How to Value a Commodity

By Joe Ponzio on April 27, 2009  |  12 comments

There is no discounted cash flow method for commodities. They don't pay dividends or bear interest rates; they don't generate cash. Long-term investing in commodities is all about finding opportunities where supply and demand are out of balance and the price is low relative to where it "should" be on an inflation adjusted basis.

With no external forces acting on a commodity price (ie., supply and demand are in balance and the currency doesn't change), commodities prices would move in lockstep with inflation. A 3% increase in inflation would result in a 3% increase in commodities prices.

Of course, this is the real world; so, supply and demand aren't always in balance, currencies fluctuate, and speculators push prices up and down regardless of supply, demand, inflation, and currency fluctuations. And that messes with prices.

The Inflation-Adjusted Price of Copper

To get a good handle on what the price of copper should be, we need to look at the inflation-adjusted price throughout history. In 1946, the US Government lifted their temporary, war-time fix on the price of copper; so, that will be our starting point.

From 1946 through 2008, inflation in the United States averaged 4.07%. If we look at the average annual price of copper in those years, and adjust those prices for inflation, we can look at how the price of copper has changed over the past six decades and get a handle on where it should be in a perfectly balanced world.

The above chart is very telling as to how copper has performed during periods of high inflation, particularly in the early portions of those periods before supply could ramp up to meet demand. (All those juicy, higher prices invited more competition and more mining, calming rising prices.) Ignoring everything else, copper's best returns were during periods of high inflation. When inflation was in check, the commodity performed poorly (relative to other investment options.)

This chart shows the inflation-adjusted price of copper during those times. You can easily spot the points in history when the price of copper got way ahead of where it "should" have been (green line) on an inflation-adjusted basis. (Remember: Copper doesn't get better or worse; it is just there, growing at the rate of inflation if supply and demand are in balance.)

You can also spot times when investing in copper made sense. When it dipped below its inflation adjusted price (the green line, about $2.27 in today's dollars), copper would have been a good investment.

How do the numbers play out?

The Results of Investing In Copper

Let's take a rational approach to investing in copper. Before we buy, we need our purchase to meet a few conditions:

1. The price is below its inflation-adjusted average at that time (ie., it's cheap);
2. Supply is falling versus demand (ie., net production, including imports and exports, is less than the previous year's net production).

And, of course, we sell when the price returns to a more rational, inflation-adjusted level, ignoring any really compelling reason to hang on. One such reason, for example, would be that we expect high inflation which would naturally serve to increase the inflation-adjusted "normal" price and give us a higher selling point; but, we'll just do this blindly for now.

Keep in mind: This is not about speculating where copper will be in a few days or months. Rather, it's an investment based on the laws of economics.

So, we're buying in 1957, 1958, 1960, 1961, and 1965. Then, we sell in 1969, when the price gets back to "normal." (We don't speculate that a bubble would develop and then try to ride it up. We make cold, rational business decisions.)

Of course, we're using annual figures here; but, you would have been able to dance in and out a little more if you were watching the price more closely.

You would have bought copper again in 1978, only to sell a year later:

And again in 1984 and 1985, selling in 1988:

And so on, buying in 1993 and selling in 1995, and then buying in 1999, 2000, 2002, 2003, and 2004, and selling all of those lots in 2006.

Buying Copper Today

Notice that the results were not based on massive, macro calls. That's not to say that you couldn't do better — or worse — by timing your purchases and sales based on macro events. (Like Buffett's belief that oil is due for a massive increase — a belief that led him into, and quickly out of, ConocoPhillips, and that he has repeated in a number of interviews.)

Instead, these purchases and sales were made based on the ordinary course of economics. When prices were low and supply and demand were out of whack, you would buy, expecting that prices would go up to rebalance supply and demand. When prices were high, you found other opportunities in other investments.

Today, prices are low and supply and demand are out of whack. Production has slowed, meaning that, when demand comes back, supply will likely trail it for a while. In addition, when we first bought DBB, copper was around $1.87, about 20% below its inflation-adjusted average.

We have a good margin of safety against macro events. If we have deflationary pressure for some time, I don't expect that to rage at 20%; so, we're still in cheap. When inflation hits, today's $2.27 inflation-adjusted "normal" price target would rise, offering a chance for even greater gains.

And, of course, production is low based on current demand and the expected demand of any recovery (and recovery will come); so, the price would be expected to rise as (a) demand increases, or (b) demand holds steady but production continues to fall.

It Could Go Lower

In every investment you hold, you must have expectations. I expect copper to be $2.27 plus future adjustments for inflation. In that case, it could easily drop from today's levels. It wouldn't bother me a bit because my data and reasoning tell me that, at some point in the future, supply and demand will have to work towards balance again.

The same is true with all of the stocks we hold. When Wells Fargo dropped below $9 a share, a leap of faith was required. Our data and reasoning said (says) that Wells Fargo is worth considerably more than $20 a share, and a helluva lot more than $8.70. The leap of faith required was (is) that the US Government wouldn't universally nationalize all banks, profitable or not.

The important thing when investing, whether in commodities or stocks, is ignoring the "in between." You know — the noise and market action that rips you one way or the other while you patiently wait for the fear surrounding your asset to lift and a more rational price to show through.

If you could buy a one-year treasury today for $800, knowing that, one year from now, you'd get back $1,000, would you really care if the markets pushed the price of that bond to $700? $500? $100?

Though stocks and commodities aren't guaranteed like US Bonds, that's exactly how we should be thinking about the daily market action. So long as the US Government isn't going to default on its one-year bonds, you could feel very comfortable with a 70% quotational loss. So long as your businesses are performing as expected, or so long as supply and demand are out of whack, quotational losses shouldn't bother you one bit.

Also Filed Under "Investing in Commodities"

• Selling DBB Because I'm a Bonehead
• Investing in Commodities; Base Metals
• What Affects Commodities Prices
• How to Value a Commodity