Everyone Wants the Commodity Bubble To Be Pricked

Crude Oil has corrected over 15% from the top. Gold, Silver, Copper, Wheat and other commodities have also retreated from their respective highs. The heavy selling witnessed in the last few days has raised concerns that the air is leaking from the Commodity bubble and that a multiyear bull market might end soon.

It has been well established of late that the commodity market has exhibited many of the characteristics of a bubble. Thus we may be very well at the beginning of a bursting asset bubble. Historically, price bubbles have been destined to burst under their own weight, and at a moment's notice. As the charts of the dot-com and housing bubbles show, the fall can be just as dramatic as the climb.

Now, when the bubble in the commodity space is showing signs of collapse, an analysis of various factors that inflated the same will make for an interesting study.

Commodities prices have increased more in the aggregate over the last five years than at any other time in U.S. history. Commodity price spikes have occurred in the past as a result of supply crises, such as during the 1973 Arab Oil Embargo. But today, unlike previous episodes, supply is relatively ample: there are no lines at the gas pump and there is plenty of food on the shelves.

It can be said that what we are experiencing is a demand shock coming from emerging economies like China and India. In recent years, the two countries, which together possess more than a third of the world's population, have witnessed rapid economic growth. There has been a jump in national income; consumption levels and standard of living in this part of the globe on back of heightened pace of industrialization, urbanisation and benefits of globalization.

This particular demand factor attracted a new category of participant in the commodities futures markets: Institutional Investors like Hedge Funds, Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments etc. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.

According to the US Department of Energy, annual Chinese demand for petroleum has increased in the past five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels. In the same five-year period, institutional investor’s’ demand for petroleum futures has increased by 848 million barrels. In other words, they have almost created another China in terms of demand. However, what was being ignored was that these economies are still not consumption/export driven. Also, the population and politics of these countries, unlike the western ones are quite price sensitive and any abnormal rise in price is met by demand destruction.

The rise in global food grain prices has also been attributed to the phenomena of “Agflation”, i.e., diversion of crops and land for biofuel cultivation. A large portion of corn is being diverted to produce ethanol which has emerged as an attractive substitute for Crude Oil. A leaked internal World Bank study suggested that biofuels have forced global food prices up by 75%.

OPEC, which accounts for 40% of total World Crude Oil production, has also been blamed for the high Crude Oil and commodity prices. However, despite repeated pronouncements about an increase in shipments, OPEC appears to be losing its ability to influence the price of oil. According to Societe Générale economist Deborah White. "It is no longer within the power of OPEC to keep prices at $28 a barrel, OPEC can only set the floor, not the ceiling."

On its part, OPEC has repeatedly blamed financial speculation in Crude Oil, use of Ethanol as Crude Oil substitute, weaker Dollar and “mismanaged US economy” for high Crude Oil prices. As has been the case earlier, whenever prices of anything have gone up dramatically, people readily blame it on “speculators.” It has been suggested that the “Index Speculators” have now stockpiled, via the futures market, the equivalent of 1 billion barrels of petroleum, effectively adding eight times as much oil to their own stockpile as the United States has added to the Strategic Petroleum Reserve in the past five years. However, in a free and liquid market, it would be difficult for speculators to have that much influence. While speculators may have some short-term effect on prices, most investment professionals and institutions, largely discount such notions.

Globally, most of economists are now arriving at a consensus that the skyrocketing commodity prices can be best explained in terms of "too much money chasing too few commodities.". The recent monetary policy of the US Federal Reserve has been seriously questioned and criticized. In order to arrest the subprime rout and housing slump, the Fed slashed the Federal funds rate from 5.25% to 2% at a frenzied pace. Ben Bernanke, in a bid to put a floor under the housing and stock markets, cranked up the growth of the MZM money supply to an explosive 15.4% annual rate. As a result, the Dollar’s value plummeted, sending commodities price to sky high. Already, due to turmoil in financial markets, investors had began shifting from equities to hard assets. A combination of uncertain macroeconomic climate and growth in money supply only worked in favor of a commodity rally.

The dollar’s value has special bearing on commodity space, as the chief commodity, i.e crude oil is priced in dollars. "The Fed is printing money and are trying to prevent the recession, they are putting on Band Aids," commodities investment guru Jim Rogers said. Rogers added that "as long as the US central bank and the federal government keep making mistakes, you will have a longer period of slowdown, and it will be perhaps, one of the worst recessions we have had in a long time in America."

However, Ben Bernanke cannot be entirely blamed for his act as he was merely responding to the Housing Crisis (or Subprime Crisis) brought about by a low interest rate policy of his predecessor Alan Greenspan. Alan Greenspan on his part was forced to keep interest rates low as the US economy was struggling from the IT bubble burst. Thus, to counter the ills of the IT bubble burst, Greenspan slashed interest rate and thus encouraged bubble formation in US Housing sector. When the bubble in Housing sector got busted, Ben Bernanke was left with no option but to follow his predecessor’s policy and led to the bubble formation in commodities. It is being suggested mildly now that the IT, Housing and Commodities bubbles are interlinked, with one leading to another. According to this view, the recent bubbles have been largely an incidental byproduct of focus, policy and actions of Central Bankers, specifically that of US Federal Reserve.

Whatever the case, the effects of the abnormal runup in prices of commodities is now very much visible in the streets across the world. Price pressures across the world are reaching levels that may soon threaten economic, political and social stability. Global inflation levels have reached uncontrollable levels, food riots have broken out in Haiti, Egypt, and Bangladesh, economic growth has moderated and even slowed. Equity markets have been witnessing massive selloffs and thousands of jobs across the world are being lost. Policymakers are themselves finding themselves in a fix as they are facing a lethal combination of high inflation and slowing growth, also referred to as “stagflation."

Thus the “Commodity Bubble” is certainly one which everyone wants to be pricked!

Comments

[Greg Pinelli:]

It's either an "abnormal" runup or not..the question is hardly answered by "whatever the case." Every bubble I can think of either involved something that was frivolous or didn't exist (tulips..South Sea "markets") or was something people could easily live without (garbage technology or houses)...
People need to live somewhere..but they don't need to "buy" where they live. In fact..I'd argue they didn't buy anything..they rented a pretend life for a year or two.
Food..metals..oil/gas are the stuff of life..and billions..not millions..more people need them than ever before. If anyone thinks these critical denominators are coming down more than marginally anytime soon they must either be living in an alternate universe...or they believe a truly devastating depression is near. At least that would be a point of view..you offer NO point of view..NO investable ideas..NO NOTHING!

2008 Aug 01 11:27 AM

[MiningOilGa...:]

I wouldn't say there is a bubble. For the most part, the run up is a genuine consequence of a spike in demand over the last few year due to the emerging markets. One would expect the run up to continue in the near and far future, as demand will increase once Africa can stand on its feet.

2008 Aug 01 01:32 PM

[keo:]

Not everyone wants it pricked, just those countries that have to buy them from the producers ;)

2008 Aug 01 03:10 PM

[LA:]

Salman, you make some valid points. However, I believe it's important to differentiate among commodities. In my article Not All Commodities Are Created Equal (the link is: seekingalpha.com/artic...), I point out that people need to eat, and gold and copper cannot be eaten. Population is growing, and that's a fact, while arable land remains basically the same. Moreover, climate changes affect agricultural commodities and such a way that the increase in production simply cannot meet additional demand.

2008 Aug 01 03:14 PM

[Sober Realist:]

chistletoe, you are spot-on. Collectively speaking, the world population is no smarter than bacteria in a petri dish. They will continue multiplying and growing until they have exhausted all resources; then..... colony collapse. Looking at a graph, world population has grown in sync with the extraction of oil. Now we are outstripping our ability to meet the world demand for it. 70,000,000 new oil consumer appear on Earth every year. Chindia wants to become a car society like America and eat the 3,000 mile cesar salad, but we're too busy on a witch hunt looking for the oil-price-pumping bogeyman.

2008 Aug 01 06:19 PM

[Salman Khan:]

I would like to clarify certain points:-

It's not that only those countries who are buying the commodities are feeling the heat.

Take the case of Russia and Saudi Arabia- Oil rich and flushed with money. A jump in crude Oil has ensured a steady climb in the amount of money supply in the commodity based economy leading to an ever more sharp jump in inflation numbers which is ruling way above the double digit. It's not that they are not worried.

Coming to demand side of the commodities. I accept that I havent much emphasised upon the agri/soft commodities much. The reason being, the two fastest growing economies i.e, China and India are still technicallly self sufficient when it comes to food grains and essential items. A good monsoon ensures the steady supply of agri products on annual basis in the Indian subcontinent, which in itself is home to a large proportion of human population.

In recent times, In India due to outsourcing euphoria, IT, ITES and Financial services industry had enabled a large section of population to spend. Mr. George Bush/Ms. Rice had exactly this particular section in mind when they pronounced their now famous comment regarding India and China.

Commodities like Crude Oil, Zinc and Lead are fluctuating as much as 8-10% in a single day which is pretty abnormal since demand and supply fundamentals dont change in a single day. Earlier, even if Crude Oil made a sharp jump, as in the case when Katrina happened, it retreated later when things normalised.

I still feel that the entire world is betting too much upon the China and India factor. Credit consumption is yet to take off. Six months of moderation and we will stop buying homes, cars, motorbikes. Jobs are being lost, wages have frozen. Though I am still optimistic about these economies, I feel that the world need to be patient.

2008 Aug 02 09:11 AM

[keo:]

Russia would be *nowhere* without the run up in commodities in the last years (not just oil), it is rising from its ashes and flexing... Let commodities crash, and Russia would be broke. Latin America is absolutely booming thanks to commodities. Australia is making tonnes. High prices gives these countries power, look at Russia, Venezuala posturing like they do. Argentina, Malaysia, Venezuela are no longer interested in IMF membership. If you have expensive commodities, people are nice to you and will take you to dinner. These countries have nothing to gain from lower commodity prices. Now, if they would stop printing their fiat papers (and in some cases let the dollar peg go), they would have less inflation too.

2008 Aug 03 05:05 AM

[chistletoe:]

The ultimate culprit for the rise in commodity prices,
seldom ever mentioned,
is the population "bubble".
More and more people on earth chasing fewer and fewer resources.

If all the people who believe that prices will go down
would simply kill themselves right now,
then prices would go down.
But that's the only way ...

2008 Aug 01 07:48 AM