You've probably heard about the oil price crash by now…
The headlines have been plentiful, ASX-listed energy producers have been hit hard, and (in the one bright spot) we've been filling our tanks for a bit less cash.
The price of Brent crude oil has fallen from over US$115 a barrel in June of this year to under US$70 now.
That's a drop of about 40% — in less than five months.
The cause is a combination of a slowing in the growth of demand for oil — and, as a result, also LNG — as well as a decision by the Organisation of Petroleum Exporting Countries (OPEC) not to limit supply.
And while OPEC leaves its foot on the pedal, the USA in particular continues to expand its production of oil from shale, and Australian LNG is coming on stream too. That's a whole lot of energy for a market that doesn't need it.
If that story sounds familiar, it is!
Here we go again…
This is exactly the same force that came to bear on the iron ore price, and therefore iron ore miners, and the gold price and producers before that.
The force in question is the investing equivalent of gravity. Try as you might, you can't escape it.
Supply and demand is one of the oldest dynamics in economics — from well before we had a term for it. When demand exceeds supply, prices rise. When supply exceeds demand, prices fall. It has ever been thus.
That's what's hurt the iron ore price. It's what hurt the gold price…
And now, in the absence of artificial supply constraints from OPEC — and realistically, the growth in supply of shale oil and LNG meant there was little point in trying to hold back the tide — the oil price is following suit.
Gold, iron ore, oil, wheat… they're all called commodities. And commodities, by their very nature, are universal, substitutable goods.
Quality grades aside, a tonne of iron ore is a tonne of iron ore, no matter where it's mined or who it's sent to. That's the origin of our use of 'commodity' in everyday speech.
For investors, though, there's an important consideration…
If the price of iron ore is $140/tonne and your cost is, say, $70/tonne, you'll keep producing for as long as you can. And if you're a miner looking for growth, and you figure you can open a mine with a cost of, say, $100/tonne, you'll do it, because there's profit to be made at that price (and, after all, mining is your job).
Of course, the growth in supply will tend to push prices down, as will any reduction in demand.
Writ large, the basic laws of economics will see supply rise and prices fall until the selling price reaches around the average marginal cost. If prices go above that level, supply will be incentivised. Below that level, supply will tend to fall as production becomes uneconomical.
The net result?
Absent OPEC-like artificial market manipulation, any time prices are significantly above the cost of production, you're a brave investor if your investment requires prices to stay high or go higher…
And how many investors do you know that buy shares in miners or energy producers with the express view that prices will fall?
What this all means for you
Maybe Australians love commodities because our country has largely been built on the back of primary industry, and because we're lucky enough to have some of the best mineral deposits in the world.
(And maybe we just love a punt, and the chance of riches is too great to ignore.)
But let's remember that investing is more than just assessing the possibility of wonderful gains…
It's also about understanding how things could go badly, and the chances of such an event.
Investors who got that last piece right have avoided miners, energy producers and mining services — and their portfolios are much healthier as a result.
