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Is there a bubble within the super commodity cycle?

There is a tremendous hype all over the world about the wonders of investing in timber, rhodium, carbon emissions credits, private equity funds and various ETFs (Exchange Traded Funds) that seek to double the return of wheat, corn, soybeans and the like. Each week, over the last four months, between $5 billion and $10 billion of fresh money has poured into the Goldman Sachs Commodity Index, the Dow Jones-AIG Commodity Index and other Index Funds, which now total over $200 billion.

Hedge funds, banks and pension funds have poured capital into oil trading in recent years, betting that demand will outstrip supply. Such bets have become self-fulfilling prophecies, helping to push prices higher. Trading volume in commodity futures and options contracts has soared across the globe, with the number of agricultural contracts gaining 32 per cent from a year earlier, followed by industrial metals and energy products, which increased by 29.7 per cent and 28.6 per cent respectively, according to the Futures Industry Association.

Impact costs help spiral

Index-based commodity strategies allow investors to own a broad cross-section of commodities, all at once. Hedge funds and small investors alike have been especially attracted to ETFs that allow investors to buy and sell anything from steel to coal, just like they buy and sell stocks.

Big fund inflows may be having a large impact in relatively shallow markets like those for corn, wheat and other agricultural commodities; prices of wheat shot up by 31 per cent in just one recent trading session. Commodities have become the target for momentum-chasers, and have given them their own momentum.

Increased demand for commodity futures has also had an effect on their supply. If prices are high now, producers are less keen to sell forward. So, they offer fewer futures, even as demand increases, creating an upward spiral.

No underlying business

Commodities, as an asset class, do provide diversification, but at today’s high prices, they do not provide much protection. The beauty of stocks and bonds is that their fortunes are inextricably linked to a business. On the other hand, commodities generate no cash and pay no interest or dividends. They are worth only what someone else will pay for them, and history shows that over time, their price is more likely to go down than up. Gold soared in the 1979-80 bear market. Had someone bought gold then, he would have only recently managed to break-even. In fact, adjusted for inflation, one would be very much in the red.

Speculative surge

With a global slump in economies, speculators have moved from stocks to commodities. In the absence of long-term futures contracts, investors who are bullish about long-term prices can put their funds only in commodities indices and other products that invest in near-term contracts and, as a result, contribute to higher spot prices.

Oil prices have risen more than five-fold since 2002 and about 30 per cent already in 2008. Although most analysts blame rising demand and tight supply, the truth is that this upsurge in oil prices has attracted floods of investment money, and exaggerated the effects of supply disruptions.

Over the past 10 years, global oil reserves have increased by 140 billion barrels to 1,200 billion barrels. If you add Canadian oil sands to the total, the increase was 300 billion barrels. Over the same time span, the increase in world oil demand has been a lower 45 billion barrels. If supply and demand are not entirely behind the recent price increases, it is speculation which has played a key role. Over-the-counter commodity derivatives held globally grew sevenfold, to $7,000 billion in the three years to June 2007. If we assume that only 50 per cent of the open positions are oil, the exposure as of the last data point equated to 48.5 billion barrels of oil, or about 20 times the size of the New York Mercantile Exchange.

Some of the diversified exchange traded funds (which invest in a basket of commodities and precious metals) are, by charter, allowed to invest only 60-70 per cent in commodities. The rest, therefore, by default, goes to precious metals such as gold, whose prices have risen without any reference to its fundamentals. By any definition, there is a global glut of sugar. Brazil has ramped up cane production in a burst of expansion. Yet, sugar futures have jumped 40 per cent since December 2007.

We are currently not witnessing what is popularly being called a ‘late cycle demand-pull inflation’ analogous to the one that occurred in the 1970s.

What we are seeing is a ‘paper crisis’ due to the after-effects of over-leveraging, where investors have been shunning paper assets and buying commodities and real assets. As Fed’s easing begins to blow away the current subprime crisis, we could see rapid de-leveraging of speculative positions built in world commodity markets.

Decoupling from economies

The US and Western Europe account for 47 per cent of world Gross Domestic Product (GDP) and more than half of the global private consumption growth. A consumer recession in the US and European Union will require an improbable 3-4 per cent rise in demand elsewhere, if it is to be offset. If China and India report slower growth, the impact on global economic growth will be considerable.

Traditionally, demand for commodities has followed levels of economic activity. Societe Generale research shows that, since 1981, the CRB index, the longest-established commodity index, and the OECD’s (Organisation for Economic Co-operation and Development) leading indicators have moved almost in alignment with each other. But in the past few months, that relationship has broken down completely. The commodity surge has co-existed with an unmistakable economic slowdown.

Pack of cards

Commodities can be on an upward momentum for years (as has happened since 2002) and suddenly crash like a pack of cards. This may not signify an end to the commodity super-cycle. However, an unwinding of leveraged positions can cause a sharp correction in prices. After the system has cleansed itself of leveraged positions, the upward move in commodity prices should resume as China and India continue to add to their infrastructure at a rapid pace.

The speculative binge in precious metals in 1979-80 is illustrative of what could transpire. Silver went up from $5 to $50 per ounce and back to $5 in the space of a few years.

A number of silver consumers, such as film producers, went bust, and mining companies that had hedged found themselves in great difficulties.

Many of today’s energy traders have never seen a situation where the price of oil traded below $50 a barrel, as they have entered the game recently.

Some believe that the commodities scenario resembles the dot-com scenario where people were scared that if they did not enter the dot-com ring immediately, they would be left out. And they sure entered, only to see the infamous dot-com crash and their life’s savings evaporate. The dot-com companies did re-emerge a few years later, stronger than before. I believe a similar stream of events awaits commodities.

(Sunil Kewalramani – The author is an alumni of Wharton Business School and CEO, Sunil Kewalramani Investments. He advises foreign financial institutions and other institutional clients on Foreign Direct Investment and Global Wealth Management.)

Source: Business Line

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