naked capitalism

Today we offer two contrasting takes on the commodities market, although they are also looking at very different issues. The post immediately prior to this one, on Martin Wolf’s worries about the impact of commodities price rises, contrasts with Ambrose Evans-Pritchard’s view that in many commodities markets, the recent price spikes are driven more by speculation that by supply/demand fundamentals.

Some reader detest Evans-Pritchard, so let’s deal with that first. He does like to over-state and over-dramatize his case (which the Telegraph heightens via its headlines), but he gives his logic and his evidence, and he generally offers some caveats, although often at the end. And this piece probes an issue that needs discussing, so it will hopefully provoke some useful debate.

Also note that despite the headline, Evans-Prichard is not saying that commodities will go into a long-term decline. However, given a 20% runup in many indices in a mere two months after a 30+% increase last year, some observers deem the market to be overbought and due for a correction. Evans-Pritchard points out that if you believe that the US and Europe are going to enter a recession (insiders believe that European financial institutions will soon see the kind of stress their US peers have suffered), Chinese demand isn’t strong enough to justify continued robust prices (ex agriculture). Deflation tends to be an across-the-board syndrome. However, if the powers that be do forestall deflation or a bad recession, the cost is likely to be inflation.

Why does Evans-Pritchard believe that speculation is at work? He is using the term in a broader sense than most might. Historically, institutional investors have steered away from commodities. If you think the gap between equity and debt market types is large, the divergence between securities markets investors and commodities players is a yawning chasm.

Yet well proven investment research shows that the more assets classes you are in (asset classes being defined as, say, stocks, bonds, cash, international equities, real estate), the further out you are on the efficient investment horizon. Investing in another asset class lowers your risk while producing a very small reduction in expected returns.

And commodities are a very good addition to model portfolios. They have positive skewness, while stocks and bonds have negative skewness, so their impact on expected returns is actually better than hedge funds (they also exhibit negative skewness).

So in theory, all investors should have some commodities exposure. But many big institutional investors did plenty well with hedge funds and private equity, and so didn’t feel the need to venture further. But the difficult markets of last year have led to more interest and investment in commodities.

The other wild card is China. Domestic inflation is increasing social unrest in China. Some of the causes, such as high pork prices, are temporary (there was a porcine disease that led to large scale slaughter). Nevertheless, the Chinese authorities have made a series of interventions to try to stem domestic overheating. If they raise interest rates or let the yuan appreciate even more rapidly, that could alleviate commodities price pressures.

What would prove Evan-Pritchard’s thesis conclusively is more information about inventory levels. He points to some markets where inventories are high or tightness is exaggerated. But while there is some fungiblity among commodities, such as grains and energy, the supply and demand conditions are very specific to each market.

Of course, even with a correct diagnosis of the dynamics, Evans-Pritchard’s day of reckoning could be considerably delayed. As we saw with the dot-com and housing markets, buying fever develops it own self-validating logic.

From the Telegraph:

India faces a mountain of surplus sugar. Over 20m tonnes sit in warehouses, begging for buyers. Brazil has ramped up cane production in a burst of expansion. It is now exporting record amounts of sugar, even after diverting half its harvest into ethanol for cars.

By any definition, there is a global glut. Yet this has not stopped sugar futures jumping 40pc since December, reaching 14.18 cents (7.1p) a pound on the March 2008 contract.

Sugar has been swept up with the whole gamut of commodities – grains, metals, oil and gas – in a fevered surge of investment in futures contracts, regardless of the real demand from daily users. Wheat has risen 112pc in four months.

Judy Gaines-Chase, a commodity expert at J Gaines Consulting, said the market had become unhinged.

“Investors have made far too much of the link between sugar and biofuels. We’ve had one massive surplus after another, yet people still keep planting more cane. Brazil is the only country where ethanol is actually viable in cars. Everywhere else is building up sugar stocks in mere hope,” she said.

The sugar syndrome is the starkest evidence to date that the raw materials boom is getting ahead of itself. A variant of the pattern is emerging in industrial metals, crowned by an explosive “short squeeze” in copper last month. Arguably, even crude oil futures have decoupled from the real market.

The benchmark CRB commodity index has risen 15pc so far this year, eclipsing moves in the 1970s. It is the most spectacular new year rally in half a century.

It is taken for granted that China will continue gobbling up the world’s resources with a limitless appetite, the world faces an inflationary fire and that the dollar will slide further.

However, these assumptions are less certain than they look.

“The strength of base metals is absolutely bewildering given that the US is falling into recession,” said Stephen Briggs, a metals analyst at Société Générale. “America matters. There is economic contagion in Europe and it is spreading to emerging markets as well, yet people don’t seem to care. They are taking no notice of the economic fundamentals, or they’re betting that supply will continue to fall short even if demand slows. This is dangerous. Base metals are highly cyclical. Sentiment can change overnight,” he said.

The “culprit” is the new breed of commodity index funds. Each week over the last two months, between $5bn and $10bn of fresh money has been pouring into the Goldman Sachs Commodity Index, the Dow Jones-AIG Commodity Index, and other funds, according to a UBS study. Together, the indexes now hold $200bn.

“Some commodities have leapt into the stratosphere over the last year: they’ve been pushed higher than the fundamentals merit,” said John Reade, head of the UBS metals team. The buyers are typically big institutions such as Calpers (the California retirement fund), or the Dutch pension funds.

“This is passive long-only investment, so it is not really a bubble. It would be a much bigger problem if it was leveraged speculation,” Mr Reade said.

Crude oil has surged to $104 a barrel, yet US gasoline inventories are at the highest level in 14 years. Oil stocks have been rising for the last seven weeks, even though we are at the top of the winter season when inventories normally fall. The tsunami of pension money is beginning to distort the market for energy futures. Texas oilman T Boone Pickens said investment froth has pushed up prices by $15.

This is not to downplay the powerful reasons behind the oil boom. Output has been flat for four years despite efforts by BP, Shell and peers to find new supplies, yet China’s oil imports rose 14pc in 2007. The era of ‘peak oil’ is certainly with us. But it was with us a decade ago when oil prices fell to $10 a barrel.

The data from the US is dire. Manufacturing orders fell 5.3pc in January, with a 14pc slide in the transport segment. “The slowing is really comprehensive right now,” said Bill Zollers, head of the trucking giant YRC Worldwide. “We have seen something recently that we have not seen in a long, long time, and that’s the port activity has begun to slow a little bit. This thing is becoming global,” he said.

James Steel, a commodity expert at HSBC, said oil had been driven $25 or $30 a barrel above par. “This flood of money into the indexes is unsustainable. This underlying weakness in markets will come back to haunt,” he said.

Mr Steel said inflated oil prices were automatically spilling over into gold, since energy makes up 65pc of the index baskets. The funds have to buy non-oil commodities to keep the weighting constant. Gold would normally fall in February for seasonal reasons. There is a ‘buyers strike’ for jewellery in India. Yet gold hit a record $984 an ounce yesterday.

If oil tumbles we will find out whether gold really has regained its status as a hard currency, a haven for investor flight from discredited paper in a world of sub-prime wreckage, or whether it is still a cyclical commodity like the others.

The bullish case is strongest for the “Ags”, above all grains such as soybeans, corn, and wheat. The world is adding 73m mouths each year, yet arable land is running short. The US – the superpower of grain production – aims to divert 20pc of its output to biofuels. China is paving over its most fertile acres in the east.

Asian countries with a combined population of over 2.5bn people are rapidly moving up the food ladder, switching to an animal-protein diet like the Japanese before them. It takes 8.3 grams of animal feed to produce a 1g weight gain in cattle. Deeply alarmed, the United Nations is mulling plans to ration food aid to poor countries. “If you had any major crop upset this year, I believe you’d see famine,” said William Doyle, head of Canada’s Potash Corp.

There is no question that fuel technology has now made oil and grains interchangeable for the first time, but this cuts both ways for investors. If oil slides, so will the “Ags”, and they in turn may take down the rest through the index effect.

The “Commodity Supercycle” has many more years to run. The Earth is being stretched to the limit as India and China join the affluent society. But that does not preclude a jagged upward path with violent dips along the way.

Is China really big enough to offset construction slumps now engulfing the US, UK, Japan and much of the Eurozone? One cannot ignore 60pc of the world’s economy.