writes: 

Hi Craig.

I'm not sure I fully understand the argument, but I would like to participate in the conversation

You said, "that nat gas, at these levels is a direct result of crude trading 150 approx, in 2008." I'm not sure this is true, but it might be.

I would like offer the following:

1. Natural gas is trading at these levels because, in the U.S., there is more supply than there is demand,
2. Demand is lower now than it was in 2008,
3. Supply is greater than it was in 2008, and
4. The U.S. gas market is entirely domestic, it cannot be exported and
it cannot respond to international market forces.

I believe there is more supply because oil prices floated over $100 making previously uneconomic plays economic. Some of those new plays come from stimulating shale where oil and gas are produced. Producers are exploiting oil but are also getting gas as a byproduct.

It turns out 2008 was a seminal year for another reason. It was the first time in decades were the downward production trend reversed. Every year starting 2008, the U.S. produced more oil than the previous year.

Leases are another driver. In order to maintain a leasehold, producers cannot sit on unproductive wells. They must produce or lose their rights (lease). As such, many are producing, even though they prefer to defer.

You ask, "What other "secondary markets" to the main event see capital inflow?" I recently learned of several. A big one is waste water wells. People are making fortunes constructing deep geologic waste water wells and providing producers access to those wells. Typically, producers see about one barrel of brine for each barrel of oil and they have to safely dispose every barrel.

Another is piping. Massive amounts of piping are needed to build the well and even more to transport product. I am aware of an Ohio company that is going to old wells and pulling out pipe, straightening it out and reselling to producers.

Another is specialty sand (and rail to deliver that sand). To stimulate rock requires truckloads a specific type of sand to lodge between the fissures. I am aware of a company that has developed special technology that produces pellets that work better than sand.

Finally, wet gas derivatives, or natural gas liquids. These are used to make all sorts of products, including plastics. The market will be flooded with these products.

Rather than going short on these secondaries, would it not be better to go long?

I may have completely missed your point. If that is the case, I hope others will add to this thread.

Craig Mee responds:

Very interesting points, thank you.
I suppose by "secondary" I was referring to Nat Gas as a secondary energy source to Crude (each obviously very specified in there uses though). However my thoughts were really that markets get bid up as the leader runs through the roof, bringing in fresh capital investment, but the overload increases supply x fold, where as the primary market i.e in this case crude, doesn't have the massive over supply coming through, no matter what the investment is that's pumped in…I suppose its a relative issue.

Price increase leads to capital investment generated by the leader(crude) = x increase in supply….. to related capital investment in the secondary = x increase in supply. If the investment in say gas, in this case, leads to large new finds, then the overall price maybe under some pressure for some time to come. (Interesting you mentioned that "Producers are exploiting oil but are also getting gas as a byproduct ) This only adding to the assistance of this potential strategy, since they are directly linked in exploration).

Hope that's a bit clearer, and no doubt there's lots to be quantified, when looking at a strategy such as this, where a deleveraged position is taken on (to maximise hold and volatility whipsaws), but I like the idea, that much interest is centered on the driver" i.e crude , but it's the passenger" i.e gas, which may prevent the better trade. 

The anonymous commenter strikes again:

Hi Craig. I think I see where you are going. However, I believe crude is a special case.

First, I don't see crude as a pure commodity. The crude coming from the next well is not the same as the crude coming from the existing well. The only reason producers move to the next well is because of increasing prices. If prices were to decline, the next well would be off the table.

Arctic offshore and oil shale (kerogen) have production costs $100 and above. Oil sands have production costs of approximately $70 per barrel. Presalt deepwater has production costs of approximately $60 per barrel (not including litigation costs). Tight oil has a production cost of about $50 a barrel.

As the price of oil moves up and down, different types of oil are "discovered" or are lost. But, it is clear, the general trend for oil is up as the low hanging fruit is depleted and the costlier fields are gradually becoming economic.

Second, crude oil by itself is useless. It takes refining to extract the important commodities, namely gasoline, diesel, jet fuel, kerosene, and so on.

Third, I see natural gas, not oil, as the bubble. Actually, it is an inverted bubble. Natural gas is responding to market forces. Refiners can make gasoline, diesel and jet fuel out of natural gas. Qatar just invested $20 billion to do such. Canada is contemplating another facility and I'm waiting for the US to follow suit (if anyone can raise a few $B, the pro formas are unhedged but the earnings potential is insane).

Do these points shift your thinking on oil, or am I still missing an important point?
 


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