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Has the bubble popped?

If you were long silver, wheat and base metals at the start of 2008, you have my deepest sympathy. All these counters have become substantially cheaper in the last three months. Any bets you placed last year would have certainly made you richer. But things haven’t been quite that simple from 2008 onwards.

On Friday, Reuters Jefferies Commodity index fell for the ninth time in 10 days. Rogers International was down 16% while the benchmark S&P GSCI was down more than 8%.

With crude oil hogging the headlines, one tends to forget that metals have been especially pathetic performers in the last three months. Lead is 37% cheaper now than on January 1. Nickel has fallen 30% this year, the worst among all LME-traded metals. Even gold has remained flat on average after shooting up 10% in the beginning of 2008 while silver has barely budged.

Platinum fell 5% in July. Palladium fell for a 10th session on Friday. Natural gas has fallen more than twice the distance that oil has. The plunge from $13.50 to $9 marks a 33% reversal. Wheat is 7% cheaper than 2007, after shedding 8% since March.

With coffee, sugar, cotton, palladium, aluminum, platinum and copper all clocking single-digit price increases over the first quarter of 2008, the big question is has the commodity bubble deflated? And most important, who do you blame for your pain? The answer lies mired in a confusing slush of demand-supply fundamentals, market sentiment and threats from regulators.

Take demand-supply first. Zinc, nickel and lead had it coming. All three are in surplus as new supply overtakes increase in demand. Research by Fortis Bank shows that tin gained 13% on LME in the last three months because supply was tight.

In the case of soft commodities, the unusual price signals last year have stimulated an equally amazing supply response. Wheat is bearish due to record global production and wide availability of high quality wheat. This column itself warned you six months ago to stay clear as farmers were awfully keen on wheat. So in all these, anyone who went long forgot to do the maths.

Second, there was the factor of market sentiment. For copper and aluminium, which are in short supply, this was the killer. Copper added 2% and aluminum 3% on LME in this quarter after jumping 25% in Q1 2008. Since these metals are a good barometer of how punters view the global economy, price declines show the market believes demand will decline as industrial growth turns sluggish.

Third, threats of investigation, tighter rules, and a very public hounding of so-called speculators by US sarkari busybodies and Commodity Futures Trading Commission (CFTC) have scared off the larger hedge funds and index traders. The House of Representatives voted 402 to 19 to approve legislation directing the to curb immediately what was termed excessive speculation in energy markets. The bill has to go to the Senate before it becomes law.

Independent Senator Joe Lieberman, chairman of the Homeland Security and Governmental Affairs Committee, wants greater regulation of pension funds investment. He has proposed prohibiting private and public pension funds with more than $500m in assets from picking up agricultural and energy commodities traded on a US exchange, foreign exchange or over-the-counter. Second, the CFTC would have the right to set limits on the market share that speculators can hold in any one commodity. Plus, he wants to close the swaps loophole which allows individual speculator limits to be exceeded by swap dealers (who tend to be acting on behalf of investment funds linked to commodity indices). If his proposals are implemented, commodity investment would be dead in the water.

A preliminary report by an Interagency Task Force for the CFTC concludes this week that “current oil prices and the increase in oil prices between January 2003 and June 2006 are largely due to fundamental supply-demand factors”. However, CFTC commissioner Bart Chilton was quoted as saying, “The simple fact remains that there is nearly $250 billion in US commodity futures markets that wasn’t there just a few years ago, held primarily by non-traditional long investors. There has got to be, to some degree, impact from this significant new influx of trading.” As you can see, commodity traders have reasons to get nervous.

But should it scare you into turning tail? I don’t think so. Where demand-supply fundamentals point to bearishness, hoping for the opposite is plain foolishness. However, where market sentiment is overpowering inherent demand-supply mismatch, I’d say keep faith. This may be the perfect time to load up on copper and aluminum, for instance, or even cotton because they are going so cheap.

Instead of exiting completely, hedge funds are also more likely to move from the more high-profile contracts such as oil and natural gas to more innocuous contracts such as cattle and hogs.

In the case of crops, any substantial increase in the supply of one crop is invariably at the cost of some other. The world’s arable land is diminishing as urbanization and deforestation take a toll, while demand driven by population and income increases is rising. The world has consumed more food than it has produced for the past five years.

In India especially, one of the strongest bull runs in soft commodities is clearly on the horizon as drought has decimated everything from rice and pulses to cotton, oilseeds, coarse grains and sugarcane. New urban infrastructure is keeping metals demand buoyant and we all know the upside potential in coal, natural gas, and gold. Those who came late to the commodity party are certainly shelling out more to join the fun. But the music won’t stop any time soon. My advice: forget your woes and start dancing. The money will come.

Source: Economic Times


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