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 Was it a bubble? That's the question on the minds of commodity investors everywhere. Does the recent pullback in commodity prices represent the bursting of a short-term bubble or a modest correction in a broader bull market?
Those questions have taken on all the more importance—and complexity—given the recent turmoil in the U.S. stock market. With the future returns on equities uncertain, commodities will be receiving more attention than ever from investors seeking noncorrelated returns.
Heather Bell, managing editor for Journal of Indexes, spoke with several experts on the global commodities markets about some of the key commodities-related issues on investors' minds.
 Ashmead Pringle, president of GreenHaven Commodity Services, which is manager of the GreenHaven CCI Fund (AMEX: GCC)
Journal of Indexes (JOI): Have commodity prices peaked? If not, where are we in the commodities cycle?
Ashmead Pringle (Pringle): I don't think they have, for several reasons. First, I believe global crude oil production is peaking and may have already turned down. While demand in the developed countries is falling and will fall further as we substitute for petroleum energy, the growing demand from the developing world will more than offset this. Thus, for the next five years or more, we see global crude oil demand growing while supply will be shrinking. Higher petroleum energy prices are the only possible result. Second, global demand for food is outpacing supply. Water and arable land are becoming scarcer. Luckily, we have a big world wheat crop this year and no real supply issues in the grain markets. If we were to have one or two bad years in a row, you'd see a big price spike in the ag markets. Third, the U.S. has spent itself into a huge hole and is in a severe credit crisis, to boot. It's almost certain that the only way out is to keep pumping up the money supply, weakening the dollar and fueling inflation. That's bullish for commodities.
Where we are in the cycle is harder to say, but we're a long way yet from the old highs, adjusted for inflation. In real terms, commodity prices were at Depression levels in 1999–2000. Since then, they've obviously appreciated substantially, but they are still far from matching the highs set in the early '80s. That was true in July before commodities corrected sharply, and it's truer now.
JOI: Which areas of the commodities market do you believe will be most attractive over the next few years?
Pringle: Pretty much all of them, but I think the Ags will be the best-performing group, followed by Precious Metals and Energy.
JOI: Have index investors and other asset allocators been a significant factor driving the increase in commodities prices?
Pringle: No doubt. However, the impact on the market by any investor comes when they buy or sell, not when they hold a position. As money flowed into long commodity positions, it certainly pushed prices up. And if it flows out, it will push prices down.
JOI: How much of the average investor's portfolio should commodities represent?
Pringle: There really isn't a single answer for all, and you have to define commodity exposure. Is it exposure just to physicals or futures, or does it include equities that are in the commodity sector? If we don't count equities, I'd say 5 to 15 percent is a reasonable range. Below 5 percent, the average investor isn't going to see much of an impact from any asset class.
JOI: Are commodity-producing equities a good replacement for commodity futures exposure?
Pringle: The conclusion of the famous Yale study [by Gary Gorton and K. Geert Rouwenhorst] of commodity investment was that the related equities were not as effective as direct exposure. Equities as a class don't do well in periods of unexpected inflation, while commodities do, and the two classes behave differently during the phases of the business cycle. Plus, many equities are not pure plays.
Peter Schiff, president of Euro Pacific Capital, Inc., and author of "Crash Proof: How to Profit from the Coming Economic Collapse"
JOI: Have commodity prices peaked? If not, where are we in the commodities cycle?
Schiff: I definitely think they have not peaked, certainly in terms of U.S. dollars. You can probably try to make an argument that they might have peaked in terms of gold or that they might have peaked in terms of some other currency, but if you're just going to stick with the dollar as your frame of reference, then I think commodity prices have a long way to go up. As far as where we are in the cycle, that I don't really know. …. I have a feeling that it's got a long way to run.
JOI: Which areas of the commodities market do you believe will be most attractive over the next few years?
Schiff: I'm the most bullish on Precious Metals. But then after that, I would say Agricultural commodities, Energy-related commodities, Industrial Metals. I think there's going to be upward pressure pretty much across the board on commodity prices.
JOI: Have index investors and other asset allocators been a significant factor driving the increase in commodities prices?
Schiff: I don't think so. I think they've certainly affected it at the margins. I think they've exaggerated some of the moves.
The real forces driving the commodity bull market are fundamentals; it's the fundamentals of the supply-and-demand imbalances, and of course, the fundamentals of inflation, of central banks around the world creating too much money, particularly the Federal Reserve.
JOI: How much of the average investor's portfolio should commodities represent?
Schiff: It depends on the portfolio, the individual and their tolerance for risk or what their objectives are. I think commodities should certainly be there in one form or another. I think certainly gold or gold mining stocks could represent 5 to 20 percent of the portfolio.
It doesn't necessarily mean people have to own a basket of commodities; they can own companies that are in the commodities space. They can own Agricultural companies and Energy-related companies, and Alternative Energy, and all sorts of businesses that benefit. They can also invest in countries like Australia or New Zealand or Norway or Canada— places that benefit directly from stronger commodity prices. I think people need to keep the commodity theme on their mind when they're making investments, and make sure they have an adequate way to tap in to the bull market.
JOI: Are commodity-producing equities a good replacement for commodity futures exposure?
Schiff: They are not necessarily a replacement, because you have different sets of risks. I think you might want to have it covered from all angles, but when you own a company, you have additional risks that you don't have when you own the commodity itself, but of course then you have additional upside. I think there's a lot of opportunity now in some of the commodity companies that have been beaten down by a much greater percentage than have the commodities themselves.
 James B. Rogers, author of "Adventure Capitalist" and "Hot Commodities"
JOI: Have commodity prices peaked? If not, where are we in the commodities cycle?
James Rogers (Rogers): The secular bull market has years to go. Who knows [where we are in the cycle]? It depends on if/when we get new supply and/or economic collapse. History would indicate we might be 45–50 percent of the way to the end, but that is just what happened before.
JOI: Which areas of the commodities market do you believe will be most attractive over the next few years?
Rogers: Agriculture.
JOI: Have index investors and other asset allocators been a significant factor driving the increase in commodities prices?
Rogers: They have been "a factor," yes, just as they were in the huge stock bull market of the 1980s and 1990s. "Significant"? No; supply and demand have been terribly out of balance, which is why commodities have risen. Little would have happened had supply and demand not been out of balance.
JOI: How much of the average investor's portfolio should commodities represent?
Rogers: It depends on what they know—anywhere from 0 to 100 percent.
JOI: Are commodity-producing equities a good replacement for commodity futures exposure?
Rogers: The Yale/Wharton study [Gorton and Rouwehorst] showed that commodities themselves have outperformed commodity stocks by 300 percent over the past few decades. A great stock-picker might well outperform commodities, but no one has found her yet.
Kevin Rich, managing director in the Global Markets Investment Products Group at Deutsche Bank; CEO of DB Commodity Services LLC, which is managing owner of the Power- Shares DB commodity and currency ETFs.
JOI: Have commodity prices peaked? If not, where are we in the commodities cycle?
Kevin Rich (Rich): We cannot say prices have peaked, because it's difficult to speak of "commodities" in such a singular way. For instance, energy commodities such as oil, heating oil and gasoline, while off of their dramatic highs posted earlier this year, are still up between 15 and 20 percent year-to-date. Over this same period, we have seen flat agriculture commodities returns, while precious and base metals are mostly down, some significantly. Each sector or individual commodity reacts to different drivers, such as the fundamental supply and demand in their respective markets, geopolitical events, weather and global growth. …In view of the likely economic growth in the developing countries over the next decade, it is reasonable to conclude that demand for commodities is likely to remain under upward pressure (and so should prices) once the world emerges from the current cyclical downturn in the economy.
JOI: Which areas of the commodities market do you believe will be most attractive over the next few years?
Rich: The exchange-traded funds and notes I manage follow rules-based indexes, and never take a discretionary long or short position based on our view. That being said, we feel that Energy markets will continue to be influenced by the lack of slack in the system between global demand and the ability of the supply side to keep up, and how much these relative tight inventories and higher prices affect consumption. Clearly, the action of suppliers (e.g., OPEC) will always have a great effect on the price moves. Base and precious metals price movements will be influenced by growth and currency valuation. Agriculture and certain energy commodities prices are influenced greatly season to season by the supply-and-demand projections for each commodity. It is difficult to project out several years for any of these sectors.
JOI: Have index investors and other asset allocators been a significant factor driving the increase in commodities prices?
Rich: This question is currently being heavily debated, and there are different views in the market and in Washington. We believe primarily it is the fundamentals of supply and demand that drive commodities prices. The majority of commodities investments are based on prices in the futures market, so these investors in index products never hold the physical commodity. That's not to say that speculative activity in the futures market won't at times have a short-term effect on the futures prices, but the convergence of futures prices to the spot prices will mitigate the short-term movements if they are not backed by real fundamental supply and demand.
JOI: How much of the average investor's portfolio should commodities represent?
Rich: We normally see investors using commodities in the "alternative" bucket within their portfolios, and depending on how large the alternative allocation is, commodities usually represent anywhere from 1 to 5 percent.
JOI: Are commodity-producing equities a good replacement for commodity futures exposure?
Rich: Commodity-based equities are a more indirect way to participate in the market than the futures-based products. Commodity-based equities normally have a higher correlation to the equity market than the commodity markets. [They] are not bad investments; they just don't offer the same level of diversification to equities that futures-based products do.
Kevin Kerr, editor of Global Commodities Alert
JOI: Have commodity prices peaked? If not, where are we in the commodities cycle?
Kevin Kerr (Kerr): My straight-out answer is no; they have not peaked for the long term, but for the short term, we're probably seeing the first initial correction, and that's to be expected. The typical cyclical bull market in commodities lasts anywhere between 15 and 25 years. So my guess is we're about five or six years into that cycle, and clearly the parabolic rise in a lot of the commodities, such as Energy, pretty much demanded a correction. We're getting a very solid correction off of those highs. I really think things in this first leg of the move have been so extreme that we can expect the corrections to be just as extreme. Having said that, especially with Energy for example, we are still well above where we were two years ago or a year ago, and I think you'll see those patterns continue.
JOI: Which areas of the commodities market do you believe will be most attractive over the next few years?
Kerr: I think the agricultural markets and the soft commodities will have strong ongoing interest, because we have a growing population … and we have lower supplies around the world.
JOI: Have index investors and other asset allocators been a significant factor driving the increase in commodities prices?
Kerr: Absolutely. I would say that speculative buying, indexes, ETFs … all of these things have all contributed to the rapid rise in commodities, and I think anybody who says they haven't is either kidding themselves or doesn't see the big picture. What we have to understand is while that money may come and go … it certainly now has moved commodities to another asset class level that they've really never been at before.
JOI: How much of the average investor's portfolio should commodities represent?
Kerr: The traditional thing that we've always told people is about 5 percent and no more than 5 percent. But there's such great opportunities in the resource markets now that I think it's important to have at least some exposure. So actually my minimum allocation I'm telling people now is 5 percent, where that used to be our maximum.
JOI: Are commodity-producing equities a good replacement for commodity futures exposure?
Kerr: No, I don't believe so. I prefer commodities options and futures for my trading portfolio and keep the commodities resources stocks in my investment portfolio. For trading, I like to be as close to the underlying commodity as I can be.
Nicholas Brooks, head of research and investment strategy for the ETF Securities group of companies
JOI: Have commodity prices peaked? If not, where are we in the commodities cycle?
Nicholas Brooks (Brooks): No, I don't think commodity prices have peaked. I think what we're seeing is a correction in a bull market, and I think we're still in the early stages of a commodities bull market.
There have been some major developments over the past five to 10 years that indicate that this bull market has some ways to go, and the main development of course has been the very rapid rise in emerging market growth; in particular, China, but also India, Russia, Brazil and the Middle East. If you look at a range of commodities, from iron ore running down to copper and some of the agriculture commodities as well, China is … generally the world's largest importer of most commodities, and that has been a major change on the demand side. I think the only way you can make a strong argument that the bull market is over and that we're about to go into a prolonged bear market in commodities would be if you believe that the emerging market structural growth story has ended.
The other development of course has been on the supply side. For a variety of commodities, the easily accessible commodities have been taken up, so it's much more expensive now for companies to bring things like oil and industrial metals out of the ground. The higher cost of energy, which I think will continue for some time, is also affecting a wide range of commodities, including the agricultural commodities due to increased demand now for biofuels and also higher fertilizer costs. For those structural reasons, I think there's still quite some ways to go in this bull market, and what we're seeing now really is a cyclical slowdown primarily driven by valid concerns about the outlook for OECD [Organization for Economic Co-operation and Development] demand over the next 12 to 24 months.
JOI: Which areas of the commodities market do you believe will be most attractive over the next few years?
Brooks: I think the areas that will be most attractive are the areas that will be most in demand in emerging markets, and Energy stands out on that front, particularly oil. We know that auto ownership per capita in some of the largest emerging markets like China and India is extremely low relative to OECD levels, and as per capita incomes rise, people will buy cars. As long as there are no major substitutes in the near term for oil in terms of producing gasoline for these automobiles, I think that demand will remain very strong. The other area, again relating to emerging market demand, is Industrial Metals. I include in the metals also iron ore and inputs to that process such as coal and also steel. All of these types of commodities are going to remain crucial inputs to the building of infrastructure across the emerging markets over the next five to 10 years. I think agricultural commodities also are of interest because we do have limited arable land, and with increasing urbanization and increasing scarcity of water, I think there's going to be increasing upward price pressure on agricultural commodities.
JOI: Have index investors and other asset allocators been a significant factor driving the increase in commodities prices?
Brooks: If you look at commodity prices over the past few years, I don't think the index investors have played much of a role. I think it's very clear that underlying supply-demand fundamentals have driven it. Inventory levels for a wide range of commodities have dropped down to near historic lows for a number of industrial metals, for a number of agricultural commodities, and also, for example, spare capacity in OPEC is again near all-time lows. So these are all signs that supply-demand fundamentals have been the key driver of the price increases.
I don't think it's been a key driver of prices, but certainly, at the margin, it has been affecting prices.
JOI: How much of the average investor's portfolio should commodities represent?
Brooks: I think it's going to depend very much on the individual investor risk profile or, if you're an institutional investor, what your liabilities are. So it's very hard to generalize. We did do some mean variance analysis, looking at theoretical optimal portfolios composed of equities, bonds and broad commodities. Over the full 15-year period, the optimal portfolio that we came up with—it's really important to stress here that this is a theoretical construct—was 13 percent. What was interesting is we chopped up that 15-year period into different segments, and even during the period when commodities performed most poorly relative to equities, the weighting in the theoretical optimal portfolio was 6 percent in commodities. The low correlation of commodities as a group with equities and bonds provided diversification benefits that created a portfolio with a higher risk/return profile, even though returns in commodities during that period were much lower than for equities.
JOI: Are commodity-producing equities a good replacement for commodity futures exposure?
Brooks: No, I don't think so. I think that when you're trying to create optimal portfolios for long-term investment purposes, there's a big difference between being invested in underlying commodities and commodity equities. The main reason for that is commodity equities tend to have a much higher correlation with the equity markets that they're listed on than they do with the underlying commodity, so the diversification benefits are not nearly as strong.
Rian Akey, chief operating officer of Cole Partners Asset Management
JOI: Have commodity prices peaked? If not, where are we in the commodities cycle?
Akey: My response would be, "Relative to what time frame?" Certainly it's looking as if we may be at a short-term peak if you're looking at things through the end of 2008 or, at the very least, some kind of congestion zone relative to where we were a few months ago. We're not reading a lot about $200 oil like we were a year ago. At the same time, if you look at the longer-term outlook and things from beyond a 2008 standpoint, and you look at some of the general trends that have been driving the commodity markets over the course of the last half a dozen years or so, there are some very basic things, like an increase in global population, a modest increase in standards of living in some of the emerging economies that have a lot of the population, etc. Those types of movements are intact, and we anticipate they would be intact for decades to come. In the last eight to 10 weeks, we've seen very sizable and large pullbacks or corrections. You're going to have that within a longer-term secular environment that still has a lot of bullish properties. So my answer is bifurcated to some degree: In the short term, maybe yes; but over the long term, I think almost certainly, no.
JOI: Which areas of the commodities market do you believe will be most attractive over the next few years?
Akey: I wish I knew. … I think across the board your best bet is to be diversified and have exposure to a bunch of different areas. Also, if you get outside of the mainstream futures markets, there's other areas as well in things like water, infrastructure, some of the forestry stuff that's been depressed for some time and has come back in the last 12 months or so. These are areas I think that are of interest for some short-term appreciation over the next couple of years.
JOI: Have index investors and other asset allocators been a significant factor driving the increase in commodities prices?
Akey: It's a question that's getting a lot of attention, not necessarily from those in the know but from the people that think they might know. I've read decent stuff on both sides of that equation. … Do I think it's been a factor? Yes. Is it a significant factor? Maybe. Is it the significant factor? In that case, my answer would be no. I think there's other very concrete underpinning going on.
… Both the demand and supply side of the equation are generally still intact, and still has got to be the most significant factor that's driving commodity price increases.
JOI: How much of the average investor's portfolio should commodities represent?
Akey: It's funny, because if you look at this qualitatively and you look at it quantitatively, on a quantitative basis, running standard optimizations, it's probably going to overallocate to what makes sense for most people. But in some ways, you're looking at commodities now, maybe where other kinds of mainstream alternatives—like hedge funds or managed futures—were 10 years ago, and an optimizer might suggest 20, 30 40 percent because of the lower volatility and limited correlations to the balance of somebody's portfolio. Commodities on a statistical quantitative standpoint benefit from very similar kinds of properties—at least on the diversification side, not necessarily on the volatility side. They're not exactly low volatility in that sense. And you have to look at it from a standpoint of time frame: Are you a five-year investor? Are you a 50-year investor? You probably get different answers to that type of question.
But realistically, based on certain limits in terms of things like investor awareness or understanding of what they're getting and capacity constraints within the space—particularly if you get outside of the Energy markets—all of those kinds of things … I would say that a 5 to 10 percent target is reasonable for an average investor.
JOI: Are commodity-producing equities a good replacement for commodity futures exposure?
Akey: I'm coming at it from a standpoint of somebody who does use and invest in commodity-producing equities. The key here is that our investment activity uses that as a complement as opposed to a replacement, and I think that I would not choose to replace the commodities future exposure with commodity equities. I think the historical research is accurate in terms of looking at commodity equities and the fact that you get something that is going to behave more like an equity and less like a commodity. One caveat is that most of the historical research that talks about this uses long-only exposure, so if you're coming at it from a long-short equity standpoint where you are actively looking at removing some component of equity correlation or equity beta to your strategy, I think that can enhance your commodity equity exposure.
The thing about adding equities to that is you do get some diversification benefit, further diversification from adding Energy equities to your energy exposure or metal and mining companies to your precious or industrial metals exposure, just because they're not necessarily moving on a 1-to-1 basis. A lot of times even the smaller names will move even on a leveraged basis to the underlying commodity. But where you're really adding the most benefit is when you get outside of the mainstream markets. How do you invest in alternative energy? You don't get it through a futures contract. How do you invest in water; how do you invest in forestry or paper companies? You can't access most of that stuff on the futures side. So if you're building a diversified commodities portfolio, the reason you're doing that more than likely is because you're actually trying to build a basket that gives you commodities exposure as a whole, but with some diversification benefit that decreases and dampens the volatility of making an individual binomial call on one sector or one market. So if you're cutting the equity side out of the equation, you're limiting some of those diversification benefits. By including equities—not as a replacement but as a complement to what you're doing—that allows for a pretty significant increase in your opportunity side. How does that translate to an investor? Well, basically as the ability to put something together with a better risk-adjusted return profile.
Keith Black, CFA; associate with Ennis Knupp + Associates
JOI: Have commodity prices peaked? If not, where are we in the commodities cycle?
Keith Black (Black): Commodities tend to trade in very long-run cycles, with some market observers placing the timing at around 17 years. It is difficult to forecast commodities prices, but to do so, we need to analyze supply-and-demand trends.
At this time, there are physical constraints in energy production and metals mining that make it difficult to immediately and substantially increase supply to meet a growing demand. The lengths of commodity cycles are related to the time it takes to enhance production, which includes finding a deposit in the ground; securing financing and environmental permits; extracting the commodity; and, finally, finding shipping and refining capacity. Supply is currently constrained in the Energy and Industrial Metals markets, so we might be able to forecast rising prices if demand continues to grow.
On the other side, in recent years, much of the demand growth for commodities has come from emerging markets, specifically Asian markets, including India and China. The lowest commodity prices in recent years were found at the end of 1998, when Southeast Asia was experiencing currency devaluations and recessionary conditions that reduced demand for commodities. Many observers believe that your view of Asian GDP growth should have a strong influence on your view for commodity prices.
… Commodities also tend to have an inverse correlation to the value of the U.S. dollar relative to other currencies. As the dollar declines in value, the U.S. dollar price of commodities tends to increase. Those who forecast a weak dollar may be more bullish on commodity prices.
JOI: Which areas of the commodities market do you believe will be most attractive over the next few years?
Black: The commodities with the tightest supply and largest demand increases will be the most attractive in future years. The risks to this supply-demand balance could be any breakthroughs in the alternative energy areas that could reduce the demand for fossil fuel products.
JOI: Have index investors and other asset allocators been a significant factor driving the increase in commodities prices?
Black: No. While institutional investments in commodity futures increased from $36 billion in 2004 to $240 billion in the first quarter of 2008, we don't believe that these investment flows were instrumental in driving commodity prices to their recent record highs. At $240 billion, commodity index investment (assuming an equal weight allocation to the S&P GSCI and Dow Jones-AIG commodity indexes) represents only 3.7 percent of the world production of energy, and 8.1 percent of the world production of food and fiber. It is important to note that institutional investors don't store or consume commodities, and therefore don't contribute to increasing demand.
The main driver of commodity prices is the robust demand from emerging markets, as energy usage in Asia has increased by 15.7 percent from 2002 to 2006, according to the U.S. Department of Energy. The increased demand from Asia over the last five years is now larger than the total positions of institutional investors.
JOI: How much of the average investor's portfolio should commodities represent?
Black: Most investors will allocate between 1 and 7 percent of their portfolio to commodities, with many coming in between 2 and 4 percent. In our experience, mean-variance optimizers seem attracted to commodity futures products, suggesting much larger weights due to their low correlation to most other asset classes. However, many investors will not exceed a 5 percent allocation, as the volatility of commodity investments is similar to the volatility of equity investments.
JOI: Are commodity-producing equities a good replacement for commodity futures exposure?
Black: No. The goal of commodity exposure in a portfolio is to reduce portfolio volatility, which occurs when the investments in the portfolio exhibit minimum correlation to other portfolio investments. An investment in commodity futures is clearly correlated to commodity prices. An investment in a commodity-producing equity may have exposure to both commodity prices and to stock markets.
Over the last two years, we have seen that the S&P GSCI has an equity market beta near zero, while Energy stocks have had a beta exceeding one. In the long term (1994–2007), the Dow Jones-AIG commodity index has a correlation of -17 percent to the Wilshire 5000 stock market index, making commodity futures exposure an excellent way of reducing the risk of an equity portfolio.
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