RISING COMMODITY PRICES: BUBBLE OR DEMAND
by Al Robinson, Dan Denning, Gabriel Andre
A story by Gene Epstein in Barron's this weekend warns that commodity prices could fall by at least 30% and as much as 50%. Epstein's article highlights what he believes to be the influence of index funds on commodity prices. He goes on to list a number of factors which a handful of analysts argue will result in much lower commodity prices this year.
"By one estimate," Epstein writes, "index funds now account for 40% of bullish bets on commodities. The speculative juices are even more plentiful-nearly 60% of bullish positions-if you count the bets placed by traditional commodity 'pools'."
The argument that there is a bubble in commodities prices is not a new one. It is based on the hard evidence the index funds which track commodity prices account for some US$200 billion in bullish positions on the commodities options and futures markets. While the funds have given retail investors a simple way to go "long" resources, Epstein argues that the "smart money," the commercial traders and producers themselves, are betting for a fall in prices.
The position outlined in the Barron's article claims that the rise in commodity prices owes more to speculation than Chinese demand growth-at least since September of last year.
According to Epstein, analyst Steve Briese's, "Analysis of commercial hedger positions leads him to believe that commodities in general were fully valued in terms of the fundamentals as of early September 2007. Based on the 24-commodity S&P Goldman Sachs Commodity Index, that would mean about a 30% collapse from present levels."
Other factors which could lead to falling commodity prices, according to Epstein: a rally in the U.S. dollar (reducing demand for dollar-denominated commodities), a non-recession in the U.S. economy (leading to a rotation out of resource shares back into other stocks), less buying by the index funds as falling gold and oil prices lead to a reallocation of institutional money, and a fall in Chinese demand.
All of these scenarios are possible.
Yet it is hard to reconcile the commodities "bubble" theory with the reality that prices for tangible goods in the real economy are going up because of real demand and scarcity, not financial speculation. For example, prices for medium-grade Thai rice have risen from US$360 a ton last year to US$760 a ton last week. There are other examples:
*** Russia's Agriculture ministry has slapped tariffs on mineral fertilisers containing nitrogen, phosphorous, and potassium. The tariffs are designed to make more fertiliser available local grain growers in the face of high global grain prices.
*** China's government raised spending on agriculture by 36% over last year in an effort to curb politically destabilising rising food prices. The government raised wheat and rice prices by ten percent to encourage local production and prevent hoarding. China's Premier Wen Jiabao called agriculture the "priority of priorities."
*** Indian rice traders have begun hoarding rice from sale, banking on much higher prices. "Rice prices are likely to increase...with major rice exporters Vietnam and India yesterday confirming that they will curb overseas sales in an effort to combat food inflation," according to arabnews.com
*** And from today's Herald Sun, "Global food prices, based on United Nations records, rose 35 per cent in the year to the end of January, markedly accelerating an upturn that began, gently at first, in 2002. Since then, prices have risen 65 per cent. In 2007 alone, according to the UN Food and Agriculture Organization's world food index, dairy prices rose nearly 80 per cent and grain 42 per cent."
When countries start imposing export tariffs on key commodities, it has two consequences. First, prices rise as the global tradability of the commodity declines. Second, it highlights the essential physical nature of key commodities: you either have them or you don't. If you don't have enough of them, you limit their export abroad.
Rising food prices or an out-and-out shortage of food and cooking oil are serious political issues for governments all over the planet. This suggests to use that the ceiling for grain prices-given historically low grain supplies-is very high.
To argue that a decline in industrial commodities like base metals and oil is a dress-rehearsal for a decline in the soft commodities and grains ignores the physical component of high prices (and 2.3 billion people who need to be fed).
Instead of arguing for an across-the-board decline in commodities as a result of reduced financial speculation, we'd be a lot more selective and say you have to be choosy about which resource prices are sustainable and which may be subject to a larger correction.
It's possible you could see a massive unwinding in the long positions commodity index funds have established. But if commodity prices do fall by 50%, it is far more likely to come from a collapse in demand brought about by real shortages in food and fuel instead of a shift in financial demand.
A China collapse remains the real threat to long-term resource prices. But a China collapse-barring some escalation in Tibet-related tensions-would almost undoubtedly be related to soaring inflation in food and fuel prices (and not a collapse in financial markets).
Still, the shift that drove investors away from broad-market index funds and into commodity-based funds to begin with is still on. That shift reflects decades of under-investment in productive capacity for real goods and a decade of over-investment in real-estate and hosing-related assets.
You should certainly be aware of and be prepared for volatility in resource prices. But we'd argue the shift to tangible assets and away from financial assets is a reflection of the times we live in, where assets that inflated because of the credit bubble will now fall in value. To argue that commodities are just the latest beneficiary of the credit bubble is to ignore the real growth in demand that's far exceeded the growth in supply over the last ten years.
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