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Sunday, February 19, 2012

Commodity valuation

A lot of people believe in strength of commodity prices but the boom is fragile for the following reasons.

Substantial part of valuation depends on strong and sustained commodity consumption driving growth in India and China. The growth is unlikely to be either strong or sustained (in near term). This may take the wind out of the boom.

But I believe we have underestimated two other reasons.

Commodities as store of value
A part of boom in commodities can actually be explained as a result of money trying to protect value of developed countries investors. To protect value, you translate your money into equivalent basket of benefits (goods and services) that can be bought with your money. So we can imagine the equation as (money I have in year "t") = (sum of products and services that can be bought in year "t").

Every year this equation must be evaluated from the RHS not LHS. Thus, the true comparison can be achieved when we compare (sum of products and services that can be bought in year "t") vs. (sum of products and services that can be bought in year "t+1"). Ideally, we must be able to buy more products and services in "t+1".

However, in common parlance we do compare LHS. The question we ask ourselves is "do I have more money than last year?" It is a misleading question. People get fooled when the answer is yes. In fact, American middle class thought they had more money in every subsequent year. But in real terms the wages are stagnant for more than 2 decades.

To protect the RHS value, investors try to hoard certain commodities that are irreplaceable. The degree of irreplaceability, knowledge of alternatives, certainty of whether commodities will indeed be part of value-store equation are all unknowns.

The Real Chinese demand
The resource intensity of growth of China will reducing drastically. This is simply because of three main reasons.

Firstly, China has built out infrastructure for next N years, advancing their consumption of commodities. This will revert to mean in the next N-4 years. (The value of N is matter of debate).

Secondly, China has already bought or locked in its commodity requirement for next few years and this has no price implication for commodities hereafter.

Lastly, it has to reduce drastically just to make scientific sense. This will have new winners and losers within different commodities. 

Evaluating commodity boom is difficult
Thus, the factors affecting commodity prices and demand are different than normally discussed. I am yet to see a reasonable assessment of the two main changes above. Hence, I advise to be really, really careful with commodities. At least do not build any position you cannot liquidate quickly.