How to get Margin of Safety with commodities- NB

How to get margin of safety with Commodities.

According to Warren Buffet "Margin of Safety" are the three most important words in investment. This concept is also the corner stone of the philosophy that Benjamin Graham taught.

To get an answer of what margin of safety would mean in terms of investing in commodities , we need to be able to value a commodity relative to it's price. The lower the price in relation to the value, the higher the margin of safety. Commodities are also non-income producing assets, in fact there is a cost to carry the commodity. This cost is made up by the cost of money as well as the storage cost of the relevant commodity. The prudent commodity investor should thus factor in this cost when calculating value and should be more conservative in valuation to increase the safety margin.

How do we value a commodity? A whole book can be written about the valuation methods for commodities but we will try to capture a few key concepts.

- Production cost
This is the cost of producing the commodity. In the case of grains that will be the cost to produce per bushel. Unfortunately this is a difficult calculation at the best of times.. Sources to get this information would government agencies such as the US Department of Agriculture or the US Department of Energy.

-Producer break-even
This is the price under which some producers will start losing money. If this situation continue for too long, producers will have to stop producing or go insolvent. This method is handy when looking at metals or other commodities that are mined. Sources for information are the corporate reports of mining companies.

Supply/ Demand Ratios
- This method is widely used to determine a relative value number. This method should be used conservatively though, especially when a commodity is priced above production cost. The price might already factor in low supply/demand ratio.


So, this is a mine-field and the best approach is to be as conservative as possible in valuation. As a rule of thumb: If we are close or under production cost, producers are not making money or going out of business and prices have been depressed for a long time, the case for a value investment could be made..

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Goldman Calling Commodities Higher

Goldman Sachs called commodities higher this morning suggesting we buy Oil, Copper and Zinc..
I think energy remain long term bullish but I still prefer my Natgas stocks;

New home sales in the US are coming out this morning - so this might give the market some direction.

Italy on Credit watch - more dollar strength possilble

S&P announced that they might drop Italy's Credit rating - with all the problems still in Greece it looks like this whole debt scenario is escalating.. What does this mean for us .

a. Short term dollar strength
b. More retracement in commodity prices..

For now I still stay with a large percentage in Cash and my only new buys are Natgas producers..

PS: Europe is dry; Grains can run up if this continues...

Where to find value? NATGAS?

We are still finding it very hard to see value in Commodities. The only idea that seem to make sense is that Natural Gas is still undervalued. We would avoid the ETF or Futures for now as the carry costs will make the trade difficult. I am more inclined to look at cheap producers; So I still like Contango Oil & Gas (MCF) and Ultra Petroleum (UPL)..

Fund Manager turned Farmer faces drought

England’s hottest weather in more than three centuries is making Graham Birch, the country’s best natural-resourcesfund manager for a decade, concerned about the state of his spring crop.

The corn and grasses grown for livestock on the 2,300-acre farm in the southwestern county of Dorset are already beset by the heat and lack of water, Birch said by phone on May 18. Rain will be needed soon to keep yields for wheat and rapeseed planted at the end of last year from dropping, he said.

European farmers are contending with the driest growing conditions in more than three decades. The European Union warned this week that soil moisture is now “critical” in at least six countries after some places had their driest March on record. France’s soft-wheat crop, the EU’s largest, will drop 12 percent, and German output will slide 7.2 percent, local forecasters said May 18.

“It’s the spring crops I’m worried about because that’s what’s seeing some severe drought stress,” said Birch. “It’d be nice to have some rain in the next couple of weeks.”

Birch started a sabbatical from BlackRock Inc. (BLK), the world’s biggest money manager, in 2009 and formally left in 2010, when the team was managing $36.3 billion of assets. His BlackRock Gold and General Fund was the top performer among 858 U.K.- domiciled mutual funds over a decade, averaging gains of almost 23 percent a year, data from Morningstar Inc. (MORN) show.

Ruined Crops

The former fund manager left BlackRock in a year in which drought or flooding from Europe toCanada ruined crops and spurred Russia to ban grain exports. Wheat rose as much as 90 percent and corn 87 percent, driving the United Nations Food Price Index to a record and draining global stockpiles.

Weather is threatening crops again this year, from drought in China to temperatures as high as 100 degrees Fahrenheit (38 degrees Celsius) in Kansas. Wheat traded in Chicago rose as much as 7.6 percent on May 18 as European forecasters predicted smaller harvests.

On Birch’s farm, winter wheat and rapeseed were seeded in the fall when the ground was moist and roots could grow deep. Corn and grasses planted this spring in dry conditions didn’t have those same conditions, he said.

http://www.bloomberg.com/news/2011-05-20/blackrock-fund-manager-turned-farmer-birch-contending-with-drought-stress.html