Why Commodities May Be Nearing a Turning Point

From this article, we learn that a commodity fund went bust due to being long metals and energy.

The hedge fund manager Ospraie Management has said that it will close its flagship fund after it plunged 27 percent in August on losses in energy, mining and natural resources equity holdings, in one of the biggest ever closures of a commodities-focused hedge fund.

The closing of a large hedge fund that has long had exposure to a certain security or group of securities may actually be a bullish event for the security or group of securities.

We will examine a few historical examples:

1) Barings

Barings was ultimately brought down by a huge net long exposure to the Nikkei 225 index. When the unauthorized trades were discovered, the Nikkei stood at 17000. Though it did fall to an eventual low of 14500, it soared to over 20000 within a half a year.

2) Amaranth

Amaranth was taken down by a large net long exposure to natural gas. After September 2006, however, natural gas bottomed and rose substantially afterwards.

3) Red Kite Hedge Fund

From Bloomberg:

"I don't know who has got what positions and in what, but I know when some of them start blowing up, it's going to have huge ramifications,'' Rogers, the chairman of Beeland Interests Inc., told journalists at a briefing in Sydney today.

However, January marked the bottom in copper prices, which went on to gain over 40% in the next few months and were still substantially higher in the years ahead.

4) Semgroup

I do not have enough information, so this will be mostly guesswork. Semgroup was largely shorted oil, and since it was imperfectly hedged, suffered large losses. It may be that market participants who were aware of this large short position and Semgroup's "hanging by a thread" so to speak, drove up prices in order to sell at a high price to Semgroup when it covered.

When a fund has a large net exposure in a market and is hanging by a thread, market participants that are savvy to the fund's problem position may take a position against it, thereby exacerbating the fund's losses, and profiting when the fund is forced to close its position at an even more disadvantageous price. This tends to exaggerate upward and downward movements, and the price "reverts to mean" after the hectic trading is over. This can also be seen in Long Term Capital Management's case, where implied volatlity derivatives were pushed up to 40% which would imply a crash in the market every month.("When Genius Failed")

However, the effect may not be seen immediately after a fund's bankruptcy as liquidation may take time and other factors may come into consideration.

To sum up, the decline in commodities, especially oil and commodities, but also agriculture (and strength in the USD), has been quite extended. The market has at least partially discounted the weakening EU economy and probably decreased the interest rate differential between major currencies and USD. Therefore, commodities may see a sharp bounce soon.

Disclosure: none

Comments

[Prudent Inv...:]

Nice reminder that bull markets like to travel with as little baggage as possible.

2008 Sep 04 08:09 AM

[kkin365:]

I wonder if market reactions are different for funds winding down because of long position (first 3) or because of short position (last one).

2008 Sep 04 10:11 AM

[JasonC:]

Commodities will fluctuate. But long term, they have punk returns for huge volatility. They are a diversification hedge that outperforms only in specific limited time windows in the cycle. Treating them as a substitute for a portfolio that actually earns money is a typical headline-chasing, short-term mistake.

2008 Sep 04 10:55 AM

[JasonC:]

Oh and on the headline, one of the first theorems you learn about any random process in financial math is that it is continuous but nowhere differentiable. In other words, it has a "turning point" 50 times per day.

2008 Sep 04 10:57 AM

[User 184146:]

Here is an alternative thesis supporting the view that we may be nearing a turning point in commodity prices.

China is concerned about inflation and the rising cost of raw materials for its growing economy. They have stated publicly they will not slow down economic growth and they have stated publicly they intend to control inflation. Further, they have expressed the view that high crude oil costs are partly a function of excessive speculation as well as supply and demand. Some analysts have expressed opinions that China may use the cover of the Olympics to implement a plan to stockpile raw materials and then abruptly stop buying both raw materials and shipping until they break the speculative froth in the commodity markets. It would be helpful if the dollar was gaining strength at the same time, which just so happens to be the case. We also know that proposals to reinforce the margin and reporting rules of the commodity futures markets could be introduced on September 15th and this could get the downward momentum really moving in crude oil and other commodity futures.

If this is indeed the plan then all they now need to do is wait a few weeks longer before restarting to crank up the Chinese economy. By then the impatient Westerners will have thrown in the towel and sold all of their speculative commodity plays, especially those large pension plans that have been long the commodity future indexes.

Preposterous you say, governments don’t get involved in market economics. My reply would be that China is a centrally planned economy and they could very well have implemented such as plan. From the organizers and managers of the Olympics that pulled off spectacular displays and crushed all political dissent, I say they could pull this off as well.

2008 Sep 04 01:20 PM

[Marc Courtenay:]

The levels of negative sentiment and the negative real returns on money should help to create a tipping point, a sort of "equal and opposite reaction". My 35 years of investing experience teaches me that whenever commodities or any investment is suppressed and held down for too long there is at some given moment a strong upside reaction that will surprise many. The amazing thing is how long and how far "they" can drive prices down and create the "capitulation selling" that sets the stage for the best buying opportunities.

2008 Sep 04 01:44 PM

[armadillo:]

I am still surpised when I see how far and for how long markets (people) can drive something too far in a particular direction. I guess you have to drive something further each time to keep the surprise factor going.

2008 Sep 04 03:12 PM

[kebu77:]

On a longer time-scale (years, not weeks), peak oil could be something of a game-changer. (Bear with me in this streamlined version of energy history.)

Europe was hitting "peak wood" when coal came along. People forget what a positive game-changer coal was over 200 years ago.

But oil came along before peak coal (though some did prematurely speculate about coal peaking). And hydro-electric, nat-gas, and nuclear came along before peak oil. So here we are, two centuries into the industrial age, without encountering any negative game-changers.

But. . . it is time-consuming and expensive to expand hydro and nuclear and there is cause for concern (at least regionally in N. America) that nat-gas is on a plateau (Canadian declines and US increases). Without technological advances that are not on the horizon, solar makes a miniscule contribution. Wind is expanding, but from a small base. So, if as many are suggesting, we are at peak oil production (now or on a plateau that ends in the next five years, pick your prediction from several), in the mid-term commodities prices have nowhere to go but up.

While not directly responding to OT's article, the US badly needs a national discussion on energy, leading to a coherent energy policy. Hope is not a fact. We should want to know if peak oil is imminent, not place blind hope in a technology fix (which seems to be a standard response when peak oil is put on the table).

(Of course we could all get lucky. Dr. Brussard (RIP) was working on a cheap fusion device; the Navy Dept. is continung his research and could prove him right. But do you want to bet your kids on that?)

2008 Sep 04 04:04 PM

[tweeder:]

I think people need to realize the game is over. The hedge funds, all 8800 of them are largely in commodities, and one by one, they will blow up and continue to take down commodities as well as the entire market. The only thing coming is bad news from all aspects of the economy. Best to sit on the sidelines with cash, even if you have big losses, don't be afraid to sell and get out. Remember, you need to have the cash to trade another day, when things are a lot cheaper. You can always get back in when the time is right. Even Bill Gross said there is no bull market anywhere and things are just going to go down. How this will all end no one knows, but cash is king. And look to buy gold when it hits it's 200 dma. JMO.

2008 Sep 04 05:56 PM

[nevket240:]

2 things to remember.
1/ The next US Pres. will have to implement a newer "New Deal" to get the stagnant economy going. A stronger $$ will only increase the ruin. So, a massive infrastructure rebuilding program will HAVE to be started, and quick!! How much copper & iron will that require??
2/ The Chinese have already earmarked $1 Trillion worth of infrastructural spending over the next decade. If things slow enough that time frame will be shortened. How much copper & iron will they need??
regards

2008 Sep 04 06:35 PM

[jdl51:]

Population will go up another 500,000,000 in the next seven years. I think I can safely say food production will be hard pressed to keep up and that's not even taking into account regional droughts, rains, etc. So from a long term perspective the ags look like the place to be. We are one crop report away from a run up, frost, flood. Everything is now lumped together with oil and the dollar. If they decouple from the two because of demand increases, look out.

2008 Sep 05 08:53 AM

[Dame Daxx:]

I think we're seeing a differing performance between Commodities and Commodity Stocks. The performance of Commodity stocks in the past 4 months has been far worse than Commodities themselves. I suspect this divergence is what is causing problems for hedge funds, and as they liquidate their positions they exaggerate the disparity even more. I think that's what we're seeing this week.

2008 Sep 05 12:25 PM

[fxtrader07:]

@tweeder: there is always a bull market, somewhere and remember, Bill Gross just talks his book as anyone else does. he might do it in a more informed and competent manner than most - but still, he talks his book

2008 Sep 05 01:04 PM

[BxCapricorn:]

I just feel sorry for Jim Rogers, George Soros and Ken Heebner. Those poor misguided fools. Why didn't they just follow Bill Miller's lead?

2008 Sep 06 12:43 PM

[traderjohn2:]

It seems that this fund went bust because it was long commodity stocks and short commodities. The hedge went bad on both sides. It caused a mini-crash in the stock markets but that does not say much about commodity prices in general.

2008 Sep 07 08:47 AM

[Yael Pipano:]

Commodity ETF hit markets today by Jim Rogers, what timing!
Funny Timing For Commodity ETF
Carl Delfeld, Chartwell Advisor 09.09.08, 1:05 PM ET

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The newest member of the Van Eck family of exchange-traded funds is the the Market Vectors-RVE Hard Assets Producers (amex: HAP - news - people ) ETF, which tracks the Rogers-Van Eck Hard Assets Producers Index.

This Rogers-Van Eck index was developed in concert with international investor Jim Rogers, who is well-known as a strategist inclined to have significant exposure to commodities and is negative on U.S. markets and the U.S. dollar.

For the month of July, the index was down roughly 11%, consistent with the pullback in commodities. The ETF basket presently contains 321 securities, and the top 10 companies account for 34% of total assets.

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Energy accounts for 40% of exposure, agriculture is at 30%, and industrial and precious metals have a 21% weighting. The U.S. and Canada comprise 45% of exposure, and another 34 countries account for 26%.

In an interesting twist, the company weightings are done on a global-consumption basis, rather than the conventional market-cap basis.

As much as I disagree with Rogers on the future of the U.S. market and economy, this is a solid choice for investors looking for one ETF to cover what represents 15% of global GDP.

Other good choices are the iPath Dow Jones-AIG Commodity ETN (nyse: DJP - news - people ), which has only 20% exposure to oil and precious metals. I also like using country funds for commodity exposure; for example, holding the Chile Fund (nyse: CF - news - people ) for copper exposure.

Rather than try to time commodities, investors should use allocations as core holdings offering good diversification and low correlation to equity markets. Build incrementally, since prices are likely to fall more before the next leg of the secular bull market kicks in with a global recovery.

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Hong Kong Surges as Democrats Hold Ground
The iShares MSCI Hong Kong (nyse: EWH - news - people ) gapped 2.8% higher at the open Monday, as pro-democracy candidates overcame low voter turnout to do better than expected in Hong Kong's Legislative Council elections Sunday, thereby retaining a critical veto power.

The pro-Beijing forces were able to maintain a majority in the legislature, in part by basking in the nationalistic glow from last month's Olympic games.

Hong Kong voters selected the legislature's 60 members, half of which are directly elected by popular vote, and half chosen by a complicated formula of "functional constituencies" representing professional interest groups, such as bankers and industry.

Only 45% of registered voters took part in this year's ballot, compared with more than 55% in the last election, which took place in 2004 amid deep dissatisfaction with the Beijing-backed government.

While low turnout is normally deadly for the pro-democracy camp, it managed to hold on to 23 seats in the elections, down from 25 four years ago. Although it is far from the majority needed to reject government legislation, it gives the democrats power to veto changes to Hong Kong's "mini constitution," the Basic Law.

Global Slowdown Clobbers Mega-Cap ETFs
Last week was a particularly rough week for global markets and for the mega-cap stocks that make up ETFs, like the iShares S&P Global 100 Index ETF (nyse: IOO - news - people ), which comprises 100 multinational companies selected based on the firm's percentage of foreign assets, revenues and employees. The average market cap is $10 billion, and the fund's holdings are split just about evenly between U.S. and international companies.

We may not technically be in a global recession, but GDP growth projections are coming down pretty much across the board on a daily basis. European companies and Japan are suffering just as much if not more than the U.S., as growth and profit numbers mirror the weakness in global consumer demand.

While the S&P 500 and the Dow each lost about 3% last week, European ETFs lost about 6.8%; Asia fell about 6.5% and Latin America gave up 9.2%. Having a fair amount in cash, trading more actively and allocating limited assets to inverse ETFs has led to the Chartwell World Country ETF Rotation being down about 4.9% year-to-date.

If the iShares S&P Global 100 Index ETF can hold two-year support near $65, it could be a great vehicle to play the coming global rebound, even if its exact arrival time is unclear.

Carl Delfeld is editor of Chartwell ETF Advisor and global strategist for New England Research & Management. Click here for international investment analysis and ETF portfolio recommendations in Chartwell ETF Advisor.

2008 Sep 10 07:32 AM