Liquidation in Commodities Resumes

Includes: GLD, SLV
by: Acting Man

The rout in commodities is evidently not quite over yet. In Wednesday's session it was mainly the energy complex that had its turn in the barrel, so to speak. Gasoline futures went limit down (the daily limit was at 25 cents before being expanded). After the trading halt, the daily limits in gasoline and related energy futures contracts (crude and heating oil) were doubled. After raising margin requirements for silver several times, the exchanges have recently also raised margin requirements for energy futures.

The ostensible reason for the move was a bearish weekly supply/demand report, with crude oil inventories coming in above expectations and gasoline demand estimates coming in below expectations.

To this we would note that the better explanation is that the correction that started last week is simply not finished yet. During bullish phases the market tends to ignore allegedly bearish fundamental reports, while seizing on bullish ones. The opposite is true during bearish phases. It is important to realize in this context that rising commodity prices – an enduring and recurring phenomenon of the business cycles since 2002 – are largely a side effect of monetary inflation. Genuine supply shortages or the threat thereof do of course also lead to price increases in the specific commodities concerned (e.g. after a series of bad harvests, or a cut-off of supplies due to geopolitical upheaval).

However, a general, widespread increase in prices across the entire spectrum of commodities is invariably the result of monetary inflation. In other words, the only important 'fundamental' datum commodity speculators need to focus on is the speed at which money gets printed. With regards to the US dollar, over the past decade the broad US 'Austrian' money supply measure TMS-2 has grown by nearly 150%. Need we say more?

[Click all to enlarge]

The June gasoline contract, intraday. As can be seen, the huge move lower on Wednesday has brought the contract back to where it roughly started Monday's session. It was the speed of the move that raised a few eyebrows.

The June gasoline contract, daily. After a rebound that failed to reach or exceed the previous high, another strong decline ensues.

Naturally, the strong sell-off in gasoline futures was accompanied by very strong sell-offs in crude oil and heating oil as well. However, it is worth noting that as of yet, none of the long or even medium term uptrends have been violated in these commodities, as can be seen in both the gasoline chart above and the continuous contract chart of WTI crude below. The emphasis should be on "not yet," as any further weakness in the near term would most assuredly produce trend line breaks:

Texas sweet crude, continuous contract chart. Another strong sell-off, but so far the medium term uptrend has held.

Clueless Politicians Strike Again

Proving once again that they are utterly clueless about markets, a group of socialist senators (there was one nominal conservative among them as well, no doubt figuring that the opportunity to fish for the votes of equally clueless voters should not be passed up) has once again badgered the CFTC about the alleged need to manipulate energy markets by introducing tighter position limits on speculative positions in the futures markets.

In other words, they want the CFTC to engage in what they accuse speculators of: market manipulation ... only in this case with the express aim of artificially lowering prices that are considered a political problem when they rise a lot and tend to induce a clamor by the public to do something.

The CFTC, while manned by bureaucrats, is close enough to the actual markets to understand that giving in to these demands would amount to a useless and likely economically damaging charade. It would do absolutely nothing to lower prices in the long term, while increasing market volatility as liquidity evaporates. Moreover, it would simply end up driving business offshore to places where free markets are held in higher regard.

Oh, and it would allow the senators concerned to score a few cheap political points. As Reuters reports:

A group of 17 senators, in a letter to the chairman and commissioners at the Commodity Futures Trading Commission, said they wanted the agency to unveil a plan by May 23 to impose position limits in all energy futures markets, beginning with crude oil. The agency has already proposed such limits as part of the financial reform, but has not finalized them.

The senators said the recent drop in crude oil prices, which fell nearly $10 a barrel in one day last week, defy supply and demand conditions. Oil prices bounced back almost $6 a barrel on Monday, but then fell more than $5 on Wednesday. Gasoline prices slumped by more than 8 percent.

"The wild fluctuation could only be the result of rampant oil speculation, plain and simple," said Senator Ron Wyden, one of the lawmakers who wrote to the CFTC demanding action, in some of the strongest language attacking speculators since oil prices surged to a record $147 a barrel in 2008.

"The CFTC needs a plan to impose position limits on oil speculation before oil speculators drive up prices even higher just as Americans go to the pumps to fill up for Memorial Day weekend," he said.

The letter was signed by 15 Democrats, Independent Bernie Sanders, and a single Republican, Susan Collins.

A CFTC spokesman said the agency had no comment on the letter. [commenting on this political posturing would be a big waste of time and energy indeed, ed.]

The CFTC is weighing new rules that would slap limits on the positions of big commodity traders, capping how many futures and swaps contracts any one market participant can control.

The Dodd-Frank law passed last July gives the agency the power to set position limits to curb excessive speculation "as appropriate" in 28 commodities traded in energy, metals and agricultural markets.

But some of the agency's own commissioners are skeptical the limits would prevent a run-up in prices, and experts and traders have long said the rules risk making markets more volatile by reducing liquidity.

As we have noted on this topic previously, anyone who understands markets knows that they at times over- or undershoot the so-called fundamentals but never for long. There is actually no way to objectively determine what market price best reflects these fundamentals – that is why we have markets instead of socialist central planning. The allegation that speculation is somehow "bad" is simply complete nonsense. There could be no free market system without speculation, period. Every entrepreneurial activity is 'speculation', as its success depends on a correct assessment of future prices.

A speculator buying oil futures must correctly anticipate the future price of oil. An entrepreneur manufacturing e.g. a consumer product must correctly anticipate the price at which he can sell the product once it is manufactured. Unless the future selling price exceeds the prices he must expend on the factors of production, he will lose money.

Speculation in commodity futures does not represent a free ride. Speculators who err about the future state of the market can lose part or all of their capital. The market process sees to it that the most able speculators will be the ones thriving in the marketplace. Their capital will increase, giving their vote in the market more weight over time. Their input into the price discovery process creates the signals the market economy needs to determine where to direct scarce resources.

It makes no sense to artificially suppress a price one doesn't like by political means – this will only lead to less supplies of the commodity concerned being produced, leading to even higher prices in the long run, or in the worst case, genuine shortages. Note here that this is true even in a case like the current one, where the most important fundamental driving force of commodity prices is monetary inflation. After all, the production of oil is not "free" either – the inputs required are also rising in price. If crude oil's price were artificially suppressed, marginal production would soon become unprofitable and cease. At the same time, the artificially lowered price would fail to ration demand. There simply is no point in suppressing speculative activity in these markets – it will have unintended long term consequences that will be the exact opposite of the intended ones.

We'll say it one more time: speculators fulfill a valuable, indeed indispensable, role in the market economy. As is the case with so many populist causes, political interference with the futures markets will end up costing consumers a lot more in the end than just letting the markets work.

Commodities and the Dollar

Given that we strongly believe that periods of large nominal price increases in commodities are a function, or effect, of monetary inflation, we would broadly agree with an analysis Deutsche Bank presented last week after the recent rout in commodities began. This was discussed in some detail at the FT Alphaville blog. The short version is: speculators who up until recently held very large net long positions in numerous commodity contracts are becoming worried in view of the impending cessation of the Fed's QE2 program and hence decided to take profits.

It seems to us also very likely that some speculators were becoming wary of the persistent decline of the US dollar, which has brought it close to a zone of strong technical support. Of course the dollar's decline is also related to the Fed's inflationary policy – in a way both rising commodity prices and the weak US dollar are two sides of the same trade, especially as ZIRP has made the dollar into a favored funding currency for various speculative activities. The only point we wish to make in this context here is that the dollar's closeness to technical support is likely inducing some caution.

The dollar index has recently come close to the lows established in 2008. A bounce seemed increasingly likely and a bounce has in fact recently begun.

Also, inflationary policy not only in the US but also China and elsewhere has furthered numerous bubble activities, in the economy; this is to say, economic activities that would not exist absent monetary pumping, as they would not be deemed profitable without it. These activities register as economic growth in GDP statistics, regardless of the fact that they do not create wealth. China's building boom is a pertinent example for such growth that is empty of meaning and in fact consumes capital.

As Gillem Tulloch of Asianomics once remarked, the erection of empty shopping malls, empty apartment blocs, empty office towers and entire empty cities is the functional equivalent of pyramid building. It will tend to increase GDP growth, but not create any true wealth. When monetary policy is tightened, many of these manifestations of phantom wealth are eventually unmasked for what they are – namely massive capital malinvestments.

Depending on the severity of the discovery, economists will then speak of a bust, 'recession or, if the monetary pumping effort is redoubled before a full unmasking has the chance to emerge, a so-called growth scare. This is a temporary glimpse of the ugly reality of capital consumption that is quickly forgotten again in light of fresh showers of free money from the central banks. The summer of 2010 can be classified as such a growth scare. It was officially triggered by the beginning euro area sovereign debt crisis, but the true culprit was likely that one month earlier, the Federal Reserve's QE1 money printing effort had ceased.

What speculators now need to determine is whether the recent swoon in commodity prices is just a temporary shake-out, the beginning of such a growth scare, or something more serious. So far, the jury is still out, in spite of the spectacular short term plunges witnessed in many commodities. However, even if a mere short term shake-out has taken place, it represents at the very least a warning shot. It is telling us that the approaching end of QE2 combined with the tightening of monetary policy in emerging market economies over recent months is likely to redound on the aforementioned bubble activities. Caveat emptor.

Silver has remained in focus as well. After rebounding to its 50-day moving average, it has once again plunged. It seems unlikely that the correction in silver is over, but we would note that it has yet to break its medium term uptrend, in spite of the recent volatility. Note though that a rise in the gold/silver ratio is also a typical feature of a growth scare. Silver tends to outperform gold during periods of waxing economic confidence and underperform it when economic confidence wanes.

Silver plummets again. The decline of silver relative to gold is a sign that economic confidence is waning – fear of the end of QE2' is the most likely motive.

Interestingly, the decline in precious metals has led to a very swift reassessment of their prospects by speculators and investment advisers alike. The closed end gold & silver bullion fund CEF is once again trading at a discount to its net asset value and there have been outflows from the Rydex precious metals fund that have brought its cumulative cash flow ratio to one of the lowest levels of recent years. In addition, Mark Hulbert's HGNSI (Hulbert gold newsletter sentiment index), a measure of the average gold exposure recommended by gold timing newsletters, has plunged from a very high 73.7% to just 7% in a matter of days. It has in fact moved from one of the highest to one of the lowest readings of recent years in what appears to be record time.

As Mr. Hulbert has put it:

This sixty-seven percentage-point reduction in a week’s time is impressive, and most definitely enough to get the attention of contrarian analysts.”

If it is the job of corrections to take the froth out of a market, this recent one certainly seems to have succeeded in the case of gold. We would also note here that if the euro should weaken against the dollar due to worries about the sovereign debt issues in euro-land, then this should per experience not be considered bearish for gold.

The Central Fund of Canada, CEF (which holds both gold and silver bullion) once again ends the day at a discount to its NAV. This is a sign that there is currently no bullish froth in the precious metals markets.

The Rydex precious metals fund with total assets and net cumulative cash flows – the cumulative cash flow is currently at a multi-year low.

We hasten to add to the foregoing that it can take a while for such signs of investor caution to translate into positive price action. The reason why the recent swoon in sentiment is so remarkable is that gold has not declined all that much from its high. A 7% correction from high to low is rather modest in fact. Silver has of course crashed, but even this outsized plunge has failed to dent its longer term uptrend so far.