Commodities Are Not Investments.

It's not hard to believe the strong economic case for the growth in commodity prices in the years ahead. With emerging economies like China and India coming online the world's supply of various raw materials to support their development is under pressure, hence pushing commodity prices up. I certainly see the reasoning behind it and I believe that it will happen.

However, I don't want to invest in commodities even though I believe in the story behind them. Why? Because commodities are not investments. They are links to economic production. They have no cash flows so they create no value related to any future productive enterprise. Also, as there is no possibility of any future cash flows how can I discount their value back to a present value today? Other than discounting the final cash flow when it comes time to sell there is no real value created to me as an investor that makes them difficult to value. Obviously the only real way to make money on a commodity transaction is if the price has gone up when it comes time to sell. But there is no way to really place a value on how much and how this price will occur.

Of course, this argument is not isolated to commodities. I would not class derivatives (futures, swaps, forwards, options etc, etc) and currencies as investments because, like commodities, they do not create any future value. They merely shift wealth from one side to the other. In other words, there is no win-win situation; there is only a win-lose situation where one person "wins" a pound at the expense of another person losing a pound. As an example, Stocks on the other can create wealth for all those involved. Consumers receive a marginal benefit from the products they purchase, employees receive benefit through their salary and investors receive a benefit through economic profit.

However commodities, derivatives and currencies do have their place in the area of risk managment. This was was the original motivation behind many derivative products. For an example read more here

So if the purchase of a commodity is not an investment then what is it? I can only conclude that commodity purchases are merely speculative- no matter how much research and thought go into the decision to buy (or sell). Commodity purchases can really only rely on macro economic information which is general at best and pricing information which is provided by the general sentiment of the market (which as any investor who has experienced a market correction knows this can change quickly). How can an investor have any fair degree of confidence to reasonably predict where the intrinsic value and margin of safety lies when we have nothing to quantify against?

As an someone who works at a large commodity hedge fund in London told me, the January 2007 commodity market recorrection was the most stressful periods of his life. Not a very nice way to spend a skiing holiday in France. Maybe if the nature of his "investments" were a little more like real investments then maybe he wouldn't have had as much to worry about.