On average, stock investors enjoyed a pretty good year in 2010. Commodity investors with a taste for long exposures fared even better. The S&P 500's 12.8 percent return was trumped by the 17.4 percent gain notched by the Thomson Reuters/Jeffries CRB Index, a benchmark tracking 19 domestically traded commodity futures.
Investors holding long positions in certain individual commodities — accessible through exchange-traded securities offered by BlackRock, Barclays, State Street and others — fared better still. The gleam of precious metals especially caught investors' eyes in 2010. The SPDR Gold Shares Trust (NYSE Arca: GLD) ended the year with a 29.3 percent gain, but was handily outdone by the iShares Silver Trust (NYSE Arca: SLV), which rose a whopping 82.5 percent.
So-called soft commodities were big winners as well. Cotton, in short supply because of cascading crunches in Asian production, was a standout. The value of the iPath Dow Jones-UBS Cotton Sub-Index Total Return ETN (NYSE Arca: BAL) shot up a heart-pounding 98.3 percent as a result. Coffee drinkers got a little jittery in 2010 as they watched bean prices — beset by the impact of bad weather and low carryovers — soar. The surge translated into a 66.9 percent appreciation in the value of the iPath Dow Jones-UBS Coffee Sub-Index Total Return ETN (NYSE Arca: JO).
So what if you or your clients didn't own any commodity exposure last year? Is there still some life left in the commodity bull or is it just too late to jump on its back? A little probability theory applied to 2010's key markets ought to give us some clues.
Gold, the Barbarous Metal
Among commodities, gold's fundamentals are unique. Bullion, by and large, isn't consumed. Only about 10 percent of gold's total demand is industrial; most of the trade demand for the metal comes from jewelry. And that's waning as prices have risen. The slump in jewelry off-take has, up until now, been offset by volatile investment demand. Meantime, the supply of metal has been steadily augmented by rising mine production and a boom in scrap jewelry reclamation.
The pivotal element in the gold price equation is that pesky investment demand. And that runs on fear — of inflation, of currency debasement, of terrorism and market implosions. Those fears propelled bullion to better than $1,400 an ounce in 2010. The dissipation of that fear will remove significant underpinning from gold's price.
Some of that fear evaporated with fresh indications of thawing in the economic winterscape as the New Year began. That, together with the lightening of top-heavy gold allocations by institutional traders and the unwinding of end-of-year window dressing, yielded the most significant technical damage to gold's uptrend since mid-2010.
An improving economy would likely feature higher bond yields which would raise the opportunity cost of holding gold. After all, gold pays no dividend and costs money to store. Capital flows would likely be diverted from gold and towards paper assets such as stocks and bonds.
There's, of course, no certainty to the timing or the degree of the recovery. Overhanging liquidity from the Fed's quantitative easing must eventually be reabsorbed. That remains a potential inflation threat.
The market's momentum currently favors a continuing high price for gold, though the risk for a blowout top as described in our December 2010 article, “Is Gold in a Bubble?” remains a distinct possibility in 2011. If gold blows up, other commodities are likely to follow.
Based upon gold's volatility last year, the odds are still good for the GLD trust to exceed last year's high by the end of 2011, but even more likely, if only by a slight degree, is the prospect that gold prices end up somewhere between 2010's high and low.
Silver, to some extent, is likely to move sympathetically with gold as investors continue to regard the metal as a safe haven. Silver prices, because of the metal's industrial utility, are also likely to be buoyed in a recovery.
The metal's volatility, however, is its Achilles' heel. Investors flooded into silver as a “poor-man's gold” and on sentiment that the metal was undervalued given historic levels in the gold/silver ratio. After nearly doubling last year, pullbacks are likely to be dramatic. Odds are better than 50-50 that silver prices end 2011 somewhere between last year's high and low.
Global demand for copper is likely to continue in 2011, barring a lead-footed quashing of the Chinese infrastructure boom and a deepening of the Eurozone debt crisis. Supplies of the metal remain short and investor demand is likely to burgeon with the introduction of metal-backed exchange-traded securities in 2011.
Production shortfalls are expected to double in 2011, compared to last year's deficit, as Asian and North American demand increases. The supply tightness is reflected in the backwardation of the copper futures market — a condition in which the nearby contracts trade at a premium to futures calling for later delivery. Higher prices for front-month deliveries denote the immediacy of traders' need for copper. The market inversion also enhances returns for the index underlying the extant iPath copper note and that of the long-only ETF products in registration.
Cotton prices reached record highs in December, forming a potential double top. A hike in Chinese interest rates signaled a step-up in the People's Bank's effort to cool a clearly overheated economy. Continued tightening could eventually dampen import demand for cotton.
Fluctuations in discretionary spending, both here and abroad, affect cotton demand significantly. Improvement in the U.S. economy — especially a boost in employment — could bolster prices. On the supply side, weather conditions in Asian growing regions may ultimately improve but the damage to the old crop, together with export restrictions, has severely limited carryovers. U.S. planting intentions — driven by high market prices — are likely to build as farmers rotate out of lower-yield competing crops.
Tight near-term supplies have kept front-month prices hovering a notch or two below their record highs, but odds heavily favor a middling price by year's end.
Despite a 15.2 percent gain in the spot price of West Texas Intermediate crude oil last year, the USO product suffered mightily from a bad case of contango. Contango — the polar opposite of the backwardation exhibited in the copper market — is manifested by discounted prices in front-month contracts. Contango mostly reflects the cost of carrying supply surpluses forward for later delivery. Based upon average prices in 2010, the average monthly cost to roll an expiring WTI futures contract forward was 76 cents per barrel. That represents an annualized headwind of 11.4 percent that a long-only fund must overcome just to break even.
USO's contango-resistant sibling, the United States 12-Month Oil Fund (NYSE Arca: USL), uses an index methodology that spreads rolls over a dozen forward contracts on the curve to minimize the negative roll yield. USL gained 6.5 percent in 2010.
Oil demand is likely to strengthen as the domestic economy recovers. That largely depends upon OPEC adhering to its production curtailment program. Any strengthening in the U.S. dollar, however, is likely to cap outsized gains in crude prices.
The WTI market entered 2011 in a trading range with a slightly bullish bias. There's a strong likelihood that front-month prices will continue this trend, trading back and forth between $80 and $100 per barrel.
The coffee market was defibrillated in mid-2010 after languishing for nearly two years. Low warehouse levels and limited “off-year” production from the world's leading exporter, Brazil, put pressure on the market. Global demand for coffee, too, has been on the rise, especially in developing countries.
Coffee prices are notoriously volatile, however. After 2011, Brazilian and other South American farmers will transition into a more robust phase in coffee's biennial production cycle. That's likely to improve the new crop picture.
Source for all tables and graphs: Brad Zigler