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The two major financial headlines in the first week of 2016 surrounded China and oil.
I recently gave readers my thoughts on all the major emerging markets, including China.
Now I want to do the same for the commodities markets, which I have been following since the 1980s. I will start with the soft commodities, then look at the metals, and finally energy.
Soft Commodities
Actually, soft commodities are the commodities that I think have the most long-term upside.
Both cocoa and coffee have very strong stories on the demand side. Demand from the emerging world, despite the turmoil, continues to grow. The Chinese, for instance, are developing a real taste for both coffee and chocolate. Meanwhile supplies, particularly for cocoa, grow increasingly iffy.
Investors can play this trend through two exchange-traded notes – the iPath Bloomberg Coffee Subindex Total Return ETN (NYSEArca: JO) and the iPath Bloomberg Cocoa Subindex Total Return ETN (NYSEArca: NIB).
Grains
The other softs – which include grains such as corn, wheat and soybeans – have had a terrible past three years on a price basis. Abundant crops in the Americas have been the result of favorable weather patterns such as El Niño.
But there is a very real possibility than the current El Niño will switch to a La Niña. This weather pattern is characterized by blazing hot summers and drought in grain-growing regions in the Midwest.
It may be worth looking at the ETFs that will benefit from a rise in grain prices in 2016. There are a number of them, including the offerings from Teucrium Trading. These include the Teucrium Corn Fund (NYSEArca: CORN), the Teucrium Wheat Fund (NYSEArca: WEAT) and the Teucrium Soybean Fund (NYSEArca: SOYB). One drawback is that these funds have rather high fees.
Precious Metals
Both gold and silver interest me. One saw the value of gold in this past week of stock market turmoil. It is a wonderful insurance policy against calamity. But one has to be cautious. Wall Street loves to hate precious metals. In other words, they love shorting gold and silver and knocking them back down when they make too much headway.
Both platinum and palladium are avoids. Both are too reliant on now-faltering industrial demand.
Base Metals
Avoid all base metals – copper, nickel, zinc, lead, tin, iron ore, aluminum – until either ignorant management wakes up and curtails output sharply, or one of the big five global miners goes belly up.
The former is very unlikely to happen. Look at iron ore. China has said steel production has permanently peaked. Yet leading miner Rio Tinto PLC (NYSE: RIO) is saying the Chinese don’t know their own business and are forecasting huge output increases.
The latter is a very real possibility, however, with both Glencore PLC (OTC: GLNCY) and Anglo American PLC (OTC: NGLOY) likely bankruptcy candidates.
In other words, the vast overcapacity has to be eliminated one way or another. When that happens, the survivors should prosper.
Natural Gas
The one word that best describes energy is: ugly.
Natural gas is a definite avoid. I’m sitting right in the middle of glutland, otherwise known as the Marcellus Shale region of western Pennsylvania. Companies are being forced to sell natural gas from the Marcellus at even lower prices than the depressed Nymex gas prices.
There’s no hope over the near term either from liquefied natural gas exports. Asia, where demand was once soaring, is demanding less LNG. Some countries there are simply switching back to cheaper domestic coal. That’s not good when LNG exports from both the U.S. and Australia are just getting set to expand.
Oil
Finally, no look at the global commodities sell-off would be complete without a discussion of oil. The question everyone is asking is when will this precipitous decline end?
My feeling is that the price has to crack $30 a barrel before a bottom begins to form. All the major players – Saudi Arabia, Russia and the United States – keep pumping out oil as if there’s no tomorrow. It just has to get very, very painful to do so before they will stop.
Production is exceeding demand by 1.5 million to 2 million barrels per day at the moment. This makes Goldman Sachs’ forecast last summer that oil will go down to $20 per barrel quite realistic. Traders in the options market have been taking out protection against oil falling below $25 a barrel.
Investors should watch for one of two things to happen that will signal a bottom is forming.
First, Saudi Arabia’s budget deficit is huge and growing. It does have lots of currency reserves, but they are not infinite. Eventually the Saudis will have to choose between cutting production or revaluing their currency, the riyal, versus the U.S. dollar. In a way, they are in a similar dilemma as the Chinese. My guess – and it’s strictly that – is that the Saudis devalue the riyal and keep oil production high.
Second, a number of U.S. shale players need to disappear. Many likely will.
Why? One word: debt. Rewind back to 2005 and the industry owed lenders a mere $50 billion. Fast forward to 2015 and we see that the debt mountain grew to more than $200 billion. For many firms, their business model is unsustainable at current oil price levels.
Yet, the U.S. shale industry still doesn’t get it. At the recently concluded Goldman Sachs conference for shale producers, the companies’ outlook was all sunshine and roses.
Until the managements at these companies face reality, it will be all downhill for investors.
Of course, a bottom will form – eventually. To play the coming bottom, I would either own a blue chip like Exxon Mobil (NYSE: XOM) or perhaps an ETF like the United States 12 Month Oil Fund (NYSEArca: USL) that holds some longer-term oil futures.
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