@CIWC: Bubbles and Supply Shocks

Brian Kelly attended last week's Commodity Investment World Conference on behalf of Seeking Alpha.

I spent the last two days at the Commodity Investment World Conference in New York. The general theme and tone of the conference was that the world has changed dramatically and unprecedented market "anomalies" were occurring. In fact, most of the presentations were compiled three weeks ago and were grossly out of date, so most presenters went off the cuff.

A simple look at the Dow Jones AIG commodity index illustrates the massive dislocations in the market.

The index peaked in July of 2008 and has since fallen 53%- the largest move in the shortest amount of time since the index began. If you have not looked at the news in 6 months this chart is a surprise, however, even a casual glance at the front page of any newspaper tells you the financial world is in turmoil. Deleveraging resulted in unprecedented correlations occurring between all asset classes, while institutional investors were making irrational decisions to pull money out of well performing funds.

As the conference got through the "Chicken Little" stage, there was some blue sky. Thierry Wizman of Fortis spoke about hedge fund withdrawals coming to an end. I asked him for some detail and he told me that the numbers he has seen suggest that hedge funds have raised upwards of 80% of the cash they will need for year-end redemptions. This follows the anecdotal evidence that I have gathered from friends and colleagues at large funds. Almost all have gone to cash and are waiting for the New Year before they start to re-invest. In fact, many have told me that after this week they are done for the year.

I also chatted with one of the conference organizers and asked him how conference attendance has been overall. He told me that they had seen a surge in interest over the last few weeks as institutional investors were looking for opportunities for the New Year.

Supply Shocks

The second general theme was that sometime in the next six months to two years there would be a substantial supply shock in many commodities, especially oil. The credit crunch has caused rigs to shut down, infrastructure improvements to stop and high cost supply to be unprofitable. The two examples examined were the tar sands of Canada and crack spreads.

In western Canada, the cost to pull a barrel of oil out the tar sands is roughly $70, the highest of all production methods. This does not include deep water Brazil that has yet to begin. In this environment, any company that is perceived to have exposure to oil is being punished and cutbacks will lead to supply shortages.

Further, the refiners are losing money from negative gas crack spreads. The gas crack spread is a measure of how much money per barrel a refiner makes by "cracking” oil and producing gasoline.

Currently the gas crack spread is negative and has been that way since the end of October. Obviously, refiners will not be able to stay in business for too long if they continue to lose money on the products they produce. This unsustainable trend will likely cause refiners to shut down production and lead to a supply shock.

All in, the take away from the conference was that while the world has changed rapidly, ultimately it would begin to normalize. Eventually, market participants will recognize the unsustainable trends and fundamentals will once again become relevant. However, as long as the credit crunch continues look for the insanity to continue.

Disclosure: I am short SLV.

Comments

[long_on_oil:]

Good article, author hit the nail on the head and we all know it.
For example Transocean is selling for the same price it did 5 years ago. This totally discounts the fact they have added Global Santa Fe plus all the new oil rigs. The insanity of the investment universe is driving me nuts...lol

2008 Dec 07 08:38 AM

[socrateazz:]

I think things are worse than you may think. Agriculture is leveraged too greatly and a lot will find they can not get the money to plant the crops to produce the food. Fuel may be more important than a shiney metal alright. But food is more important than fuel. I think everybody will be shocked at the record agricultural bankruptcies they will see in the next six months. I assume major agricultural production will need to be guaranteed by bailout also this spring. A failure to do so will pobably result in so called unexpected food shortages.

2008 Dec 07 08:41 AM

[elliot_mllr:]

Socretazz:
If food production declines as precipitously as you believe it will prices will increase and production will respond.
That's the thesis of the article: when credit conditions normalize the downturn in commodity production will give rise to higher prices and increased production. The real issue is getting credit conditions to normalize. Right now the inability to get trade letters of credit has caused a 95% decline in the Baltic Dry Index and is ruining the dry bulk shipping and container subsectors of the shipping industry. Presumably, when conditions get drastic enough increasing prices will spur normalization of credit conditions.

2008 Dec 07 11:22 AM

[Pipo:]

Oil had its Biggest weekly drop since the Persian Gulf War in 1991. Is a short covering rally ust around the corner?

www.oiltradersblog.blo...

2008 Dec 07 12:03 PM

[User 30121:]

So you are short SLV. So what? Who cares? What is the point of this article? Silver? Where is ANY logical reasoning given for shorting the metal?

2008 Dec 07 07:03 PM

[jimmy46:]

COMMODITIES DOWN 53%

IS THERE ANYONE WHO DOUBTS IT WAS THE HEDGE FUNDS THAT

INFLATED ALL THOSE PRICES?

2008 Dec 08 01:22 PM

[GMiki1:]

Makes sense--but why are you short SLV with silver long overdue for a bounce? Up today: infrastructure plays plus aggregates (crushed stone/concrete). Can base metals be far behind? Or do we build without copper, zinc, and moly? (I don't thinkkkkk so.)

2008 Dec 08 06:19 PM