Don't panic, the world will still need commodities

In the past few weeks I have read recommendations from investment houses that investors should sell all their shares. I have also read forecasts that Australian house prices are surely set to collapse.

Notwithstanding my thorough enjoyment of a good doomsday scenario (make sure you read Michael Lewis's book The Big Short, or watch the movie) I think a measure of common sense is needed before you take the most dramatic of investment actions.

As Lewis's book points out, economic collapses (such as the GFC) were created by the coincidence of a slack regulatory environment, massive leverage in the wrong assets and traders' ability to bet that the doomsday would occur.

In the case of the US housing market, this came about via collateralised debt obligations (effectively a form of insurance in case home buyers defaulted) and, in turn, collateralised debt securities (synthetic versions of the CDOs).

The ability to sell short gave investors the opportunity to profit from the downward spiral in the US housing market in 2007 and that accelerated the collapse - that plus the overwhelming debts that US banks had taken on with sub-standard home loans, loans they thought would never come undone completely.

Today, almost nine years on, the world is still reacting to the near implosion of global economies. The US banks were right in one way. The US government (and other major Western governments) were so fearful of a banking collapse that they used taxpayer money to bail them out. Today that is still playing out with the new capital banks are forced to set aside in protection and the capital required to back mortgage books.

Yet investors around the world are still seeking opportunities to profit - and this is exaggerated when you can profit as easily from falling prices as you can from rising prices. Think oil - perhaps the biggest game of financial chicken since 2007.

Its price has fallen from $US100 a barrel in the third quarter in 2014 to below $US30 a barrel recently. There are two fundamental reasons: the slowdown in demand in China and, more importantly, the abandonment of production targets (or limits) set by the OPEC nations.

Traders can see a play when it hits them in the face. OPEC's action to try to squeeze out Russian oil interests and US shale oil producers (the Saudis, especially, think their price of production is lower than anyone else's so they can prevail in a price and production war) means a massive world oil glut (at least in the short term).

So the sensible play has been to short oil (and the knock-on energies, coal and gas), which has accelerated the price falls. The bigger question is whether the overproduction of oil (just like the oversupply of iron ore, or even milk powder) can be reversed. A second big question is whether the demand for oil is likely to decline rapidly in the future.

To go back to China for the time being, it is being cited as a cause for alarm. It is true that China's central government has spent trillions of dollars building infrastructure while trying to control the trajectory of its economy.

But what I think the world overlooks is the rising prosperity of the Chinese middle-class and its spending power. It is probably true that the pace of China's infrastructure spending will slow, cooling its economic growth even further. It may even cruel the chances of iron ore prices bouncing any time soon.

But the infrastructure already created is helping to lift the incomes and wealth of China's 1.3 billion people. They will continue to consume energy and oil (through fuel) in increasing quantities, at least until alternative technology is viable.

As investors this year, continue to believe that the world's rising population (and, more particularly, China's growing population) will still need oil, food and healthcare. As well, seek the companies doing the best from the free trade agreements.

The traders might make money shorting energy but long-term fundamentals say the world still needs these commodities. So beware: rapidly falling prices might kill off some weaker players. But those same falling prices might also be the bedrock for a future fortune.

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