All the Boom
Commodities experienced super cycle and all the boom from early 2000s until 2011. Look at the thermal coal price chart below where the price rose from 20s to 130s. It’s not straight line going up, but the price trend was rising years after years. The middle sharp spike was during 2007 – 2008 when the extreme bullishness was sudden reversed with deep recession.
All the Gloom
During that super cycle, every producers increased their production capacity to the point of overbuilt. China, being the largest importer of commodities, also started slowing down. Suddenly, commodities experienced all the gloom from 2011 to 2015. See the thermal coal price chart below where the price fell from 120s to 50s.
Supply and Demand
I started looking at commodity sector in 2012 when I joined my previous hedge fund, which focused on commodity. Most of the positions in the portfolio were short. After all, commodity prices kept falling, and so were the share prices of the producers.
For commodity sector, we look at Supply and Demand, but both are negative. Oversupply and falling demand. China, being the largest producer and consumer of many commodities, has oversupply situation and slowing growth. Even picking the best company in the sector won’t help you for long position. It just reduces the pain. Therefore, shorting is how to play in this sector.
Looking back, it’s easy to say that we could see the *big picture* and price trend. From early 2000s to 2011, just go long, and from 2011 to 2015, just short. Ignore the monthly fluctuation, and we’ll do fine.
But, the question is: How do you paint that Big Picture?
As professional investor, analyst, fund manager, you need something to support your views, the Big Picture. In order to paint that Big Picture, you drill into details.
You will look at more details with many data points. You monitor companies’ production capacity, government action to clamp down obsolete capacity, weather and seasonal demand, substitute to the commodity of your interest (e.g. hydropower to substitute coal during monsoon season), infrastructure construction, new property development and housing price, fluctuating exchange rate affecting price and cost, new government regulation and tariff, falling GDP growth, interest rate, Eurozone crisis, etc etc. You have so many variables to look at that it’s hard to draw a conclusion. That’s why brokers’ research reports can easily go to 30 pages or more.
Often, you bury yourself in so many moving variables that you confuse yourself and miss out the big picture altogether. Your study of all these data points end up painting the wrong Big Picture.
Forecasting the Price
The goal is to find where the commodity price is going for next few months. If you get it right, you can profit from going long or short the commodity itself or the producers. The problem is it’s very hard to get it right *consistently*. Without this *consistency*, you will not be able to generate above average investment return. You will end up buying too early or too late and selling/shorting too early or too late.
When you are in the game, you look at all the various data points to forecast where the price is going for next few months. When next month comes, you collect new data points and forecast where the price is going for the following months. This cycle repeats. If the trend is clearly going up or down, then you are watching for any inflection points on which the trend will reverse.
With so many moving data points, it is really very very hard to get it right consistently. When the commodity price fluctuates so much within a year, you have less confidence on the valuation estimate of the companies. After all, the value of company is derived from the free cash flow that it generates in the future. If the price of commodity fluctuates so widely, your estimate of free cash flow will fluctuate widely too.
I realized this difficulty less than one year into the job and asked my broker out for lunch to seek his advice. He has been covering several commodities for more than 20 years and is Executive Director at Morgan Stanley. His advice to me was to be on top of the game. That means you have to understand and monitor all those moving data points that are affecting the commodity price. And not only that, you have to do it better than the market.
This is certainly easier said than done. It requires lots of hard work and time. But the chance of forecasting it right consistently is very slim (to none). Every year, you will see some analysts predicting the price correctly, but you rarely see the same analyst getting it right twice in a row. Some investors avoid commodity altogether, and it’s not a bad idea.
If you predict the trend correctly for three years and make profit, you have to be aware that predicting it wrongly for the fourth year could wipe out all the profit you made in previous three years. Look at the thermal coal price chart below from 2011 to 2016. The mid of 2016 was the inflection point, and the price rose from 50s to 100s in one year, reversing more than three years of decline.
From the above chart, you see that the risk of getting it wrong is very real. At the same time, the reward can be very high. It’s not a game that a typical retail investor can play. Retail investors won’t have so much resources and time to follow commodity sector.
If you say that you can see the big picture and just follow along the trend until it reverses, you are exposing yourself as a big liar.
Fantastic Year 2016
Given the rising coal prices in 2016, coal producers (thermal coal, coking coal) had a fantastic year.
Look at the price chart of several big cap coal producers in Indonesia below. On average, they gained 200% in 2016.
Source: Google Finance. (ADRO is Adaro Energy, PTBA is Tambang Batubara Bukit Asam, ITMG is Indo Tambangraya Megah, and HRUM is Harum Energy)
Chinese coal producers also had good year, though not as fantastic as Indonesia counterparts. On average, these three big players gained 50% return in 2016.
Source: Google Finance (1898 is China Coal Energy, 1088 is China Shenhua Energy, and 1171 is Yanzhou Coal).
I did not follow coal sector. My fund manager did. It’s a harder sector to understand than palm oil. I doubt many investors got the inflection point correct in the mid of 2016.
After a sharp rise, as always, the next question is where is it going next? Is there more upside? Is it overpriced already? Where is the next inflection point?
As always, the rear-view mirror is always clear, but not the windshield.
As an investor, you have many choices and you have to act wisely. Different sectors have different complexity. Some are very difficult, some are easier. If you just omit those difficult sectors and focus only on the sectors that are easier understand, you can improve your overall investment performance by several percentage points. You will also save yourself from doing the extra hard work and the agony of losing money in sectors that are difficult to understand. This is what Warren Buffett meant with his quote:
I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.