Commodities: Lessons from a 100-year history

By Juergen Buettner

Increasing demand and a shrinking supply ensure long-term rising commodity prices – at least that is the theory. But the reality is different, with consequences for the investment strategy.

Commodity prices always go up in the long run. For those who get in contact with commodities directly only when refueling their vehicle, the everyday experiences seem to confirm this assumption. In the past, the average fuel prices mostly went up. Only in the last year have motorists become aware that the prices can also fall considerably. Strictly speaking, not only oil and petrol suffered losses, but also commodities across the board.

Overall, the price decline after the bull market from 2001 to 2008, when commodity prices exploded, recently reached historic levels. According to Bank of America Merrill Lynch, the annualized 10-year rolling total return from commodities at the beginning of the year was minus 5.1 percent, the lowest since 1938. Moreover, the commodity futures price index CRB, which currently consists of 19 commodities, in February reached its lowest level since 1973.

The myth of rising prices

Even more disastrous is the result for base metals and crude oil on a real basis. Based on prices rebased to 2015 price levels, using historic U.S. inflation figures, virtually all base metals as well as oil are now trading at prices below their long-term real averages since 1915. Some look particularly cheap – the prices of aluminum and nickel, for example, are significantly below their long-term real average prices, according to data based on calculations of Metal Bulletin Research in a recent study published by Unicredit Bank.

That is an astounding result, since it strongly contrasts with the thesis usually hammered into our heads that commodity prices in the long run always go up. All the more so as the argument used by proponents to underpin their assumption sounds convincing by referring to a steadily increasing demand coupled with continuously falling supply.

But these results are really surprising only for those who do not deal with economic theory. The academic belief in general is that prices of goods in real terms are heading down eventually. This is due to improved efficiency through technological advances, substitution and supply increases in case prices rise too much. Ultimately, it is therefore mankind, with inventiveness and flexibility, who keeps the prices in check. Current examples include the strong expansion of shale oil production or the increased use of renewable energies.

In the light of the above, investors who do not want to risk their capital carelessly should, in particular, look at the 100-year commodity price chart in real terms, since two extremely important conclusions can be derived from it. The first results from the realization that commodity prices in the long term on a price-adjusted basis become cheaper rather than more expensive. Those who understand that will see commodities in a different light and not automatically consider them a real long-term investment.

Low prices encourage speculators

The second important finding is that by looking at the charts since 1915, short-term investors can feel encouraged to try their luck in betting on base metals. This attitude can build on two points: First, the raw materials’ inherent volatility, and second, the low basis the prices reached recently.

With regard to point one, Unicredit points at real prices that have fallen just as often as they have risen in any 10-year period during the observation time. Hence, commodities offer a volatile environment just as speculators like it. In this light, Andrew Cole, principal analyst at Metal Bulletin Research, concludes, “I understand that traditionally the value of commodities lies in portfolio diversification, but this analysis suggests they might deliver their best returns as a well-timed cyclical investment.”

The second point derives its significance from prices, which in the cases of base metals and oil have traded below their long-term averages since 1915. That is so low that the likelihood became relatively high that the next move would go up, especially since commodity prices usually tend to show cyclical fluctuations.

This, by the way, also fits with the usual course of a commodity cycle. With regard to mining shares, this cycle has four phases, according to Bank of America Merrill Lynch. The analysts at the U.S. investment bank currently see the cycle in phase two, the consolidation phase. This is followed by the earnings-driven phase, in which a favorable supply and demand situation not only leads to rising commodity prices, but also to growing profits of the producers.

Investors who agree with that conclusion put money into the sector. Interestingly, commodities recently showed a strong sign of life. The index of the London Metal Exchange, for example, is now trading even higher than at the beginning of the year – a trend that could continue since the supply growth in industrial metals has slowed considerably in recent months, as the analysts of the ANZ Bank explain.

Historically, commodity bear markets last long periods

Anyone who wants to earn money with raw materials in the long run will probably also need strong nerves. The end of volatile price fluctuations is not in sight, and thus an environment remains in which money can be made with commodities with well-timed investments. Unfortunately, however, studies show how extremely difficult it is for most investors to find the right timing for short-term investments. Noteworthy in that respect are data from Ned Davis Research. According to their calculations, the five secular commodity bear markets since 1814 lasted on average 22.5 years. If history repeats itself, the current bear market initiated in July 2008 would still have a long way to go.

However, hope comes from the amount of losses we have already seen, since these losses have exceeded the historical average of minus 53.7 percent, but there are no clear signals. This fits with a commodity sector where traditionally divergent fundamental factors often occur simultaneously – a phenomenon that contributes to the verdict that commodities are a playground for market-timers and a very tricky area for long-term investors.