You Decide
Pop quiz…
You have the choice:
Make 1,400% gains? Or
Lose money?
Of course, anyone would take a 1,400% gain over losing money.
But to do it, you would have had to step outside the box… and make an investment in commodities in a very different way from normal.
Commodities have performed poorly in recent decades. They currently trade at 1990s prices. It’s crazy. But there’s a better way to own commodities…
Instead of losing money, this way of buying commodities has soared more than 1,400% since 1990. Take a look at the chart below…
Believe it or not, these two commodity indexes aren’t that different…
They both track a large basket of commodity prices. It’s just that the regular commodity index is a “dumb” index. Our other commodity index – the one that soared 1,400% – is a “smart” index.
To understand the difference, we need to take a step back. There’s a fundamental reason the smart index soared 1,400% and the dumb index lost money. And it’s the same reason making money in commodities is difficult for the average investor…
Why It’s So Hard for Most People to Make Money in Commodities
We have a great setup in commodities…
While virtually everything else has soared, commodities crashed for the better part of a decade. As a result, investors gave up on them in recent years.
Most folks haven’t even noticed that the next boom is likely underway… that huge gains are likely ahead of us.
This is a great setup… and it could lead to massive gains.
However, you need to understand something…
Investing in commodities is tricky. Doing it the wrong way can result in BIG losses – even if commodity prices go higher.
The danger of investing in commodities isn’t that commodity prices are volatile. That’s not a secret. The problem with investing in commodities isn’t with commodities at all.
The problem is how typical investors make commodity investments. Here’s an example…
During the financial crisis in late 2008, the price of oil fell below $40 a barrel. In the past year, oil has risen quite a bit off its bottom. It’s now in the mid-$60s a barrel.
If you’d bought oil at the bottom in late 2008, you should have made a good bit of money, right? Around 50%, based on oil’s move over the past decade.
Not so fast…
Most individual investors would have bought the United States Oil Fund (USO) to take advantage of a potential rise in oil prices. This fund exists to track oil prices, which it does with futures contracts.
Buying oil in late 2008 would have been a brilliant idea. But if you’d bought shares of USO to make the trade, you would have lost money.
While the price of oil has soared from less than $40 a barrel to more than $60 a barrel, the price of USO is less than $15 per share. Take a look at the chart below…
What went wrong? How could an investment thesis that was right turn so sour?
The answer to those questions – and the reason investing in commodities can be dangerous – is explainable with a single word… “contango.”
I’d bet 99% of investors have never heard of contango. But it’s incredibly important when it comes to investing in commodities. And it’s the exact reason shares of USO dramatically underperformed oil prices over the past nine years.
You see, USO doesn’t hold barrels of oil. Instead, it invests in oil by purchasing futures contracts. These futures contracts are an agreement to buy a certain asset – oil, in our example – at a certain price on a certain day.
In the case of oil, a futures contract exists for every month of the year. The way those prices relate to one another can create contango, which is terrible for investors of futures-based investment funds like USO.
In short, contango means that next month’s price of a commodity is higher than this month’s price.
The table below shows hypothetical oil futures prices. These aren’t today’s actual prices, but they illustrate the problem of contango. Take a look:
As you can see, the lowest-priced futures contract in this example is the current month (known as the “front month”). As you go further out in time, prices get higher and higher.
This is a killer for investors…
You see, USO attempts to track oil prices by holding the front-month futures contract. The front month usually has the most trading volume and most accurately tracks the true commodity price.
However, on July 15, the current front month expires. In order to keep the fund ticking, USO must sell that contract and buy the August 15 contract – which becomes the new front-month contract.
The futures lingo for this process is “rolling” a position. And when contango exists, it’s expensive…
In this case, selling the July contract nets $65. USO then immediately buys the August contract for $66. In short, the fund loses $1 for every contract it owns.
This happens month after month to commodity funds when the commodity they own is in contango… And commodities spend a lot of their time in contango. So that means most commodity exchange-traded funds – the way most investors would try to own commodities – are completely broken.
Dr. Steve Sjuggerud is the editor of True Wealth, an investment advisory which specializes in safe, unique alternative investments overlooked by Wall Street, and based on the simple idea that you don’t have to take big risks to make big returns.
He alerts readers to some of the biggest opportunities in the market every weekday at http://www.dailywealth.com/.
