6-29-09

Raw Ingredients for Wealth

People often ask why I focus a lot on commodities (like oil, gold, wheat, gas, etc.). But the thing is, I don't have a certain bias towards commodities, I have a bias for maximizing upside while minimizing downside.

Let me explain...

As you well know, a stock can go to zero. Sure, there are many times when a stock is trading at less than the value if it were to be liquidated (and those are often excellent buys!), but you can never know for sure.

A commodity on the other hand, can NEVER go to zero. The basket of commodities traded in Chicago futures pits are specially selected for the fact they are deemed essential for our way of life to function. Food, energy, industrial metals etc.

This means, they will ALWAYS have a value and therefore, they can NEVER go broke.

And this is the important part: from a trader's perspective therefore, there is a strict limit on the downside.

In this regard, commodities are subject to something called 'elasticity'. Dear reader, elasticity, if understood, can be a license to print money.

Here's what 'elasticity' effectively means. There is a price range in something that displays elasticity, hence the name; it stretches only so far before it has to be snapped back to the starting point like a piece of elastic. It's effectively a law of nature.

Let's take the drastic fluctuations in the price of oil over the last year; we've seen it move between around $140 and $30 a barrel!

At $140, the world couldn't function. It was at a point where oil-related activities simply weren't economical to the point where it wasn't practical to conduct those activities as much. Take a look at how you as a simple individual reacted to that oil spike; you tried not to drive as much, right? Or maybe you bought a car with lower gas mileage.

So it's a self-correcting force.

Now, of course, the piece of elastic can stretch both ways; down as well as up. Over winter the price of oil sunk to $32 a barrel at its low point and I practically begged readers to back up the truck to buy the stuff (oil is now over $70 a barrel). You see, just as the consumers of oil can't function at $140 oil, the oil producers can't function at $32 oil when it comes to the cost of exploration and digging the stuff up.

The result was the oil companies simply stopped drilling and that sent the price back up.

Now this is interesting: microprocessors, though not listed on the commodity exchange, in my view should be because these days, they are essential for our way of life.

Also, because microprocessors display elasticity. For different reasons though...

As you may well know, Moore's Law explains how microprocessors are continually becoming more powerful, thereby making the older microprocessor obsolete. This obsolescence is effectively adding to the supply, thereby lowering the price (price is determined by supply and demand, right?).

But here's the thing. Industry then finds a use for the outdated processors, thus causing demand to rise and this corrects the price back up. Last Christmas, I couldn't believe the fact I was able to get my son a genuine pair of night-vision goggles from Wal-Mart! I thought it was a gimmick substitute, but they were once military grade and the real deal. This is a result of the elasticity in the microchip market.

Keep a close eye on microprocessor manufacturers stock prices. You will see a perpetual fluctuation on these prices because of elasticity and you can therefore profit greatly by buying at the lows and selling at the highs.

So why doesn't everyone give up work and trade commodities then?

Well, one reason is because people are scared away by the image they have of being such risky assets. And in the hands of amateurs, they really are like giving a machine gun to a monkey, but we aren't amateurs...

You see, while the price of a commodity can't go to zero, it can certainly go down and in the process, cost the purchaser a lot of money. That's why my solution is to be on the long side of a commodity trade (rarely the short side) when it gets terribly beaten down.

Take the example of oil. When it was $30 a barrel, the commodities futures would be prices at 3000. That is 3000 points.

So, we know that oil could not go to zero, right? We also know that at these stupidly low prices it would only be a question of time before elasticity kicked in and snapped it back up, right?

So the risk we have is this: do we have enough money to hang in there and wait if the market continues to go against us? It could take months for this correction after all.

Because we know oil can't go to zero, we therefore have a defined downside from 3000. If I bet $10 for every point, I have to face a maximum running loss of $30,000 (and that's being stupid because of course oil can never be this price).

But on the upside, I could make well over $40,000 as and when elasticity kicks in.

So going long on commodities when they're particularly unloved by the market and are therefore at prices which make their extraction process unviable is a sure way to make money.

You usually know when that time has come because everyone will think you're an idiot for buying.

Does that answer the question?

Until next time,

Mark Patricks

 

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