Have you ever wondered why renowned investor Warren Buffett refrains from trading commodities? If so, you’re about to delve into a comprehensive analysis that could potentially redefine your investing and trading approach. The following sections unravel a captivating dialogue between Catherine Voorhood, a Los Angeles-based investor, and Warren Buffett, alongside his long-time partner Charlie Munger. Voorhood’s trading and investment journey and her curiosity about the potential pitfalls and peaks of oil investments set the stage for some insightful responses from Buffett and Munger.
As you read on, you’ll discover why short-term speculations on commodities like oil might not be the best strategy for most people, the implications of the ever-changing value of the dollar on commodity prices, and the potential risks involved in commodity trading. You’ll also understand why Buffett advises focusing on productive assets like common stocks and distressed bonds for long-term gains.
Whether you’re an established investor, a beginner looking for trading strategies, or someone interested in the thought processes of two of the world’s most successful investors, this article is a treasure trove of wisdom. Keep reading for the insights and teachings of Warren Buffett on commodities trading and more.
Warren Buffett on Trading Commodities
Below is a transcript from Warren Buffett and Charlie Munger at an annual Berkshire Hathaway shareholder meeting, where he discusses why he doesn’t trade commodities.[1]
Question posed to Buffett and Munger, “Hi, Warren and Charlie. My name is Catherine Voorhood. I’m from Los Angeles, California. I invest primarily in commodities and commodity equities. I started out back in 2007, buying oil. In the summer of 2008, we reached the peak of the oil bubble. That’s when I reversed my holdings and started shorting oil. I made a nice profit. In 2009, I started buying oil again and oil equities, and I’ve been doing pretty well. But given the status of the world today and the price of oil, I’m questioning my investments. Is this another oil bubble? Has oil reached its peak? Should I keep my holdings? Should I short oil? Should I exit oil altogether and move into other commodities or other investments? So, my question to you is: What are your sentiments regarding oil?”
Warren Buffett replies, “Well, I would say you’ve done a whole lot better than we have, so I think the crowd would rather hear from you. We actually did take a position in oil; I don’t know how many years ago. A long time ago.”
Charlie Munger interjects, “It was ten dollars a barrel.”
Buffett continues. “It wasn’t that long ago. And, incidentally, that was in the 1990s. Although, we’ve seen oil a lot cheaper than that, and East Texas oil sold for a dime a barrel in 1932.”
“We really don’t know. Obviously, you’re dealing with a finite resource. I don’t know whether the world’s up to 88 million barrels or was not around 85 million barrels. But there’s got to be some comeback, so I wouldn’t be surprised if the current figure’s getting pretty close to 88 million barrels a day. That’s a lot of oil to take out of the ground every day. Of course, new frontiers have been found, but you’ve stuck a lot of straws into the earth, and there is a finite number. So, the one thing I can almost promise you is that oil will settle for a lot more someday.”
“Interestingly enough, do you know how many producing oil wells do you think there are in the United States? The answer is something like 500,000. Now you know there are these stripper wells, wells out in near Charlie that have been going for 100 years. But we have looked in a lot of places now. And what’s happening, of course, from the standpoint of the United States companies, is that the smaller countries where oil is being found now are quite a bit smarter about how they grant their concessions than people were 50 or 75 or 100 years ago. So, they drive much more intelligent deals than it was originally the case when we went exploring around the world.”
“But I have no idea. We traditionally, BNSF had hedged a certain amount of oil because they obviously use huge quantities of diesel. And I suggested to them, although how they run the BNSF is up to them, but I just really didn’t think we could guess the price of oil, and I thought if we could guess the price of oil, we didn’t need to run the railroad. I mean, it was a lot of effort and time to run that railroad, and if we know how to make money just sitting in a room trading oil, why not do that instead? So, I don’t really – we don’t hedge.”
“Well, in terms of Berkshire’s parent company policies, we don’t hedge anything in the way of commodities. Some of our subsidiaries do, and that’s fine. They’re responsible for their businesses. But there are very few commodities that I’ve ever thought I would know the direction of their movement in the next six months or a year. The one thing I’m quite convinced of, as we talked about this morning, is the fact the dollar will become less valuable over time so that the dollar price of most things will go up and maybe go up very substantially. Whether they go up enough so that you have the same amount of purchasing power after you pay tax on your nominal gains is another question.”
“I really think that an intelligent person can make more money over time thinking about assets, productive assets, rather than speculating in commodities or, for that matter, fixed-dollar investments. But that’s maybe my own bias. Charlie?”
Charlie Munger adds, “Well if we’d done nothing but oil from the very beginning, I am confident that we would not have done nearly as well as we have. To me, that’s perfectly obvious. So, I think what we’ve done is much easier than what you’re trying to do.”
Buffett interjects, “And we like easy.”
Munger continues, “Yeah, we’re not trying to make it any more difficult than we have to.”
Buffett explains, “I really don’t know any way to have an edge in that sort of activity. If you are going to try and figure out when to be long or short, oil, or natural gas, or copper, or cotton, or whatever. I don’t know of people who I feel would have an edge in trying to do that over the next ten years. But I do know people where I think they’d have a very significant edge in investing in common stocks, and maybe distressed bonds for that matter too.”
Munger concludes, “Yeah, trading oil worked best of all for the people who bribed Nigeria.”
Buffett’s Investing Strategy
Warren Buffett is known for his value investing strategy, which involves buying shares in businesses that he believes are undervalued and holding onto them for a long time; his ideal investment is forever. His investment philosophy is guided by principles such as understanding the business, investing in companies with a competitive advantage, and being patient.
Regarding commodities like oil and gold, they do not generate cash flows or profits like businesses do. A bar of gold or a barrel of oil will not produce anything or earn money over time. This is fundamentally different from a business, which has the potential to generate revenue, profits, and cash flows over time.
Buffett prefers investing in businesses with a durable competitive advantage, known as a “moat.” These businesses have a unique advantage that makes it difficult for competitors to challenge them. This could be a firm brand name, proprietary technology, or a dominant market position. Companies with commodity-based businesses can have a “moat” if they are low-cost producers, have long-term contracts, or own assets that are hard to replicate.
For example, Berkshire Hathaway has invested in oil companies and businesses that use commodities as their product. Businesses can profit by adding value to commodities, such as refining oil into gasoline or using gold to manufacture jewelry, drilling for oil to sell, or mining for gold to sell on the open market.
Commodity prices can be volatile and are influenced by factors that are hard to predict, such as geopolitical events, changes in supply and demand, and currency fluctuations. This unpredictability is another reason Buffett prefers investing in businesses rather than commodities.
While commodities can be a part of a diversified investment portfolio, they rarely fit into Warren Buffett’s investing philosophy of buying undervalued companies with a durable competitive advantage and holding onto them for the long term.
Key Takeaways
- Successful investing and trading require an edge, not random speculations: Catherine Voorhood’s experiences suggest that while short-term gains can be made by speculating on commodities, long-term success is more likely achieved with a well-thought-out strategy.
- Understanding the industry is crucial: The oil industry, for example, is complicated and affected by numerous factors, such as geopolitical shifts, the global economy, and technological innovations.
- The dollar’s value over time: As the dollar becomes less valuable, the dollar price of most things, including commodities, will increase. It is uncertain whether they rise enough to maintain purchasing power after tax on nominal gains.
- The potential pitfalls of commodity trading: Without an advantage or a unique edge, trading commodities can be risky, as it’s challenging to accurately predict the direction of their price movement. Trend followers that make money trading commodities use systematic signals to profit from capturing movements. They also don’t try to predict.
- The advantage of investing in productive assets: Warren Buffett suggests that focusing on productive assets such as common stocks or distressed bonds could be more profitable in the long run than speculating in commodities.
Conclusion
Warren Buffett’s insights into the unpredictable nature of commodity trading provide a compelling argument for a different approach to investing. Rather than chasing speculative short-term gains in markets such as oil, his strategy focuses on long-term investments in productive assets. The aim is to leverage understanding, knowledge, and patience to generate sustainable returns. This approach and an eye on the dollar’s devaluation offer a blueprint for long-term investing success. According to Buffett, investing is less about guessing the next big thing and more about identifying value, understanding the market, and maintaining a long-term perspective.