"Fears of a commodity crash grow"

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.

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11 comments

  1. john haskell

    I strongly suspect that the sugar in India which is “begging for buyers” is in some sort of strategic reserve. If you visit Brazil you will not find a lot of euphoria about sugar at 14c a pound. With the BRL appreciating against the USD almost every day (hat tip: Warren Buffett) BR farmers’ cost base continues to rise in USD terms.

    As for high oil inventories in the US this “news” has been repeated so long (going back to ’02, I think) that it can be considered “evergreen,” having even more lives than “Ambac to be bailed out.”

  2. S

    There is something truly ironic in listening to the pundits gloat about the productivity gains as reported this am. It is doubly ironic in light of this article. They simply don’t get it! The only inflation we need is wage inflation and it isn’t forthcoming. Why is this so difficult for them to grasp this elementary concept.

    We hear companies have record cash on the balance sheet juxtaposed against rising unemployment (weak ADP) and spiking bankruptcies – a precurser of what is to come considering the turn in nonresidential investment and retail carnage. Bernanke gets it considering his increasingly urgent language. His only problem is in trying to solve the problem within the exising global construct. My owns sense is that China and the global central banks – per brad Sester – continuing buying to protect an incumbant system that if they can nurse it through will revert to mean. To wit, I would disgagree with bill gross that the US is a going concern in the traditional sense. Unless there is a fundamental restructuring you end up in the same culdesac, like autos. So yes the US isn’t going to die, but neiher does Rome look the same as it did in its heydey.

    John McCain’s and for that matter conservative reflexive defense of free trade is anachronistic thinking. The democrats are on to something in thinking throuhg new ideas although the tax breaks to incent investment is a little too cute. Again no attempt to address underlying structural issues. Mish has been big on discussing overcapacity in the retail, construction etc, but there is also a growing overcapacity in the financial services business. That does not bode well for the “trade” policy makers agreed to decades ago. When does manufacturing become the new service.

    The dollar is a lagging indicator of the policy decisions that offshored US standard of living in exchange for geopolitical and special interest goals.

  3. Anonymous

    If China decided to create more job than it is now doing, would it worsen the situation?

    It seems like there’s not enough employment needs to keep a level of employment that doesn’t create riots and civil wars.

  4. Demand Side

    The commodities bubble is real. The dynamic is that identified by the Austrian School, that liquidity seeks the rising asset. When housing hit the fan in August and the Fed began its interest rate cuts, take a look at the commodities indexes.

    Money fleeing housing combined with the new liquidity to make a financial asset of the basic stuff of the economy. It is cruel that speculation in food is hurting the poor.

    What is amazing is more people do not see it happening. What is scary is not only the current burden of energy and food prices that are high only because of speculation, but the crunch that will hit farmers and other producers hard when the bubble bursts.

    Give it a critical think.

  5. Anonymous

    john haskell,

    Good point about Brazilian farmers. Lost in all this discussion about commodities is the margin squeeze on the foreign producers of ag commodities. With a rising currency relative to the dollars, but consigned to selling their product in $$$, they are at a disadvantage compared to the American producers, and probably watching their margins shrink.

    As for high oil inventories, I don’t know what to believe. I don’t really think they know what the inventories truly are, as I constantly hear differing opinions almost everyday.

    Lastly, are commodities in a bubble? yes, but so is everything else. At least commodities have real demand pressure, unlike shares in ABK to anyone with half a brain cell floating between their ears :-)

  6. Lune

    As a commodities newbie, I’m a little perplexed about how a speculative bubble can be built in this market, as most of these futures are for physical delivery. In other words, if there truly isn’t enough actual demand to justify $100/bl oil prices, then oil companies (who one must assume can’t sell all their oil at that speculative price to real consumers) can just buy the futures, and force the counterparty to accept physical delivery of the oil. In which case, you’d have numerous hedge funds in NY physically holding barrels of oil in OK, something I doubt they want to do.

    What this should translate to in the commodities market is a drastic decline in the price of futures when you get close to the expiration date, as speculators scramble to dump their contracts to avoid taking physical delivery of a commodity they can’t sell, while producers keep their positions open in order to unload their goods at an inflated price. According to my logic, then, the price should reach equilibrium at the time of the expiration of the contract, unless you’re willing to speculate by physically storing your commodity and selling it at a later date (something that has increasing costs in perishable commodities like agriculture).

    So except for a few players who can speculate with the physical goods themselves, everyone else who’s just speculating on the financial markets should get squeezed out at the time of contract expiration. So why isn’t this happening?

  7. HBL

    Lune-

    I have no experience related to commodity investing, and initially had the same question as you due to the physical delivery aspect to commodity futures. However, thinking through it, I think it makes sense — I’m guessing investment funds that are long commodity futures have to roll them over each time they come due (that is, if they aren’t choosing to stockpile the actual commodities). For example they would sell the futures for April (to actual commodity users) in order to buy new futures due in May. Assuming the prices between April and May futures are highly correlated, demand for that commodity’s futures as a whole doesn’t drop. Someone tell me if I’m wrong…

    And as long as the gap between demand for the futures (speculative or real) and supply of the futures keeps growing, prices will rise as increasing numbers of potential buyers bid up the price of the contracts. Just like condo flippers did with housing! In fact it seems like many of the same arguments are being used as to why commodities aren’t in a bubble as were used for housing — just because the of the trends of increasing demand and limits to supply, it doesn’t mean prices can’t get way ahead of themselves! And when the deleveraging and destruction of credit-based money accelerates and no one new is left on the demand side, prices could plunge…

    It even seems to me that the idea that there must be unused stockpiles for it to be a bubble isn’t accurate.

    Now, if only I knew a way as an individual US investor to short commodities… (I did see that one fund company opened a bunch of commodity short funds in Europe a few weeks ago). Outside of short term climate and geopolitical risks, it seems safer than equity shorts (since the US government at least would have more incentive to artificially support equity prices than commodity prices).

  8. artichoke

    Well, even if the net open interest exceeds deliverable physical supply (the rest will be settled for cash rather than physical delivery), all those contracts will settle for the physical price. So there’s a bit more of a tie to reality than with stocks which are always linked to an “infinite stream of future dividends”.

    With some commodities there is some possibility of storage. I doubt that tulips could have bubbled as they did, if they could not be stored. In fact tulips became very easy to store, as one little bulb held a great deal of value. So I suppose that once those commodities leave touch with true pricing, the more they bubble, the easier it is for further bubbling, as storage becomes easier per dollar value stored.

  9. Lune

    hbl,

    Your analogy to housing is apt, but critically different in one way. Essentially, housing speculators are taking physical delivery of the house, with the expectation that they can sell it later for a higher price. Along the way, they incur carrying costs (e.g. interest, taxes, maintenance, etc.) similar to carrying costs for storing physical commodities. Thus, since housing speculators can and usually do take physical delivery of their “commodity”, they can continue the speculative bubble even though they’re not really “consuming” the commodity (i.e. living in it).

    OTOH, the vast majority of commodity speculators are unable to take physical delivery of their commodity. That means at the end of the day, the only open contracts left will be with people who can actually utilize the commodity (plus some small number of people who have the ability to take delivery and speculate with the actual commodity in hand). The speculators should by and large be squeezed out.

    For example, say that Exxon has a million barrels of oil to sell in March. And say that at $80/bl there is demand for the whole mil barrels, but at $100/bl, there is only demand for 900k barrels (I realize that both demand and supply for oil is relatively inelastic, especially month-to-month, so pricing is intrinsically volatile since it’s set on the margins, but plenty of analysts are saying that the equilibrium price of oil should be ~$80/bl). That means that Exxon should sell as much of their supply to consumers at $100/bl, and sell futures contracts for the remainder 100k barrels to speculators willing to buy contracts at $100. Then, they just sit and wait until expiration, and dump their excess supply to the speculator on the other side of the contract. The speculator OTOH becomes increasingly frantic to get out of his contract to avoid physical delivery, but none of the other speculators want to take physical delivery either, so the price keeps coming down until an actual oil consumer bites (which in the above example, would be at $80).

    Isn’t this the way futures are supposed to work? I thought the physical delivery part is supposed to keep speculators on a short leash. If that isn’t happening, then the only likely explanation I can come up with is that there is no excess supply, and consumers are willing to pay $100 with no reduction in demand.

  10. Yves Smith

    Lune,

    The option of physical delivery is meant to provide for an arbitrage mechanism between the cash and futures markets.

    However, it appears that futures prices are having a significant impact on cash price formation. My understanding is that it the case at least in the oil market. Similarly, gold prices appear almost entirely futures market driven. I know people in the jewelry business in the US and it has never been worse (and it’s not due to the price of gold. Pearls, diamonds, estate pieces are very hard to sell in the trade, as they call it).

    In fact, that happens in a lot of derivative markets. As the derivatives become more liquid, traders prefer the derivative to the cash market. Then price formation moves to the derivative market. This has happened with bonds versus credit default swaps.

  11. HBL

    Lune,

    You are correct, I got ahead of myself on the housing analogy — that was primarily intended to be in terms of the replay of unquantified rising demand / limited supply arguments.

    Let me try my take on your Exxon oil example… I think the key difference between our assessments is whether you assume that there is enough consumption demand for the commodity even at the higher price point in order for physical delivery to be taken by consumption-oriented parties — i.e., in your example, are there enough consumers of the oil even at $100 a barrel to buy up all the futures even as they are coming due for physical delivery? My guess would be that in most commodity markets the answer has been “yes” (although in some markets the buyer may stockpile rather than consume), but it sounds like your assumption has been “no”. If “no” is correct, then I do see the problems you describe, and perhaps that is how some commodity markets will peak and crash.

    But if we go with the “yes” assumption, then what speculators are doing is just bidding up the price of things above the level implied by consumption demand alone (relative to supply).

    Someone tell me if this is off base.

    And by the way — Yves — thank you for this blog, it is one of my favorites!

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