Commodities -- Has That Boat Sailed?

By Padraig O'Hannelly | 15 May 2008

| 3 Comments

"Commodity prices are rising", said Mervyn King, Governor of the Bank of England, on Wednesday. Note his use of the continuous present tense - not only have commodities risen in price, but they will continue to rise.

But just look at the commodity inflation we've seen so far:

•   crude oil prices have risen twelve-fold in less than ten years;
•   the price of copper has risen more than six-fold since 2001;
•   wheat has quadrupled in value since 2004, but has since fallen back.

According to commodities guru Jim Rogers, this is just the start; we are now only half-way into a boom that he expects to last seventeen years.

The underlying reasons for this have been well publicised. At its most basic, more people in the world means more mouths to feed. And as those people become richer, there's a greater demand for electricity, motorised transport and a diet of animals rather than plants.

On the supply side, new reserves of oil and metals are harder to find, and when they are found they are often in more inaccessible locations and in smaller quantities. What's more, building new mines, refineries and the like takes a lot of time and capital.

As the prices have soared, speculation has added to the supply and demand argument. Consider the following:

•  Over the past ten years, the amount invested in commodities has risen 15-20 fold, to nearly $200bn -- other sources put the figure much higher;
•  The number of commodity ETFs has roughly tripled in the past year, as more exotic variants are added;
•  Hedge funds and pension funds are becoming bigger players in the market;
•  Sovereign wealth funds are also reportedly investing extensively in commodities. This is interesting because, in addition to normal investment reasons, many sovereign wealth funds have an interest in high commodity prices, as their wealth is derived from the production of commodities;
•  Everyone is talking about commodities.

Do any of those items give the appearance of a bubble?

And here's my problem: While I buy into the fundamental argument for investment in commodities, how do I know when the price has got ahead of itself? With shares, I can calculate a PE, a dividend yield, and other key metrics, but how to I calculate a "fair value" for aluminium, or wheat? Many place their faith in charting, but I am not convinced.

I'll be looking at some of these issues in more detail in future articles.

You can buy commodity ETF's just like normal shares, and if you want to bet on a drop in prices, there are ETFs that gain when the price falls. You can even hold ETFs in an ISA. As with any investment, proceed with caution - commodity prices can be very volatile. Remember that with Motley Fool Sharebuilder, you can buy shares for no commission until June 30.