Burst Bubble? Commodities' Long-Term Story Remains Intact

I heard it on TV so it must be true.

All kidding aside, the last two days have been absolutely brutal for the commodities side of our portfolio and Wednesday, the energy stocks also got whacked. And I don’t know about you folks but I haven’t reached that zen, Buffett-like state where falling prices don’t faze me. They faze me. A lot. In my experience, the periods in which my self-doubts peak are honestly the times I should have been buying. Even in the short time since this website/blog has been up (since 01/2007), the market has already tested me many times and I can’t profess to have bought every time at that bottom. I have regretted it every time.

Yesterday, I spent the day asking myself:

• “Should I have sold Agnico-Eagle? (AEM)” I knew that at $80, it was a bit ahead of itself and if I had held it for over a year, I would have sold it earlier at $72, $75. Doing quick math, taking profits at $80 and paying 30% tax was roughly equivalent to holding to $70 and selling with a 15% tax rate but now it’s at $68.
• “Should I have sold Chesapeake Energy? (CHK)” It’s at the low-end of my fair value estimate and I’ve held that stock long enough for favorable capital-gains treatment. Am I getting greedy?
• “Did I make a mistake on SK Telecom (SKM)?” The damn thing is below $20 but I can’t find any news that justifies the pounding it’s taking and then you have the Korean Won going parabolic in the last month.

So yes, I have my doubts. Every day, I question my theses, analysis, picks, etc. Especially on a day like yesterday.

That said, I just can’t buy into this commodities “bubble” story for the following reasons:

• Have the central banks stopped pumping money into the financial systems? No, nor has the Fed given any serious indication of tackling inflation. The Fed is the only thing propping up the markets It strikes me that the Fed cannot raise rates until the market signals a sustained 'all clear.' Otherwise what was the point of all this if the markets are just going to tank again the moment you raise rates? Even a 3/4 point cut (off a 3% base — that’s a huge 25% move) can’t buoy the markets for longer than a day. So I don’t see how the new Goldilocks scenario plays out — that is, the Fed cuts rates, the economy responds after a brief recession & then the Fed raises rates again once we’re in the clear. It all comes back to housing and credit — this will be years in the unwinding. Housing does not bottom in a V — it bottoms in an L. People still can’t afford housing and wages aren’t going up so that means prices will continue to fall.
• Did we discover any giant oil fields in the last week that I didn’t hear about? The long-term supply and demand picture is still overwhelmingly in favor of higher prices. Many people consider supply as the weekly inventory reports. I refer to supply as reserves in the ground. I don’t care if it’s in Cushing or some tanker or floating bitumen in Canada as long as there’s visibility that we’ll have access to energy when needed. The peak for production still remains the summer of 2005, despite record high prices.
• Domestic natural gas production is still running to stand still — more wells drilled just to maintain production. Imports from Canada are dropping and apparently, the rest of the world values natural gas more than the US.
• Despite the drop in agricultural commodities, the FT reports on record high rice prices in Asia. Some of this year’s harvest disappointed and I’m not sure if the issues that have led to countries like Vietnam imposing export restrictions have been resolved in the last week or so.

Obviously, we are in a corrective phase of the commodities bull run but I think any characterization of the run in hard assets as a bubble is absurd. We know what bubbles look like — they leave indices like the NASDAQ or the Nikkei ravaged years/decades after the fact, they devastate whole industries and professions like realtors & Wall Street financiers, they transform thriving municipalities into ghost towns and retirement accounts into part-time work well into your 70’s — basically an awful lot like what’s happening today in real estate and Wall Street. Just study previous oil busts — we are obviously nowhere near that phase with commodities.

If you are a nimble trader, I’m sure there is a lot of money to be made in this correction as well as the run back up. I can’t handle trading so I remain committed to my discipline of long-term investing.

I don’t know where the story goes next from here. Maybe, some of the commodities will drop another 20% from here. And I’ll cringe every step of the way. But I know where this story must end — with higher inflation, strained energy supplies and a burgeoning emerging rest of the world who won’t continue to foot the bill for Americans living large. The long-term fundamentals dictate that any major corrections remain buying opportunities for long-term investors.

Disclosure: Long AEM, CHK and SKM.

Comments

[sedek]

Good piece and I agree with your analysis of the fundamentals. What I'm seeing the last couple of days is profit taking turning into a lemming rush over the cliff. Just a guess without charting, but Dollar $1.45 and gold $800 should be solid bottoms, about 20% off the tops.

In an election year with congress and the candidates bidding for votes with borrowed money, this is temporary and I see it as an opportunity.

[phdinsuntanning]

look at the chinese demand david, this will be a good leading indicator for you and for many of us

[James Seaberg]

This is a good assessment of Davy. We need also to understand that the US central bank needed to do something about price inflation. To lower interest rates and pump money into the economy (= monetary inflation) is very price-inflationary and hurts the dollar. Strangely enough starting 2:30 on Tuesday, the 18th of March, the opposite occurred. The dollar rose and commodities fell.

The fall in commodities was also a concerted action by the Fed and its banking and brokerage minions. Foreign central banks had to buy dollars and the US banks and brokers were told to raise the margins on commodity accounts and go short. Most of the mmargins have now risen to 90% from formerly 25%! In such a way nobody could blame the Fed to have increased price inflation, even though they increased tremendously money inflation. Price inflation usually follows monetary inflation with a certain time lag. But all this money will still creep into the economy and create in the US and worldwide further price inflation. That means the bull market in precious metals and the food complex is by far not over.

In my opinion, we have seen the lows at least in gold. I doubt it will go to 880$ as forecast by some analysts. These prices are buying opportunities. So why not buy today some and next week more.

[wobatus]

High powered money has not been growing. It has been stagnant. And recession is deflationary, not inflationary. Plus the market expected a 1.0% cut, not .75%. U.S. demand has dropped. Look at oil service stocks (OIH). it had been dropping for a while during the most recent leg of the oil upsurge. Basically, it called bukllshit on $110 oil, and for good reason.

[User 142738]

I like how some of the commentators mentioned trading commodities on margin: isn't this basically moving the credit crisis from real estate to oil and gold?

I see it this way: people were buying homes on credit, expecting a huge return to outpace the high interest they borrowed on. Now people are buying both futures and physical bars of gold and silver with the same lines of high-interest credit.

History is repeating itself at an incredibly high frequency.

[enviro111]

No market goes straight up forever. All mania's eventually end in a bust.

First it was the stock market mania in 1998-2000 with the speculative Nasdaq stocks leading the way. This went to a bust; but the bust was buffered by FED actions. Too low interest rates and massive infusions of cash. Also, buffering the Nasdaq bubble was the fact that many 'traditional' stocks didn't move in sympathy during that period; thus, the bust was muted and could easily be transferred to a new arena.

Second, the next bubble was the housing bubble. It was caused by exceptionally low interest rates, massive tax cuts for lower income people and a renewed focus on 'a house for everyone'. Construction jobs and new retail for everyone to replace former industrial jobs - who wants to work in a dirty factory anyway?
The bust came... Lots of low income folks now 'rent' their homes from banks and many house flippers own multiple houses. This bust is now in progress and is being buffered by cheap credit, massive FED bailouts and huge deficit spending.

Third, the next bubble WILL BE the commodities bubble. Before this one is over, commodities will be at:

Unheard of prices
Hundreds of commodity funds will be launched
Experts will view commodity investing as a one way street to riches.
More than 20% of the general USA public will be buying and hoarding gold and silver.
The US dollar will be much, much lower unless other nations coordinate and devalue their currencies simultaneously.
The Dow Jones stock average will be equal to the price of gold.
The gold / silver ratio will be 15 or less.
The gold / Wheat ratio will be 30 or less.

Note that none of these conditions have occurred yet.

Fourth, the final bubble will be the CASH bubble when the entire ediface of shakey debt and overpriced everything comes crashing down. Inflation will have been out of control for a long time and interest rates will have risen considerably. The US dollar may not even be the currency of choice for American's much less for anyone else. The place to be might be Chinese Yuan, Russian Rubles, Swiss Francs. Maybe even Canadian loonies??

[Elliot Miller]

One other factor in the precipitous commodities/oil decline is the dumping by hedge funds and others to meet margin calls.

[birdland5]

A bear market is not complete until the last speculator is shaken to the core and gone. We have a ways to go.

[dieuwer]

The bullmarket in gold is over when DOW/Gold ratio is around 1.
At the moment it is about 13.
I surmize that at the top, gold will be at $7000-$8000 and the Dow at around 12,000. Thus, I my opinion gold is still VERY undervalued.

To put action to words, I'm heading to the coin shop this weekend to buy gold.

[BrucePile]

If you look at a chart for relative valuation between paper and hard assets over the last 50 years, it's clear that there is a powerful cycle at work with about a 15 year bull/bear phase. We seem to be clearly beginning a bull phase for hard assets that is just now getting going (only about 4 years into it). The cycle has yet to even revert to the mean.

As for the volatility that goes along commodities, you can either be the fast trader and try to anticipate each gyration and buy and sell around them (good luck with that) or you can dollar cost average into a line-up buying more aggressively after the corrections and adjusting the line-up only if the good areas of sector warrant it. You pretty much have to make up your mind which approach suits you and stay with it.

It seems to me that most fast traders anticipate 4 or 5 phantom corrections for each real one and wind up rotating in and out too much and being on the sidelines when a lot of the quantum surges happen when they least expect them. They chop the bull climb into bitty pieces of small gains to mix with small loses, which typically results in underperforming a more stable strategy. Not that there aren't traders who can do better with faster trading, but averaging better long term results this way is precarious to say the least.

[yank]

Davy:
Right on with your analysis. I have to just laugh when I hear that everyone expected a full point cut and when he "only" cut by 3/4 of a point that was the all clear sign that the USD was on the way back up and commodities were dead. Gee, I must have missed that kind of torturous logic in Deductive Reasoning 101 in high school. Listen up you brain surgeons. Ben cut by 3/4 so he could keep some ammunition for further cuts in April and June. Wow, these people are dense, Davy. They just don't get it. It is NOT the time to pile back into Financials, Retail, or Tech. They are all dead money people. The commodity bull is far, far from over. The uptrend in commodities is clearly intact (Louise Yamada said as much this week). And as for the bold pronouncement that oil demand is dead. Please spare me the idiocy. A decline of 0.1% in one week (yoy) is NOT a meaningful trend people. Did anyone also consider that in February we had some of the worst winter weather in over 25 years and that maybe people don't drive as much when they are shoveling snow out of their driveways? I just marvel at all this stupidity. Commodities will recover this week. You can count on it.

[SKYY]

I agree with 95.43% of your article. Especially your last paragraph:

"I don’t know where the story goes next from here. Maybe, some of the commodities will drop another 20% from here. And I’ll cringe every step of the way. But I know where this story must end — with higher inflation, strained energy supplies and a burgeoning emerging rest of the world who won’t continue to foot the bill for Americans living large. The long-term fundamentals dictate that any major corrections remain buying opportunities for long-term investors."

I hate quoting dudes, but I whole-heartedly agree with that sentiment. Inflation isn't going to settle down anytime soon. I, too, believe that it's going to get worse, and commodities like gold and pork bellies (I always laugh at that one for no reason) will outvalue the dollar in the years to come.

[sb-tiger]

Commodity is good long term story, however we have the speculator unwind. Commodity markets are very very small as compared to equity markets - speculators can drive them up very easily. That is what was happening last few months. Now banks are asking hedge funds to deleverage (calling back loans). So the bubble prices that were rercently seen in oil, gold, Ag etc are gone for some time now. All these china/India demand stories extremely over blown.

Wait for major pullback and play long term.

[pswan]

The amazing thing is that so many experts that got the TMT and housing bubbles 100% wrong keep calling a top in commodities. This is a correction in a Long-Term trend. Dr. Faber has it right oil may go to $80 before it goes to $300.

[TM]

I think we are just seeing a bit of the speculative buyers selling for some profit taking and to move back into EQ (hard to resist the past couple up days). The supply of commodities are pretty sticky, and demand is still growing rapidly, which means prices should continue going up.
Read more here: fiateconomics.blogspot.com /

[User 157113]

I'd like to see how much "demand" there really is if buying on the margin was discontinued. Would you really want to pay full face value for a futures contract for 110 oil and 1,000 gold?

To me, most of the arguments for the commodity super cycle are bs. for the following reasons.

1. The Inflation Story: The popular hoards think that since the fed is pumping money into the system, it will lead to inflation. The reality is that the inflation was already built into the system with derivatives that dwarf that real money supply (est. 515 trillion dollars). When looking at the fed liquidity injects, they are miniscule compared to the deflationary impact of these illiquid investment vehicles falling apart. This is why a couple of bad mortgages are destroying the housing industry

2. Oil supply has "peaked" in 2005 and will inexorably decline: Not true according to the EIA. We have had several instances of supply over the "peak" in 2005.

3. Oil/commodity demand will march onwards and upwards unto eternity: Not true again. See declines in OECD consumption. As the US/EU slows down, less demand for cheap Chinese goods, reduced Chinese incomes, and less commodity demand. Total OECD petroleum consumption DOWN over the last 2 years and stagnant since 2004.

4. Emerging markets will grow forever and ever and ever. These markets are most prone to crisis.

[jeff a]

I am not an expert in commodities or macroeconomics but the planet can only produce so much oil, gold, copper, etc. I don't see emerging markets focusing a lot on alternative energy either. I'm long on CHK, MOS and FCX but short term it's painful. Damned if I'll short commodities though.

[User 42142]

If one uses these replies as a contrarian guide, what would one do?

[paultaut]

On top of all the smoke and mirrors by the Fed, This Week Was The Quadruple Witch. Lots of profit taking by both shorts and longs.

The next couple of weeks will involve Window Dressing and end of Quarter contract expirations.

Meanwhile, the financial problems continue.
The Fed has opened the discount window...yes...But only for Investment Grade collateral.

The majors would have to mark to market to find out what was still Investment Grade. The small regional banks will take off since they have suffered from "guilt by association"

[iThinkBig]

Hard for speculation to keep oil going up indefinately with the banks running out of money to lend hedge funds to use for commodities leverage now isn't it :) Some people who give a damn about having a country have been sending some road maps to the Administration. They are listening. The second part of the plan is the 'National Energy Crisis' bill and an injection of hundreds of billions into alternative energy, offshore drilling, ANWR, nuke plants, biodeisel, coal liquification and expanded railroads. This is a massive bubble deflating and while I agree it will pause and begin to go back up, the moment this announcement is made (think GOP wants to lose White House?!?! Think again!) oil will be down to $65 and gold will also level off. The crisis is smacking every American in the face and all you people think about is the market leverage, your not factoring in emergency policy at all.

[Bruman]

I think that the commodities story still has legs to it in the long term, especially Gold, but the need to delever is overwhelming in the short term, so people who placed commodity bets on borrowed money need to sell.

[vaduz]

good piece.
guess its going down a bit further - gold 800 or even 700. but then in the long run, 1 to 2 yeARS we will be higher than the tops so far.

[topax]

Thanks Dave, I too am cringing at the commodity drop, but I am not selling; not a one. It's the hedge funds, unfortunately, driving the volatility. SEC needs to undo what it did last summer -- put back uptick rules; reinstate legislation that controls the hedge funds so they cannot bankrupt normal investors.

[Eyesonyou]

It seems to me there are commodities and there are commodities. While gold and silver are often bought strictly as investments, things like oil and other metals used for building infrastuctures are a different animal. Therefore to lump all commodities together may be convenient but they will not act together as a group for too much longer

[misterchan]

Thanks to all of you for the interesting opinions. Except for one or two who deplore gold and oil. I especially liked Yank and would have written something similar. But he said it all. Now all we have to do is pray we are right. I think we are.

[swimjames]

misterchan, you're one of the clearest thinking individuals on this site, I wish more wrote similar sentiments that make sense! People reading weekly data and then applying it to their portfolios (especially those on margin, using derivatives, and covering shorts) are part of the craziness in the markets now. Those 'panic traders' are the reason long term investors like us make money in the LONG TERM...

[swimjames]

David: the below portion of an article I read yesterday says it all!
Why have the prices of commodities like oil and gold risen so dramatically in the last year? Why has the dollar fallen so much? Normal business cycle? Bad management from the world’s financial institutions? And why hasn’t the world’s largest and strongest economy, backed by the most powerful government, been able to change the course of the situation?

Perhaps the larger picture is that the United States is waging an economic war against China.

The United States could strengthen the value of the dollar. It has not. China is hurt because now Chinese products are very expensive in the United States, and this will reduce the US trade deficit with China. China must import huge amounts of oil and strategic metals which are very much more expensive now. China holds hundreds of millions of physical dollars, the value of which is now much less.

[James Seaberg]

Answer to User 42142 as of Mar 21, 11:50 AM with is question “If one uses these replies as a contrarian guide, what would one do?”

A contrarian is not always a contrarian. He follows the crowd for long periods and lets the profits run. Only before major turning points does he become a contrarian. For example when gold reaches the manic phase at around $15,000 to $20,000 and having the DOW also around $20,000 as an assumption, then he will start selling whilst most everybody else expects that gold goes to $ 30,000 or even $ 100,000.
This is not a time to stop following the early adopters of gold and the crowd that will soon come in. Yes, there is deleveraging. A lower money supply means recession a much lower money supply means depression. The Fed will stem this tide. If it doesn’t succeed, the US empire is over, done, toast. The Fed will buy, if necessary, your mortgages, your houses and your dogs and cats. He has that power. There are several executive orders in the #12,000 to #13,000 range where this power was given to the Fed shortly before Y2K (year 2000 date computer problem).

Whoever thinks that the Fed will be powerless after having reduced interest rates to 0.25% which I expect that it will do, is mistaken. In “open market operations” it can theoretically buy up each and every asset in the US and flood the country with dollars. Bernancke will not only use helicopters but also railroads to get the money to a rail station near you.

So, the smart action would be to use this pullback in gold to buy it, now. Next, I would buy down oil USO (UNITED STATES OIL FUND, LP (AMEX)) with buy-limits set at $75, 70, 65, 60. Later, when the dust has settled, I plan to buy the foods, DBA or RJA.

(Disclaimer: this is not financial advice, only my opinion. Talk to your personal advisor).

[Jake2]

I agree with topak: "It's the hedge funds, unfortunately, driving the volatility. SEC needs to undo what it did last summer -- put back uptick rules; reinstate legislation that controls the hedge funds so they cannot bankrupt normal investors>" Everyone here should write the SEC a letter to this end.

[User 155834]

James,
Thank you, I agree, but $60 for USO is a long way off. In the meanwhile, I will buy OIH puts.

[User 25584]

what a joke for analysis...."the market has already tested me many times and I can’t profess to have bought every time at that bottom. I have regretted it every time."

Duh! Who wouldn't always regret not buying at the bottom?

Let's pick up our analytic game: is this the bottom, that's the real point to be addressed.

[LJ]

The commodities market experienced a similar correction in June 2006. During that time, Goldman flooded the market with $6 billion worth oil futures (i.e. paper oil), pushing down the oil price from $70/barrel to $48/barrel.

[Bob'29]

NOTE FROM SA EDITORS: This comment has been removed at the commenter's request.

[clue me in]

The one sentence that is absolutely true:

"I don’t know where the story goes next from here."

The most detailed analysis may indicate the most general of trends, but bottoms? tops? futures?

All of history can not tell the story of today nor foretell tomorrow.

[NoGuru]

The big picture says equities bottomed last week and will be the "flavor of the month" until March 2009. Commodities will become range bound and gold will always have its following or "groupies". An intersting view (or model) is that of Martin Armstrongs back in the 1980's.

[User 168148]

Once upon a time, long, long ago in a galaxy far, far away gold, silver and copper circulated freely amongst the populous as money. Today we are force FED limitless multi-colored paper and base metal tokens via legal tender laws. The greenback is no longer as good as gold in fact its no longer even green. What's about to take place is now all but inevitable and those that fail to realize it before its too late will face financial ruin. The actions of the FED are obviously just smoke and will lead to the greatest bull market in precious metals, in dollar terms, in the history of mankind and the destruction of the dollar. Bubble? Mania? History dictates that this blow off will ultimately make the internet stock mania and the housing bubble look like small potatoes. THERE'S NO RUSH LIKE A GOLD RUSH!!!!!!!!! Bet on it. You'll be glad you did.