Has anyone tried this?

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I have suggested that people consider making long-term transactions in futures for oil, natural gas, and other commodities as a hedge against inflation. *Since making this suggestion more than a year ago, I have done so myself and done very well. *But I'm not suggesting that investors in general can profit from it because, like options, it is a zero-sum game before transaction costs and a negative sum game after those.

Ted, would you be willing to talk a bit about commodities? In particular, how far out do you go? Are you willing to invest when the outmonths are quoted higher than the near contract, or only as it has been recently in crude where the mere passage of time and a crude quote that stays stable will give a profit? Over the years I have invested in commodities from time to time, and I always keep an account. But it can get expensive when you are repeatedly rolling to a higher priced contract even though the spot is stable.

Any comments?

Mikey

[Ted]

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Ted, would you be willing to talk a bit about commodities?

Sort of. *Since commodity trading is basically a zero sum game, I'd be pretty stupid to broadcast my strategy over the Internet. *Likewise, any advice that you see given away, or even sold, should be highly suspect. *And there are a bunch of "professional traders" out there trying to sell people on their schemes for allegedly "beating the market" (which necessarily requires them to beat each other).

What I will say is that I regard the most "conservative" approach to commodities trading to be one of going long on long-term futures on economically vital raw materials. *Of these, the most vital, with the longest term contracts available, is crude oil. *And the astounding thing about oil futures is that the distant futures trade at a big discount to the spot price. *The only reason that I can think of for this is that oil producers must go short on long-term contracts when the price exceeds their costs of production, thereby locking-in a profit on future production.

The one disadvantage to trading long-term futures contracts is that they have a large spread between the bid and asked price. *All securities that are traded in secondary markets have this bid/asked spread, and I must admit that I wasn't aware of the cost that it adds to trading until I did some transactions on thinly traded futures contracts. *For example, a December 2007 contract on crude oil might go for days without there being a trade, and might have a standing asked price of $27.30 per barrel and a standing bid price of $26.80 per barrel. *So, at 1,000 barrels per contract, you could "buy" (go long) a contract at $27.30 per barrel, soon afterwards decide to "sell" (liquidate) it at $26.80 per barrel, and immediately lose $500 ($1,000 barrels @ $.50 per barrel) plus the brokerage commission on two trades.

What you need to do is to "get your feet wet" by acquiring one or a very few long-term contracts that you can afford to hold onto even if the price drops (which will require you to put up money on margin to cover your loss on paper). *The commodities that I find attractive are crude oil, copper, natural gas, and lumber (although for practical purposes the contracts on it only extend for about 6 months.) *As the contracts approach expiration, they become a lot more liquid and can be liquidated at a reasonable cost and "rolled over" into long-term contracts. *If you believe that inflation will cause commodity prices to continue to increase in the future, then going long on commodity futures contracts is a way to cash in on that prospect. *But if anyone chooses not to trust my advice on this, that's OK with me *

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And the astounding thing about oil futures is that the distant futures trade at a big discount to the spot price. *The only reason that I can think of for this is that oil producers must go short on long-term contracts when the price exceeds their costs of production, thereby locking-in a profit on future production.

Ted, thanks for your comments. I am not a virgin with commodities. I have traded corn, wheat, cotton, cocoa, coffee, world sugar and the "TED SPREAD". I made money overall, but I didn't think it was an appropriate amount, given the risk exposure.

Not to argue with you- after all you volunteered to give me some information- but I think there is an alternate explanation to the out months trading at a discount in storable commodities. While some smaller E&P companies probably "must go short on long term contracts" presumably their bankers would insist on it- many better financed producers probably go short or not depending on their reading of the market. It had been assumed that producers were obligatory shorts in many markets, but *a lot of research has shown that it is more nuanced than that. So, if the out months are at a discount, it could say that producers while experiencing strong markets in the spot, do not expect that strength to continue into the future.

Comments?

[Ted]

For most commodities, the longer term futures tend to trade at a modest premium to the spot price. (Exceptions are heating oil and certain agricultural commodities where the price tends to vary seasonally, but I don't trade those.) *

There are arguments for and against the theory that the futures price is an "unbiased estimate" of the price that will actually occur. *(My suspicion that far-out oil futures prices are depressed by oil producers hedging would be an argument that the futures price is biased downwards.) In any case, the price of the futures contract is a very poor estimate of the future spot price, and that is what permits people to make or lose a lot of money trading futures contracts. *

So it might be that somebody out there trading oil futures has knowledge superior to mine to the effect that oil prices over the next 5 years will drop substantially below the current spot price. *But their assessment of that over the past two years has been wrong and my assessment that prices would rise has been right. *That doesn't prove that I am right to think that prices will continue rising, but I just can't conceive of a set of events that would cause oil prices to undergo a long term sustained decline. *There will always be temporary fluctuations, but the advantage of long-term investing is being able to profit from anticipating long term trends.