Ready to make high risk commodity investment

A Fin24 user is willing to make a relatively high risk investment with an unexpected sum of money he received. He writes:

I recently came into some money - R100 000. I do not have any debts that I need to pay off so I am looking to invest it.

Over the last few months the oil price has taken a massive knock. Has the oil price bottomed out? Everyone has a different opinion and no definitive answer, but your opinion would be appreciated.

If so, what is the best way to take advantage of the situation? Is it a better idea to invest in oil ETFs?

The other alternative I am considering is to buy Sasol [JSE:SOL] shares, since their price has dropped a lot since July last year and the price should track the oil price reasonably well.

I should probably mention that, since I did not earn nor planned for the money, I am prepared to make a relatively high risk investment.

READ: Sasol tweaks dividend policy as oil prices fall

Braam Fouche, financial adviser at PSG Wealth in Umhlanga Rocks, Durban, responds:

From the information you have provided it appears that you are an informed investor with a specific view to gain from a possible recovery in the oil price. I have formulated my response accordingly.
Oil is a commodity and its investment characteristics are governed by the factors that impact on commodities in general. You have indicated that you are comfortable with a high-risk investment.

This is the correct view to have, as commodity-based investments are highly volatile and mostly suitable for experienced investors only. Also remember that high-risk investments require longer periods of investment to smooth out the risk.
Investment outcomes in this asset class are mainly driven by one of the most fundamental concepts of economics, namely supply and demand. It is due to this simplicity that expected investment outcomes are actually complicated, as globally these variants can change unexpectedly.

Such an investment requires in-depth research of macro-economic events. This is by nature more complicated than a simple equity-based investment, in which one tracks the expected earnings growth of a company that sells a stable product or service in a defined market.

The issue that concerns me most about commodities is the fact that the price of the "product" is unstable: Large fluctuations occur from time to time, which can impact investment outcomes negatively, even over longer periods of investment.

READ: Sasol shares in the spotlight

The prolonged period of flat commodity prices during the 1980s and 1990s is a good example.

Investments into other asset classes such as bonds, property and equity generate an income stream in addition to the return you get from the movement in the price of the asset. This forms a vital part of any long-term investment strategy. Direct commodity investments do not offer this additional return.

Growth in commodity prices

 The growth in commodity prices over the previous decade was referred to as the "super cycle". This was mainly driven by Chinese demand for resources. Market commentators agree that this cycle has surely ended.

We only need to look at the decline in other commodity prices (such as steel and copper) and the decline in Chinese imports of raw materials to support this point.

In addition, the expansion in gas to liquid operations (referred to commonly as fracking) and the discovery of new oil reserves around the world have affected the supply relationship, which has driven the oil price down. This causes oil producers taking a confrontational stance on production, which resulted in the sudden large drop in the price of oil. We believe this price drop is valid under current economic data.
Therefore, your investment decision should not be based on the price having "bottomed out" as this indicates a recovery to previous levels – which were created by completely different economic circumstances.

Rather, your decision should by based on the expected growth in the price as supported by future demand. Based on current information, the outlook for strong growth remains questionable.

The effect of the lower price on costly production operations (that is supply) is not yet clear and one can only consider this fully when more information becomes available. Over the long term, the global demand for oil may outstrip supply again, or oil producers may reduce production. However, only time will tell.

Which investment option?

This leads to the question of which investment you should consider, if you wish to proceed. I also believe that you need to determine whether you want to invest or trade (the latter term covering more speculative investing).

Personally, I prefer investments – and also those that generate an income in addition to the possible movement in price. This is the case with Sasol, and, therefore, this would be my choice.

I would, therefore, choose an equity-based investment over a pure commodity-based investment.

Sasol’s operational income is diversified and earnings from its own gas to liquid and manufacturing operations can support investment returns in addition to growth in the oil price.

It’s a top South African company and it offers rand hedging opportunities through its foreign income. The elephant in the room remains the possible impact of Eskom on Sasol’s local operations, though.
If you choose to invest purely in the commodity, you do not hold the benefit of additional compounding returns generated by interest, rent or dividends as offered by the other asset classes.

I feel that even if you are prepared to take the risk, this kind of approach is simply too uncertain. You have to bear in mind that high risk investments do not always deliver high returns, and you may want to consider alternative investment options.

I suggest you consult with an experienced investment adviser to determine such options.

ALSO READ: Commodities dip puts damper on oil benefits

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