Commodities, the Decade Ahead: 2020 – 2030

287 Pages·2020·70.052 MB·English

by  David J. Howden

Commodities, the Decade Ahead:
2020 – 2030
Your guide to earning profits (and avoiding
losses) from trading the 43 most liquid
commodities

David J. Howden, Ph.D.
Commodities, the Decade Ahead | i

Copyright © 2020 by David J. Howden

All rights reserved. No part of this book may be reproduced or utilized in any form or
by any means, electrical or mechanical, including photocopying, recording oy by any
information storage or retrieval system, without permission in writing from the author.
Inquiries should be addressed to David Howden, Ave. del Valle 34, Madrid, Spain,
28009, or electronically to [email protected].

Howden, David J.
Commodities, the Decade Ahead: 2020 – 2030 /
David J. Howden.
ISBN 978-1-7349116-1-9
1. Business & Economics—Forecasting. 2. Investments & Securities—Commodities.
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Disclaimer

Although the data found in this book have been produced and processed from sources
believed to be reliable, no warranty, expressed or implied, is made regarding accuracy,
adequacy, completeness, legality, reliability, or usefulness of any information. This
disclaimer applies to both isolated and aggregate uses of the information. The
information is provided on an "as is" basis.
All investments, including equities and foreign exchange, are speculative in nature and
involve substantial risk of loss. I encourage investors to get personal advice from a
professional investment advisor and to make independent investigations before acting
on information that I publish.
Past performance is not necessarily indicative of future results. All investments carry
risk and all investment decisions of an individual remain the responsibility of that
individual. There is no guarantee that systems, forecasts, indicators, or signals will result
in profits or that they will not result in losses. All investors are advised to fully understand
all risks associated with any kind of investing they choose to do.
Hypothetical or simulated performance is not indicative of future results. Unless
specifically noted otherwise, all return examples provided in in this book are based on
hypothetical or simulated investing. I make no representations or warranties that any
investor will, or is likely to, achieve profits similar to those shown, because hypothetical
or simulated performance is not necessarily indicative of future results.
Commodities, the Decade Ahead | v

Contents

Introduction ................................................................................... 5
Relative Valuation ......................................................................... 13
Period Forecasts ............................................................................ 21
Cycle Analysis ............................................................................... 29
A Historical Review of the Commodities ..................................... 39
Introduction to the Commodity Reports ...................................... 51
Commodity Reports ...................................................................... 57

Aluminum ..................................................................................... 59
Baltic Dry Index ............................................................................ 71
Canola ........................................................................................... 81
CBOE Volatility Index .................................................................. 91
Coal ............................................................................................. 101
Cobalt .......................................................................................... 113
Cocoa .......................................................................................... 125
Coffee .......................................................................................... 137
Copper ......................................................................................... 149
Corn ............................................................................................. 161
Cotton .......................................................................................... 173
Crude Oil: Brent .......................................................................... 185
Crude Oil: West Texas Intermediate .......................................... 197
Ethanol ........................................................................................ 209
Feeder Cattle ............................................................................... 221
Gold ............................................................................................. 233
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Heating Oil ................................................................................. 245
Iron .............................................................................................. 255
Lead ............................................................................................ 267
Lean Hogs .................................................................................. 279
Live Cattle ................................................................................... 291
Lumber ........................................................................................ 303
Milk ............................................................................................. 315
Natural Gas ................................................................................. 327
Nickel .......................................................................................... 339
Oats ............................................................................................. 351
Orange Juice ............................................................................... 363
Palladium .................................................................................... 375
Palm Oil ...................................................................................... 387
Platinum ...................................................................................... 397
RBOB Gasoline........................................................................... 409
Rice ............................................................................................. 419
S&P GS Commodity Index ......................................................... 431
Steel ............................................................................................. 441
Silver ............................................................................................ 453
Soybean Meal .............................................................................. 465
Soybean Oil ................................................................................. 475
Soybeans ..................................................................................... 485
Sugar ........................................................................................... 497
Tin ............................................................................................... 509
Uranium ...................................................................................... 521
Wheat .......................................................................................... 533
Zinc ............................................................................................. 545
Ranking and Conclusion ............................................................ 557

1
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Audentis fortuna iuvat.
- Virgil
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Introduction

This book concerns itself with two questions. The first is whether the major exchange-
traded commodities are presently under- or over-valued. By this I mean whether they are
priced at a discount or a premium compared to other goods that are available for
purchase. The second question is more pressing for the investor. Given any discount or
premium on the spot markets, what is the expected return that the investor can expect
to earn by entering a commodity investment today? This return can be thought of in
either an absolute (e.g., some percentage per year) or relative form (e.g., some percentage
above a benchmark return). The absolute return is important to aid the investor in
forming an expectation of what the return of a commodity will be, without reference to
any other investment (e.g., will the price break-even?). Even more relevant in many cases
is the relative return: how well a specific commodity can be expected to perform against
other commodities. This book sheds light on both these views.
Determining whether a commodity will under- or over-perform other assets classes
in the future depends critically not just on its current valuation, but also on its valuation
at some future date in time. In turn, these valuations can be described in the absolute
sense and a relative sense. In the former case, I am concerned with the question of
whether the price of a specific commodity trades at a discount or premium compared to
its historical norms. In the latter case the discount or premium is relative to other
commodities. Answering these questions is difficult enough for the spot price, and the
search for a method of determining the future valuation is somewhat like the “Holy
Grail” of investment analysis. This book provides a method not only to comment on
present prices but also on the prices I can expect to see prevail on the futures markets.
The problem of estimating the current discount or premium on a commodity and of
estimating the future return from holding it is eased by approaching the problems in two
ways. In economic and financial analysis all variables are categorized as being either
stocks or flows. A stock variable is one that exists at a moment in time. It is usually
reported on a balance sheet, and includes items like assets or liabilities, but also such
variables as the rate of unemployment or the price level. In contrast flow variables occur
over some period. These are typically reflected on a statement of cash flows, and include
items such as revenue and expenses, but also variables such as the rate of inflation or the
trade balance. In the latter cases the flow variables are all expressed for some period,
typically over a year. In the former case I see the stock variables existing irrespective of
any period.
This book takes the approach that the market is generally quite efficient at pricing
commodities, though waves of under- and over-valuations appear periodically. There are
6 | David J. Howden Commodities, the Decade Ahead | 7
strong economic forces aligning various prices with each other and mispricings, in the finds a way to eventually price each commodity at some fair-value level with respect to
sense of a commodity selling at a discount or premium to other commodities, cannot last the other.
indefinitely. Basic economic reasoning explains why: any commodity selling at a premium Since 1900 the average gold price has been 50 ounces of silver. (If one wanted to just
will entice firms to look for a substitute that is more cost effective and entice a greater focus on the period since 1972, when the price of gold could fluctuate freely, this figure
number of producers to supply the good at a profit. The result of this process is a increases to 60 ounces of silver.) This average price is not the fair-value price of either
diminution of the premium back to some “fair” value level more closely aligned with the commodity. The reason is that a fair-value price will change over time as market and
prices that other commodities sell at. commodity specific factors that determine its price evolve. Changes to, for example, the
Consider a similar approach: the gold-to-silver ratio. This ratio expresses the tax code will change this price. One could imagine a regime that the government suddenly
commodities’ prices in real terms: specifically, the number of ounces of silver it takes to taxes silver advantageously to gold, and consequently the price of gold falls relative to
buy one ounce of gold. Throughout history this price has oscillated around some median silver. An industrial use for gold that cannot make use of silver could cause the fair-value
value. This back-and-forth nature of the price is most apparent since the early 1970s, price of gold to surge. In sum, although the average gold price in terms of silver is helpful,
when gold´s price was allowed to be set by market supply and demand conditions, but it is not synonymous with its fair-value price.
even in earlier periods one can see that its price was anchored in terms of silver. Once a method to estimate whether a commodity is priced at a discount or premium
is secured attention can be turned to forecasting its future price path. This is the flow
variable and represents the largest challenge facing the investor. It also affects directly
where he chooses to allocate his funds.
There are several common approached that shed light on the future price path for a
commodity. One well-cited insight looks at the general negative relationship between the
interest rate on U.S. Treasury bonds of 10-year maturity and the return to holding gold
over the same period. Approximately one-third of the return to holding gold can be
explained by looking only at Treasury yields, at least historically during the post-1972
period. Using this approach yields an expected 10-year annual return to holding gold of
15.5% (given the current 10-year Treasury yield of 0.7%). This forecast is based on the
historical relationship between the Treasury yield and gold´s subsequent return,
extrapolated into the future from the current interest rate.
Although understanding this relationship is a start, there are some significant
problems with drawing conclusions from it. For starters, the relationship between
Treasury yields and the return to gold is statistically significant, but quite weak. Only 31%
of the variance in gold´s return is explained which leaves the other 69% unexplained.
More importantly, there are some
significant non-linearities in the
relationship. The negative relationship
is quite strong when Treasury yields
are under 10%, but at higher rates the
relationship loses significance.
Only rarely since 1900 has gold´s price neared or exceeded 80 ounces of silver. At The immediate problem is that the
each the six cases prior to today (1932, 1937-42, 1990-93, 2003, 2008, and 2016) the silver statistical relationship is not stable
price of gold backed off, as a result of either the dollar price of gold falling or because of over time. This instability is reflected
the dollar price of silver increasing. The immediate re-pricing of gold has typically been both in the sign of the relationship
at a price of 60 ounces of silver, and often much less. and its strength. While the overall
To look at this from the other way ´round, only rarely has the price of gold dipped period shows a weakly negative
below 40 ounces of silver (most recently in 2011). In these cases where it has, eventually relationship between the two
this price ventures higher because of a higher dollar price for gold or a lower dollar price variables, the period since 2001 has
for silver. shown an even more weak (R2 = 0.22)
The economic forces at play are obvious. To the degree that silver and gold are but positive relationship. There might be
substitutable, either to traders or producers, a high price of gold in terms of dollars will an important relationship between
motivate a shift into silver. This back-and-forth process takes some time, but the market bond yields and gold´s (or any other
8 | David J. Howden Commodities, the Decade Ahead | 9
commodity´s) return, but identifying of silver, and September 1992 when it traded for 93 silver ounces. Given this extreme
it is difficult. valuation in gold, what is a reasonable expectation for the future return on gold in terms
Even though the explanatory of silver.
power of the relationship is low, it still While the answer to this question is highly uncertain, historical norms and patterns
yields important information about can shed light on what is likely to occur. Over the past 30 years, over 49% of the variance
the plausibility of a forecast. Given in the 5-year return of gold in terms of silver, and 54% of the variance of the metal´s 10-
the standard error of the relationship year return, have been explained by the gold-to-silver ratio. By this measure, the best
between Treasury yields and gold´s statistical forecast is that gold will decline relative to silver by -14% annually over the
return I can make statements coming five years, and by -8% annually over the next decade.
concerning the probabilities of a All periods where gold was worth near or more than 80 ounces of silver (January
forecast, based on the historical 1991: 97 silver ounces; April 2003: 80; October 2008: 77) have been associated with
relationship between the variables. negative annual returns over the next five years (-5%; -7%; -4%). Considering these
Although probabilistic in nature, and historical facts, the negative return presently forecasted is not unusual, and the real value
with a large margin of error given the of the foregoing analysis is a look at the plausibility of a future event happening.
general lack of fit that my simple We have created a very simple model based only on knowledge of the historical price
model of gold´s return has, this action of gold and silver over the past 30 years. These three decades had their fair share
probability forecast is still a start and of economic and financial bumps along the way, and the booms and busts add a
sheds light on the forecast´s robustness that a mundane period (economically speaking) would not provide. Given the
plausibility. standard error of my model, I can also calculate the associated probabilities that the
For example, there is only a 19% forecasted event will happen.
probability that the return to gold will For example, the worst 5-year return from buying gold and selling silver over the past
be greater than 20.8% annually over thirty years was -13% annually and occurred over the period between February 1993 and
the coming decade given the current February 1998. What is the probability that gold will perform as badly or worse than an
yield on Treasuries. This 10-year -13% annual decline? About 65%, statistically speaking given the interactions between
return was chosen because it was the gold and silver over the previous thirty years. There is almost no chance (less than 1%)
highest that an investor could have that gold is expected to break-even against silver over this period. Now, it could be that
earned on gold historically and the historical relationships between the two metals change moving forward, but it would
resulted from a purchase made in take a significant change, as well as one that breaks from an even longer-standing
August 2001 and sold in August 2011. tradition, to meaningfully affect the general thrust of this statistical analysis.
It´s possible that buying gold today Admittedly, this forecast of gold´s price in terms of silver is not very robust. Over the
will provide a return comparable to the 301 5-year periods since April 1990 the model only explains approximately half of the
best all-time recorded return on return variance. What is needed is a sufficient number of variables and their relationship
holding gold, but given the historical with the price of gold (and each other) to be understood so that a larger majority of the
relationship with Treasuries, it´s return variation is explained. This is a difficult feat to achieve, complicated by the threat
unlikely. that I overfit the model and end up with a highly accurate description of the time period
What of the possibility that gold will return -6% annually over the coming decade? under analysis, but with little predictive capability of out-of-sample or future results.
This figure is the lowest 10-year return the yellow metal has yielded historically and Ultimately, I need to understand the determinants of returns in the simplest terms
occurred for an investment made in June 1980. The yield on 10-year Treasury bonds that possible, without including spurious factors that might compromise the statistical value
month was 9.8%. It is possible that gold could return a loss of 6% annually for the next of the results.
ten years but given the statistical relationship between its price and bond yields, the This book tries to simplify the process for the investor. Instead of detailing the factors
probability is only 0.000006%. In other words, betting on such a drastic loss is not that are relevant for future security returns, I focus on the relationship between these
consistent with historical experience. Rather than looking at gold in terms of dollars, I factors and the subsequent return. I then complete the analysis by providing the
can also think of its return relative to other commodities. This is already alluded to in the forecasted returns and their associated probabilities so the reader can judge for himself
previous figure showing the price of gold in terms of silver. At 113 ounces of silver to how relevant and robust the statistical analysis is.
the ounce, gold is more expensive today, at least according to this measure, than ever The problem of estimating future returns is simplified by taking recourse in three
(our record of this ratio begins in 1791). The closest gold´s price has come to this high simple ideas: 1) that the spot (or cash) price is efficient in that it incorporates all known
was between September 1939 and December 1941 when an ounce traded for 100 ounces and relevant information of the commodity into it, 2) that this spot price oscillates
10 | David J. Howden Commodities, the Decade Ahead | 11
between over- and under-valued positions over long time periods, and 3) that the effect would exist absent such policies. The belief that value reverts to a level consistent with
of these oscillations on the return of a commodity can be forecast with varying degrees real and reasonable expectations in the long term gives my relative valuation model a
of accuracy by looking at historical patterns. high degree of accuracy, especially over longer periods.
The first step – accepting that the spot price is “correct” in the sense that it The third step in the analysis is that these valuation cycles are probabilistically similar
incorporates the information necessary for price formation, is a standard component of over time. It is commonly said that history does not repeat but it rhymes. In my view,
price theory. The idea usually falls under the guise of the efficiency markets hypothesis the valuation cycles that commodity markets go through are not isolated events. They
(EMH) when applied to financial markets. In economics, EMH is an example of a theory are related to each other and anchored by the continual search for true value. In this way,
that drives a wedge between academics and practitioners. Broadly stated, EMH implies the price formation process – and by extension, the return from holding an asset – is no
that the price of a security at any given time will include all information which is known different for soybeans as it is for sweaters.
and relevant to that price. Simple enough. One implication of this is that no one investor In August of each year stores put winter clothes on display at high prices. As the
can estimate better what the price should be other than the current price, at least not season progresses retailers search for the true price of sweaters or, in economic terms,
based on widely available information. Applied to financial assets, this implies that no the market-clearing price. Although this simple example is easy to understand from basic
individual can “beat the market”, since the market is already priced to include all relevant supply-demand analysis coupled with the fact that it is easier for a retailer to lower a price
information. than to raise it, the same method can be applied to the commodity market.
More properly understood, it is important to note that EMH does not imply that a Traders buy and sell commodities in a bid to seek out the market-clearing price. Along
price is correct. It only implies that the price includes all information that is currently the way, central bank monetary policy skews expectations and places temporary pressure
available and relevant to it. It could turn out that the price is “wrong”, as it often looks on the spot price, causing either a period of under- or over-valuation. Eventually
with the benefit of hindsight, but this would not be known in the present given the economic forces prevail and the price returns to its “market-clearing” or “correct” level.
current state of information. This book provides the method and results of one approach to estimate these mispricings
The use of EMH simplifies the forecasting problem somewhat because I can rely on in real time and produce forecasts of future returns based on this information.
technical price data to summarize the qualitative and at times tacit information that exists We end this introduction with a word of caution. The future is fundamentally
and is relevant for a commodity´s price. This second step, that the price always unknowable with any exactness. At the same time, it is unreasonable to think that the
incorporates all information available and relevant to its formation, seems to conflict with future will not be related to the present or past in any way whatsoever. After all, how
the first step: the belief that commodity prices oscillate in valuation cycles over time. often have you read the following statements:
After all, how can a commodity´s price be “correct” if at the same time it meanders
through periods of over- and under-valuation? Remember that EMH only states that the - Past performance does not guarantee future results.
spot price will incorporate all known information relevant for its formation. For several - This time is different.
reasons, mispricings can still occur, though their cause will be unforeseen in advance, or
alternatively these mispricings cannot be quantified in a way that can be acted on. Since they are mutually exclusive, which statement is correct? The most defensible
The spot price cycles through periods of over- and under-valuations caused by answer is that they are both partially correct. The past does not guarantee the future, but
temporary mispricings, whereby investors don´t know what a commodity´s price should it provides a roadmap. This time is surely different than any other moment in history,
be, and the market undertakes a search process to unearth it. As investors bid on and sell but not completely so. The successful investor must balance these two philosophies.
commodities, prices rise and fall around the “correct” value. These valuation cycles also Today´s state of financial affairs is the result of decisions that were made in the past,
appear over longer periods. Here prices rise and fall due to changing information that dependent as they were on interest rates, advances in production technology,
concerns the market as a whole, e.g., prevailing interest rates or growth expectations. unemployed workers entering the workforce and a wide range of other real economic
Mostly these price cycles are governed by the “money illusion” – waves of expectations and financial factors.
that stem from central bank monetary policies that raise and diminish investor In all the forecasts that follow I list the associated probability of the event. These
confidence and expectations over longer periods. Under this reasoning, the global equity probabilities are based on historical experience. While not completely applicable to future
indexes were “correctly” valued in early 2000 and late 2007. The same could be said of events (since they are backward looking in nature) they give the investor a starting place
the commodity markets in 1974, or 2008. “Correct” in this sense refers to the fact that to assess the likelihood of the future. Future returns concern outcomes of various
given all the information available at the time, including expectations about future interest likelihoods. Historical relationships don´t tell us the complete story, but they give us a
rates, inflation, and optimism, investors actually did believe those lofty valuations to be foundation to differentiate between those events more likely to occur in the future and
reasonable. my emphasis on long-term secular cycles stems from central bank actions those that are less likely to occur.
that skew important expectations concerning the future. This book is not and should not be interpreted as investment advice. The investor´s
By looking at the foundation of the skewed expectation – monetary policies propensity for risk, desire for exchange rate exposure, as well as local laws governing
constructed by the world´s major central banks – I can identify periods where investments are all beyond the scope of the book. It is aimed solely at shaping
commodities are over- or under-valued relative to those counterfactual expectations that expectations and providing a roadmap to navigate one potential coming decade.