The Future of Commodities Markets

A petroleum geologist who gave a fairly convincing and sobering argument for the end of cheap oil by the middle of the century provided a major dissenting opinion from the low-investment model. This assessment, he emphasized, was not to be confused with an end to all fossil fuel discovery and usage, just the end of an era characterized by high net energy returns on investment in its discovery. In one of nature's many ironies, it takes a lot of energy to produce energy resources. Resources such as oil shale, Canadian oil sands, Venezuelan heavy oil and others demand very high energy inputs relative to output at present levels of technology [emphasis mine].

In his opinion, the high current prices are not the result of underinvestment, but rather that we have been looking for what no longer exists. I do not know why he then had to end his presentation with a screed for massive global government controls and market interventions, including this gem: "End of 'freedom and democracy' as hijacked by commerce."

Why Commodities: Second, the Disingenuous

The argument for investing in commodities based on price alone has certain self-defeating elements to it. In an argument made here several times before, commodity prices are bounded both on the upside and on the downside. Corn cannot go bankrupt, and as prices rise beyond a certain level, you cannot afford to feed it to cattle, hogs and chickens. Rising factor-input costs, be they capital, labor, land or raw materials, force both supply and demand responses that limit the further cost increases. Five thousand or so years of human history is pretty convincing in this regard.

So if the great Wall Street selling machine cannot promise you the moon on higher commodity prices, how can they promise you returns? The key step is to tell you the difference between investing in spot commodities, where the only dimension of return is the potential for price appreciation, and investing in commodity futures, where an additional dimension, the forward curve, enters the picture.

The principle behind this trade is normal backwardation, which is based on the idea that risk-averse commodity producers are willing to sell their production forward to risk-seeking speculators at a discount. This discount is a form of insurance. The discounted future must then converge to the cash market price prevailing at expiration. If the cash market stays stable or rises, the holder of the future captures the gain. If the cash market falls, however, the speculator loses.