Exuberance in Commodities: How Long Will It Last?

Commodities have been staging a strong rally for the past few months, fueled by the expectation that government stimulus packages, extensive bailouts, and hundreds of billions of funds slated by the IMF for the rescue of troubled emerging markets should sooner or later end the headlong collapse of global economic activity. The rally has been particularly striking in copper where the glut was partially eliminated by a bout of Chinese purchases aimed at bailing out the domestic producers. Similarly, oil has made a remarkable comeback, and zinc, lead, aluminum, and tin have all risen comfortably above the lows of December 2008.

The uptrend in prices is confirmed by shipping prices, global demand forecasts, and port congestion data, but the picture here is diverse. Even as oil is rallying, Saudi crude exports to the U.S. have fallen to the lowest level since 1988, according to the U.S. Department of Energy. The International Grains Council is predicting a fall of 10 million MT in wheat demand for this year over 2008, while iron and steel demand in China remains firm, no doubt bolstered by the credit bonanza, and government spending outlook.

It is clear that as the pace of inventory liquidation in the East slows down, some firms see the need to restock on commodities, which contributes to the appreciation of the prices. The stimulus programs, and infrastructure investment projects initiated by some governments also justify the recent rebound in prices. In all, however, there are significant warning signs which suggest that the observed robustness of the prices is but a temporary phase of volatility, with the underlying trend pointing to the downside with conviction.

The recent rally has been impressive. The year-to-date rise in the value of three-month LME copper futures is 67 percent. In lead the rise is about 74 percent, in nickel and zinc at around 35-40 percent. But if we look at the year-on-year change in the values of these commodities, the picture is quite different. With the exception of lead, all commodities are down significantly will falls 20-70 percent registered on a year on year basis. Given that commodity cycles move slowly, and that the impact of major changes in market dynamics is felt over a long period time with great volatility, today’s picture is still strongly bearish.

How much of the recent rise in prices is driven by real commodity demand, and how much is speculative activity? This question is extremely difficult to answer, because even commercial actors who buy and sell to restock are probably acting on speculative notions of future demand.

However, a brief look at LME stocks shows a rather unpleasant picture for commodity bulls. For instance, in nickel and zinc where prices have rallied significantly, the LME stocks have barely changed at all. They are at multi-year highs, in spite of the bullishness of traders. Aluminum stocks have actually continued to rise throughout this period, even as prices are rallying. Only in copper there is a substantial fall in stocks, but that has its own special dynamics mentioned in the beginning of the article.

Even if there is some improvement in economic activity, there’s little in the data that supports the belief that a commodity bull market is taking off, fueled by a collapsing dollar, and a rebound in activity sponsored by government spending. As far as we are concerned, today’s markets are just volatile: nothing keeps falling or rising forever in the markets, and huge spikes or collapses are naturally followed by periods of correction. Such periods may last a while, yet they are unpredictable, and often difficult to trade, especially for those who make large investments in anticipation of sustained trends which do not materialize.

In sum, although it may be possible to profit from these swings in the short term, the long term outlook for commodity prices remains cloudy and difficult. It is only a matter of time before the power of the secular dynamics unleashed with the Lehman collapse makes itself felt once again, forcing some to redraw their rosy- future scenarios.

Comments

[Chandragupta]

The rise in the price of the commodities reflects the fall in the purchasing power of the dollar (as also that of other fiat currencies). Since this fall is directly a result of the Quantitative Easing that is underway, it is unlikely to be reversed, unless the QE itself is reversed. But it is not easy to reverse the excess liquidity, without causing substantial (further) damage to the economy. That is the problem.

2009 Jul 01 07:19 AM

[Fighting Yoda]

Commodity price rise is purely based on:
- Speculation of economic recovery
- Bottom fishing
- Chinese stock piling
- Green shoot PR efforts
- Production cuts.

Each of these dynamics have their own rationale - but none of them will stand up in the medium term, as we do have a very major global recession with no end in sight.

I think prices will collapse once the reality sets in again- unabated job losses and foreclosures will finally (re)drive the message.

2009 Jul 01 08:13 PM

[Greenville]

I agree with Chandra on this one!


On Jul 01 07:19 AM Chandragupta wrote:

> The rise in the price of the commodities reflects the fall in the
> purchasing power of the dollar (as also that of other fiat currencies).
> Since this fall is directly a result of the Quantitative Easing that
> is underway, it is unlikely to be reversed, unless the QE itself
> is reversed. But it is not easy to reverse the excess liquidity,
> without causing substantial (further) damage to the economy. That
> is the problem.

2009 Jul 18 04:36 PM