Just as they were in 2008, investors and traders in commodities and commodity-oriented stocks are generally focused on the wrong things.
Commodity investors and traders are fixated on the sort of things that they usually concentrate on in normal times: Supply projections, inventory levels, marginal cost, long-term demand growth in emerging markets and etc. This should perhaps not be surprising. This is the sort of analysis that they have been trained to do.
The problem is that these are not normal times.
Commodities Specialists Fighting The Wrong War
In 2007 and 2008, investors and traders in commodities and commodity stocks were so enamored with the secular neo-Malthusian narrative of constrained supplies relative to brisk emerging market demand that they did not see the cause of the global crisis that would ultimately crush commodities and commodity stocks.
By 2007 and 2008, it was abundantly clear to all analysts with a knowledge of business cycles and financial system dynamics that the US financial system was headed for a crash, that the US economy was in a recession, and that the entire global economy and financial system was imperiled. Notwithstanding, the powerful neo-Malthusian narrative combined with unbridled greed induced commodity traders and investors to bid up the price of commodities such as oil and copper to stratospheric heights, despite these very clear and present dangers.
2011 is a replay of the same story. Commodity traders and investors continue to focus on the long-term secular neo-Malthusian theme of resource scarcity and insatiable emerging markets demand. In sympathy, investors in commodity oriented stocks such as Freeport McMoRan (FCX), Rio Tinto (RIO), Southern Copper (SCCO) Vale (VALE), Alcoa (AA), BHP Billiton (BHP), IEZ, Schlumberher (SLB), Weatherford (WFT), Andadarko (APC), ConocoPhilips (COP) and Chevron (CVX) are looking at earnings projections based on elevated commodities prices and have been piling into these stocks on the premise that some of them look “cheap” on a projected PE basis.
There is just one problem with this: There is a very substantial and growing risk that the global financial system is about to experience another catastrophe and that the entire global economy is on the verge of a crisis that could be as severe, if not more severe, than the one that gripped the globe in 2008 and 2009.
European Banks: The Existential Threat
The focal point of the problem today is different than it was in 2008. Today the problem is European banks. Let’s be clear: European banks are in considerably worse shape today than their US counterparts were in 2007 and 2008. As I detail here, the capitalization levels of European banks are much lower than they were in the US and the potential write-downs are at least as severe.
Right now European banks such as Dexia are on the verge of insolvency merely due to their exposure to the sovereign debt of a country as tiny and relatively insignificant as Greece. Ironically, just a month ago, Dexia passed the European stress tests with flying colors and soon after the tests could brag that it was one of the “best capitalized” banks in Europe. Lord help us.
In the meantime, problems at European Banks that are many magnitudes greater threaten to destroy the entire European banking system. Consider:
- Potential sovereign debt write-downs. The sovereign debt of Portugal, Spain, Italy and others that may eventually have to be written down, just as Greece’s debt is currently in the process of being written off.
- Real estate bust. Real estate in Europe is way more overvalued than it was in the US at the height of the US property bubble. The trouble is, nobody has even begun to talk about the massive write-downs that European banks are going to have to take on their mortgage portfolios and their loans to property developers.
- Importance of Banks to Europe’s economies. Bank assets as a percent of the GDP of European countries are magnitudes higher than they were at their peak in the US. Furthermore, banking and finance represent a much larger percentage of GDP than they ever did in the US. Thus, banking sector troubles could cause greater damage to European economies than they did in the US.
Right now, the entire world is in denial about the trouble that European banks are in. It’s a replay of 2007 and 2008 when the extent eventual write-downs from sub-prime mortgages was known and it was known that in the event of such write-downs US banks would be potentially bankrupt and the entire financial world could be thrown into crisis.
Commodities Community Is Asleep At the Wheel
Is it a total certainty that the European banking system will experience a crisis such as the one experienced by US banks in 2008 and 2009? No. But the probability of such a fiasco is very high – at least 50% in my estimation.
And given this risk, commodity prices are way too high.
Based on global demand and supply projections from mid 2011, the fair price for oil and copper would probably be around $80 and perhaps $3.00 based on marginal all-in costs.
Speculative activity via ETFs, hedge funds and other mediums has consistently kept prices well above these equilibrium levels.
Economic theory posits, and historical experience confirms, that in a global crisis such as was experienced in 2008, commodity prices will tend to drop below their all-in marginal cost all the way down to their cash cost at a new and lower level of global demand. This means that oil prices can go to roughly $35 and copper can go to approximately $2.00.
With oil prices currently at $86 and copper prices at around $3.35, commodities prices are essentially discounting a zero percent probability of a global financial and economic crisis. This is absurd.
This is the number one reason why commodities and commodity stocks offer an attractive opportunity to short today.
Assuming a 50% probability of a European financial crisis, oil prices should be no higher than $60 and copper prices should be no higher than $2.50. These values would represent a roughly fair assessment of expected return given the risk probabilities.
In the event of a European banking sector crisis, oil will probably collapse to roughly $35 and copper to $2.00. In such an event, I would expect commodities stocks, on average, to decline 40% or more from current levels.
I am in the process of looking for short entry positions and put positions on commodity stocks and ETFs such as some of the ones highlighted above as well as others. Such an opportunity may or may not present itself before or after the next European summit scheduled for October 23rd.
Political leaders rarely miss an opportunity to jawbone markets upwards prior to, during, and after occasions such as this. However, such rallies typically do not last long if not backed up by definitive substance. For reasons that I detail here, it is my assessment that European leaders will ultimately not rise to the magnitude of the challenges at hand.