In recent weeks, investment experts such as Jim Rogers and Marc Faber have predicted bullish moves in commodities. Many other experts agree that commodities like oil, gas, and gold offer profitable opportunities in the future.
Unfortunately, the headlines fail to warn individual investors that commodity investing is much different than stock investing and is truly not something that most people should try at home.
Throughout the weekend, countless commentators cited natural gas as being undervalued. The most widely given reason is that the ratio of the price of oil to the price of natural gas is near an all-time high, recently at a level of 17.
The ratio actually began as a way of comparing the relative energy content in the two fuels. A single barrel of oil creates about 5.8 million British thermal units (BTUs) of energy. Natural gas is priced in millions of BTUs and should therefore be roughly equal to one-sixth the price of a barrel of oil adjusted for transportation and storage costs.
Historically, the ratio has averaged almost nine. In a world where investment advice all too often boils down to 30-second sound bites, the current level of the ratio must mean that natural gas is undervalued and is about to skyrocket.
The intelligent investor might also realize that it could just as easily mean that crude oil is overvalued and is about to decline in price.
This ratio might also be telling us nothing at all. Natural gas and crude oil are both sources of energy, but that is where the similarities end. Oil prices include factors related to the strength of the U.S. dollar and geopolitical stability in the Middle East. Natural gas is largely unimpacted, at least directly, by these factors.
Another difference between the two markets is that oil is mainly used for transportation and natural gas for heating. There is really no direct relationship between the uses and therefore no reason to expect the commodities to move in the same direction, or maintain any particular ratio, over the long-term.
This example illustrates the difficulty of investing in commodities. These are highly-specialized markets used by professionals to hedge production or offset expected increase in costs related to actually using the commodity. Buying and selling is mostly driven by the needs of these large players.
Recently, EnCana, the largest producer of natural gas in North America, reported that it had sold more than a third of next year’s expected production and locked in an average price of $6.21 per million BTUs.
While this is significantly above the current price, it is below the futures market price of natural gas due for settlement in the fall of 2010. By locking in that price today, EnCana is betting against a big bull market in natural gas. Most observers would acknowledge that they know the market better than anyone else.
Commodity markets are very different than the stock markets. They are more complex and the largest participants tend to have better information. This makes it difficult for individuals to do well in commodities.
If you're following the advice of Rogers or Faber, it is best to study the markets first. It is also prudent to get a professional adviser who understand the markets and follows them on a full-time basis. Although both experts are long-term bullish, they are best known as traders and are unlikely to announce their intention to sell if they change their minds.
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