The Unusual Entry Risk Today in Commodity Investing: Weather … (Jeremy Grantham, GMO)

For agricultural commodities, it is generally expected that prices will fall next year if the weather improves. Because global weather last year was, at least for farming, the worst in many decades, this seems like a good bet. The scientific evidence for climate change is, of course, overwhelming. A point of complete agreement among climate scientists is that the most dependable feature of the planet’s warming, other than the relentless increase in the parts per million of CO2 in the atmosphere, is climate instability. Well, folks, the last 12 months were a monster of instability, and almost all of it bad for farming. Skeptics who have little trouble rationalizing facts will have no trouble at all with weather, which, however dreadful, can never in one single year offer more than a very strong suggestion of long-term change. Unfortunately, I am confident that we should be resigned to a high probability that extreme weather will be a feature of our collective future. But, if last year was typical, then we really are in for far more serious trouble than anyone expected. More likely, next year will be more accommodating and, quite possibly, just plain friendly. If it is, we will drown, not in rain, but in grain, for everyone is planting every single acre they can till. And why not? The current prices are either at a record, spent just a few weeks higher in 2008, or were last higher decades ago. The institutional and speculative money does not, in my opinion, drive the spot prices higher for reasons given earlier, but they do persistently move the more distant futures contracts up. Traditionally, farmers had to bribe speculators to take some of the future price risk off of their hands. Now, Goldman Sachs and others have done such a good job of making the case for commodities as an attractive investment (on the old idea that investors were going to be paid for risk-taking), that the weight of money has pushed up the slope of the curve. This not only destroys the whole reason for investing in futures contracts in the fi rst place, but, critically for this current argument, it lowers the cost to the farmers of laying off their price risk and thus enables, or at least encourages, them to plant more, as they have in spades. Ironically, institutional investing facilitates larger production and hence lower prices! Should both the sun shine and the rain rain at the right time and place, then we will have an absolutely record crop. This would be wonderful for the sadly reduced reserves, but potentially terrible for the spot price. (Although wheat might be an exception because the largest grower by far – China – is looking to be in very bad shape for its upcoming harvest.)

… and China

Quite separately, several of my smart colleagues agree with Jim Chanos that China’s structural imbalances will cause at least one wheel to come off of their economy within the next 12 months. This is painful when traveling at warp speed – 10% a year in GDP growth.

The litany of problems is as follows:

a) An unprecedented rise in wages has reduced China’s competitive strength.

b) The remarkable 50% of GDP going into capital spending was partly the result of a heroic and desperate effort to keep the ship afl oat as the Western banking system collapsed. It cannot be sustained, and much of the spending is likely to have been wasted: unnecessary airports, roads, and railroads and unoccupied high-rise apartments.

c) Debt levels have grown much too fast.

d) House prices are deep into bubble territory and there is an unknown, though likely large, quantity of bad loans.

You have heard it all better and in more detail from both Edward Chancellor and Jim Chanos. The significance here is that given China’s overwhelming influence on so many commodities, especially in terms of the percentage China represents of new growth in global demand, any general economic stutter in China can mean very big declines in some of their prices. You can assess on your own the probabilities of a stumble in the next year or so. At the least, I would put it at 1 in 4, while some of my colleagues think the odds are much higher. If China stumbles or if the weather is better than expected, a probability I would put at, say, 80%, then commodity prices will decline a lot. But if both events occur together, it will very probably break the commodity markets en masse. Not unlike the financial collapse. That was a once in a lifetime opportunity as most markets crashed by over 50%, some much more, and then roared back. Modesty should prevent me from quoting from my own July 2008 Quarterly Letter, which covered the first crash. “The prices of commodities are likely to crack short term (see first section of this letter) but this will be just a tease. [Editor’s Note: the section referred to is titled “Meltdown! The Global Competence Crisis,” which discusses the aftermath of the global financial crisis.] In the next decade, the prices of all raw materials will be priced as just what they are, irreplaceable.” If the weather and China syndromes strike together, it will surely produce the second “once in a lifetime” event in three years. Institutional investors were too preoccupied staying afl oat in early 2009 to have obsessed much about the first opportunity in commodities and, in any case, everything else was also down in price. A second commodity collapse in the next few years may also be psychologically hard to invest in for it will surely bring out the usual bullish argument: “There you are, its business as usual. There are plenty of raw materials, so don’t listen to the doomsayers.” Because it will have broad backing, this argument will be hard to resist, but should be.

Residual Speculation

Finally, there is some good, old-fashioned speculation, particularly in the few commodities that can be stored, like gold and others, which are costly per pound. I believe this is a small part of the total pressure on prices, and the same goes for low interest rates, but together they have also helped push up prices a little. Putting this speculation into context, we could say that: a) we have increasing, but still routine, speculation in commodities; b) this comes on top of the much more important effects of terrible weather; and c) most important of all, we have gone through a profound paradigm shift in almost all commodities, caused by a permanent shift in the underlying fundamentals.

The Creative Tension in Investing in Resources Today

As resource prices rise, the entire system loses in overall well-being, but the world is not without winners. Good land, in short supply, will rise in price, to the benefit of land owners. Technological progress in agriculture will add to the value of land holdings. Fertilizer resources – potash and potassium – will become particularly precious. Hydrocarbon reserves will, of course, also increase in value. In general, owners or controllers of all limited resources, certainly including water, will benefit. But everyone else will be worse off, and a constrained-resource world will increase in affluence per capita more slowly than it would have otherwise, and more slowly than in the past. Remember, this is not simply a recycling of income and wealth as it was when Saudi Arabia stopped some of its pumping for political reasons. Then, we paid a few extra billion and they put money in the bank for recycling. There was no net loss. But now when they pump the last of the cheapest $5/barrel of oil and we replace it with a $120/barrel from tortured Canadian Tar Sands, the cost differential is a deadweight loss. GDP accounting can make it look fine, and it certainly creates more jobs but, like a few thousand men digging a hole with teaspoons, it adds jobs but no incremental value compared to the original cheap oil. How does an investor today handle the creative tension between brilliant long-term prospects and very high short-term risks? The frustrating but very accurate answer is: with great difficulty. For me personally it will be a great time to practice my new specialty of regret minimization. My foundation, for example, is taking a small position (say, one-quarter of my eventual target) in “stuff in the ground” and resource efficiency. Given my growing confidence in the idea of resource limitation over the last four years, if commodities were to keep going up, never to fall back, and I owned none of them, then I would have to throw myself under a bus. If prices continue to run away, then my small position will be a solace and I would then try to focus on the more reasonably priced – “left behind” – commodities. If on the other hand, more likely, they come down a lot, perhaps a lot lot, then I will grit my teeth and triple or quadruple my stake and look to own them forever. So, that’s the story.

Quarterly Letter – Time to Wake Up – April 2011 17 GMO

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