By Neland Nobel

Written by Neland Nobel

Estimated Reading Time: 7 minutes

In a previous article, we noted the superior relative strength action in commodities versus the S&P, coming off what appears to be a 17-year market bear market, and the implications thereof.

We also noted that just “normal” charting of commodity price indices was positive.

For investors, remember we never deal with certainties.  You must deal with probabilities and decisions made with the preponderance of evidence.  There is always risk.  If there was not risk, the market would not pay you a return.

Our conclusion is thematic: we might be entering one of those rare historic opportunities some call a commodity Supercycle. If we are correct, a change in the asset mix (asset allocation) will be necessary for an investor to participate.

What is a commodity Supercycle?  We would define it as a prolonged multi-year (often 10–20+) period of elevated or rising prices across much of the commodity complex, driven by structural demand shocks colliding with inelastic or underinvested supply rather than ordinary cyclical fluctuations.

Notice we are saying rising prices across some, but not necessarily ALL commodities.

Commodities can roughly be broken into two categories.  Soft commodities are things like crops.  Within a growing season or two, producers can respond to rising demand.  Substitution is possible.  If you can’t get oranges from Florida, maybe you can find what you need in Brazil.

Then there are hard commodities, like copper, which takes years to meaningfully increase production.  With global production largely harmonized, you need new production, which for both geological and regulatory reasons can take decades.  Substitutes like aluminun don’t work nearly as well.

There should be a third category, monetary metals.  The demand for these is mostly for financial purposes, not for consumption.

In addition, central banks’ increasing gold reserves are also an attempt to get away from a weaponized international banking and payments system.  Economic sanctions have become a key form of warfare, and their unprecedented use has many countries looking to find ways around the stranglehold the US has on the system.

Since central bank gold reserves now exceed US Treasury holdings, you can see why a new category is needed.  Having metals as money was a standard practice historically and remained largely the case until 1971.  The copper penny was phased out in 1982.  Today’s penny is mostly zinc, with 2.5% actual copper.

Central Banks are not buying hundreds of tons of gold to make wedding bands.  This has nothing to do with normal demand for use in jewelry and electronics.

In playing this investment theme, we think investors should largely restrict their holdings to plays on key metals and minerals, energy, and monetary metals.

What would be the causes of such a cycle?

The key driver is government, especially the central planning aspects of socialism. A subset of socialism is the environmental movement.   By definition and history, socialism causes government to grow and substitute bureaucratic decisions for those of the voluntary marketplace. Socialism is based on spending money we don’t have and redistributing it.  This increases demand for things like healthcare, but socialist regulations and disincentives hamper a supply response.  It also, by its nature, increases deficits, and when increased taxes under “democratic” socialism hit limits (political revolt or Laffer Curve), government spending must be funded by more debt and currency debasement.

Meanwhile, the Environmentalists successfully captured the schools, the media, and politics in the 1970s. The result has been chronic underinvestment in the production of key commodities.  It is simply not allowed, except in China.

As a result, the need for key materials rises, while the same policies restrict the market from responding with more supply.

Once the process begins, the public sector continues to grow while the private sector shrinks.  Demand for all kinds of benefits rises, while the capacity to support them dwindles.

You can see this in today’s Democratic Socialists.  New demands for healthcare, day care, housing, and the like are being tossed out with no recognition that we already have $40 trillion in debt.  They seem to have no clue about the supply constraints.

For example, recently, a new copper mine opened in Arizona.  The first one in a very long time. Reportedly, it took 29 years of permitting and court battles before a new pound of copper could be extracted.  Who wants their money tied up in repeated lawsuits from extremely rich environmentalists, Indian Tribes, and entangled water rights issues?  Capital finds easier returns elsewhere, so chronic underinvestment prevails.

Demands for alternative energy, EVs, and grid improvements are mandated, but the market is obstructed from increasing copper supply.

Producers are often forced by both geology and politics to seek projects in Third World countries that are corrupt and lack the rule of law.  Say you want to build a huge new copper mine in Mongolia.  You get the government’s agreement on the royalty structure (how much the government gets). After you put $5 billion or so into the project, the government announces it is changing the terms.  You can’t leave and take your giant open pit mine with you, can you?  The real-life example is Oyu Tolgoi in Mongolia.

Third World corruption and socialism encourage capital to look for something better to do than get fleeced, and again, the result is chronic underinvestment.

Sitting on vast oil reserves, Californians pay higher costs for gasoline and diesel than just about any other state. This is not a case of market failure when supply can’t adjust to demand; this is a political decision driven by ideology.  You are simply forbidden to drill and, now, even refine product.

On the demand side, besides mandating that some things get built, while others don’t, there are more natural forces at work.  The build-out of AI, like the internet, requires a lot of materials and metals.

The worldwide defense buildup will use more key minerals and metals.  War is a government project, either theirs or ours, or both.

And beyond environmentalism, war, and inflation, instability in key commodity-producing areas is tightening supply.

So, in short, rising demand hits constrained supply due to chronic underinvestment.

Thus, you could summarize that this particular Supercycle will be caused by government-sponsored chronic underinvestment, currency debasement, and war.  This is then exacerbated by natural market forces such as the AI revolution and other electronic-intensive technological shifts.

OK, if these fundamental arguments and our previous technical observations hold some weight with you, what would a reasonable investor do to exploit these trends?

It does NOT mean you necessarily sell your stocks.  Instead, you change the mix of stocks you own and increase your exposure to companies that produce energy, metals, and key materials.

You also reduce the amount of promises to pay you hold, since those promises are depreciating and weakening.  This likely means lower bond holdings.

Where to start?  Probably the first move is to buy some gold and silver bullion coins.  Gold, in particular, is the key monetary metal.  We like to take delivery of some of the metal, but bullion ETFs can also be in the mix.

Beyond that, there are commodity futures contracts.  However, the extreme leverage in these investment vehicles can be terrifying.  Small moves cause big swings in the account and subject the investor to margin call risk.  Unless wealthy and very experienced, this alternative should be avoided.

There are commodity trading pools, where you let someone else make decisions for you.  Fees are often high, liquidity poor, and results marginal.

Today, there is a wide range of commodity Exchange-Traded Funds.  However, embedded in most of their structures is a built-in erosion of value called “the roll”.  This is caused by contango, which is not a Latin dance.  The fund buys commodity futures contracts that expire months away and are priced above the spot market price.  As time goes on, that premium for future months disappears. Yes, it’s complicated, but there are some new funds that at least limit the roll, and their management fees have become more reasonable.

In most cases, it is hard to own the commodity itself.  How much oil, copper, and nickel can you put in your garage?

Outside of owning the commodity, you can own companies that own the commodity in the ground and profit from its extraction.  They are not quite the same, and on occasion, shares can either outperform or underperform the underlying commodity.  However, in a Supercycle, most quality companies in the space should do well.

You can stock-pick if that is what you like to do, or buy ETFs in this sector, such as COPR, which holds a basket of copper companies. Or GDX, which owns a basket of gold mining companies.  Similar products can be found for oil, gas, uranium, and industrial metals.

There are mutual funds which tilt towards commodities.  There is the choice of open- and closed-end funds.

Some pay dividends, and some don’t.  If livable cash flow is an issue and you want exposure to the sectors, there are closed-end funds that own metals and energy and enhance yield by writing calls against the portfolio. GGN is an example of such a closed-end fund.

However, closed-end funds are thinly traded and may sell at a discount to their net asset value.

Trade-offs are involved in all these ideas.  Remember Tom Sowell: there are no solutions, only trade-offs.

If you have a knowledgeable financial planner, they can help.  But do your own research as well, and with platforms like GROK, good research is available to almost anyone at a reasonable price.

These are suggestions to research, NOT recommendations to buy!

The simplest and most straightforward is to own some gold and silver coins. We think the monetary metals will do well.  But we also think key minerals, industrial metals, and energy should do well.

So do your own research and make your advisor earn his fees by making him work to find good ideas for you.

What is needed from you is the understanding that a decade-or-longer shift is likely underway, caused by massive underinvestment in key areas of commodity production.

What could go wrong with this thesis?  The world could move quickly towards peace and fiscal sanity, and abandon extreme environmentalism.  We would love that, but what are the odds? Even so, the adjustment would still take some time due to years of neglect of the commodity production infrastructure. Or we could have a depression, which would reduce demand for everything, not just commodities.  But would not the government’s response be to “stimulate” by printing money?

The only sure thing is…there is no sure thing.

-Neil Nobel

 

*****

Neland ‘Neil’ Nobel was born in Uniontown, Pennsylvania, and moved to Arizona in 1961. He attended ASU and earned a B.A. and an M.A. in history, with a specialty in economic and military history.  He graduated Summa Cum Laude and received a Richard M. Weaver Fellowship from the Intercollegiate Studies Institute.  He spent the next 45 years in the financial services industry, ending his career with a 25-year run with UBS as a portfolio manager and Certified Financial Planner. In retirement, he remains active, having founded the Prickly Pear in 2020 and continuing to contribute content.  In his spare time, he is a certified firearms instructor and runs a hiking club and two shooting clubs.  He is married with three children and three grandchildren.

The author’s views are their own and do not constitute financial, investment, or legal advice. Investing involves risk; please consult with a qualified professional before making any financial decisions.

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