Commodities: Bubble or Wall of Worry?

by: Davy Bui

John Authers of the Financial Times penned a decent article over the weekend on the possible explanations for the commodities "bubble." It's worth popping over there and reading the whole thing but he sums up his three explanations of the commodities run-up as follows:

If the "consumer demand" explanation is right, then you should not necessarily sell commodities, as the emerging markets may "decouple". But it also suggests inflation is a real threat to the emerging markets' growth, so this still is not a safe investment for the long term.

If the "investor demand" explanation is right, then commodities are a bubble. You should get out now.

If the "supply" explanation is right, then the economy is in deep trouble and pace the 1970s, commodities offer almost the only protection against what is going to hit us.

This article is more balanced in suggesting that we may be experiencing a bubble in commodities than other commentaries which unequivocally suggest a mania in that sphere. I'd like to add the following points.

In terms of "investor demand" and throughout the article, Authers makes no mention of the pitifully weak US dollar. Much of this "investor demand" or "speculation" is a reasonable defensive move in reaction to the debasement by the Fed. It is no surprise that other currencies like the euro and yen have moved in tandem with commodities. The move in commodity prices looks fearsome in US dollar terms but is tempered somewhat when measured in foreign currencies (though still impressive).

As a brief example, oil touched ~$50 per barrel in January 2007. It has now more than doubled since that point for a ~110% gain in US dollar terms. During that month, the euro averaged ~$1.30 so the Germans or French were paying ~38.50 euros per barrel. Today, at $105 per barrel, the European price at today's exchange rate is ~68.4 euros per barrel, roughly a 78% gain. Nothing to sneeze at but a bit below the 110% pace experienced on this side of the pond.

Of course, this holds true across many other non-pegged currencies and for other commodities as well.

Combined with the move in Treasurys, it's clear we are witnessing a flight to safety. Some may call it speculation but this is just a game in semantics. I would venture to say there is even more of a speculative frenzy in Treasurys than the commodities market currently. For some reason, instead of speculation, the move to Treasurys (yielding less than official inflation) is often called "a flight to quality."

In regards to the "supply" side, Authers makes no distinction between commodities. Not all commodities face the same supply constraints and of course, some goods are more inelastic than others in terms of supply/demand dynamics. Oil supply is much different than gold supply or corn supply. So it may be possible for some markets like wheat or soybeans to drastically pull back while others like natural gas or oil to continue moving up.

Finally, the "consumer demand" argument in relation to the emerging markets may also be influenced by the world's sloshing dollars. The US authorities have sent a clear signal that we intend to limit how others can spend and invest their excess dollars. As politicians nix more deals like CNOOC/Unocal or the recent 3Com/Bain Capital/Huawei Technologies or even the recent tanker contract with EADS/Northrup Gruman, we risk discouraging foreign investment here and ultimately encouraging flows into commodity assets. If someone like the Chinese can't use their excess dollars to buy quality assets (and clearly Treasurys are not quality assets, just ask the Pension Benefit Guaranty Fund), the logical move would be to buy commodity assets with their dollars, even at $100 per barrel or $1000 per oz. Otherwise, what else can you do with dollars -- let them depreciate away, earning 2-4% interest while domestic inflation rages over 7%?

That said, I would order Authers' three explanations in the following order of plausibility and importance:

1. Supply constraints - if money doesn't grow on trees, the inverse is also true: you can't print up food on a printing press. Bringing harvests to market, mines online and oil fields into production takes time and major capital.

2. Consumer demand - obviously the Chindia story is well known but less oft-mentioned is increasing demand in the Middle East, Latin America and eastern Europe.

3. Investor demand - I do think that capital inflows are pushing up prices. But it would be a mistake to assume this is the primary driver. Any investor demand at this point is being driven more by the Fed than by speculators, who are simply responding to the Fed's moves.

Authers, to his credit, states that the true explanation is some combination of the the three.

While commodities are always a volatile ride with a hard pullback always hiding around the corner, the intermediate to long-term outlook points strongly upward. As I mentioned in a previous post, all this hand-wringing about a commodities bubble is really a wall of worry leading to higher prices.

Update: No sooner than I finished this post than I see this headline pop up on Bloomberg:

Dollar Falls as Traders Start to Bet Fed Will Cut Rates to 2%

A full percentage point cut from a pretty low base as it is. Wow. No wonder people are wondering if gold will hit $1000 this week.

Disclosure: Long