Ishan, 32, an electrical contractor, felt he had missed the stock market boom. When the Sensex was 3000, he was uninterested and steered clear of the stock market. As a result, he felt totally left out during the ensuing bull run.
Not wanting to repeat the same mistake, Ishan decided to invest and profit from the next rise in stocks. The question: should he wait or invest right away in stocks? Before he could come up with an answer, an advertisement caught his attention. It stated that the next bull run is in commodities.
Without wasting a minute, he decided he had to find out more about commodities and so paid us a visit.
Let's start with the basics
I told Ishan that before we begin to discuss a bull run in commodities we must first understand the subject.
Broadly speaking, many commodities are raw materials that the industry needs to manufacture goods. For example, in Ishan's industry, electrical wire is needed.
The wire is made of copper. Copper is a natural resource that has to be mined from the earth's crust. So it is a commodity that is used in the manufacture of electrical wires.
Similarly, other metals such as iron, aluminium, and zinc are all commodities.
But commodities are not restricted to just metals or raw materials. Other natural resources or agricultural products such as oil, sugar, coffee, wheat and soybean are all commodities. Just like stocks, these commodities are usually traded on a Commodity Exchange.
Ishan wanted to know what determines commodity prices. I told him they are determined primarily based on demand and supply. If demand is greater than supply, the price rises; conversely, if supply is greater than demand, the price will fall.
Where is demand heading?
Of late, thanks to the fast growing economies of India and China, there has been an increase in the demand for commodities.
To contruct more roads and build bridges, iron and cement is needed.
Electrification of villages gives rise to a demand for aluminium and copper.
Large industries, such as automobiles, need steel, aluminium, lead and rubber.
As consumption and demand increases, specially amongst the middle class in these two countries, demand for all these raw materials is bound to rise. Similarly, prosperity will increase the desire to eat more sweets or drink more coffee and, in turn, increase the demand for sugar or coffee.
Recent statistics show that China consumes half the world's cement, quarter of the world's copper and one-third of the world's steel. This demand is expected to increase further as India also starts consuming equally large quantities.
Can supply match demand?
While the demand is rising, the supply for commodities such as oil, lead and uranium has not increased in decades. This is because, for many years, the demand for most commodities was poor. The existing supply was more than adequate to cater to this demand. Hence, the suppliers were not making much money.
Since it was not profitable, hardly any new suppliers entered the race. These supplies were adequate to meet the demand till a few years ago.
However, with the growing appetite for commodities from emerging economies, supplies are now falling short.
"So why don't new suppliers jump in and increase the supply? I am sure they will now make money," Ishan asked. True, but things are not that simple.
Increasing the supply of a commodity is not as easy as adding more telephone operators to an exchange or employees to a BPO.
Natural resources are scarce and the existing resources are already producing to their full capacity. Take lead for example, which is used in the battery of cars. As the number of cars increase, the demand for batteries will also increases. This, in turn, would raise the demand for lead. However, to increase the supply of lead, one needs to locate a new lead deposit.
This is certainly time consuming. Locating a deposit, obtaining finance, getting environmental and governmental approval is all needed to begin mining.
In addition, these mines are usually located in the wilderness and one will need to build roads to get the lead from the mines to the ports.
One will also need to hire labour to work in the wilderness, so housing and other facilities will have to be erected.
This may take many years. Consequently, it will be a number of years before the lead mine actually begins shipping lead. During this time, the demand for lead would have gone up. So just a single mine will not be adequate to cater to the demand.
Bull run?
Demand is definitely ahead of supply. Due to the long lead-time that it takes for a new supply of the commodity to come on stream, the price of that commodity rises leading to a bull market for that particular commodity.
Most experts believe the situation today is ripe for this bull run in commodities to continue for a number of years. Of course, one must remember that, after a few years, supply will exceed demand and then prices will fall.
This, again, may continue for a number of years.
But, like I warned Ishan, commodities are more volatile than stocks. So do your homework well, talk to experts, understand the subject thoroughly and only then think of investing.