Will High Commodity Prices Last?
By Mark Bloudek Feb 26, 2008 3:15 pm
Safe haven trades may not stick.
So let's think about this now. What happens when investors sell their currency (i.e. dollars) for commodities because they want diversification away from a devaluating currency. The answer is simple, the commodities rise in price and then people/economists get worried about inflation. So now we have investors around the world competing for a fixed amount of commodities. When investors buy a commodity index, they're effectively buying/storing a house full of food (wheat, corn, or soybeans), some barrels of oil, etc.
So where do all these commodities get stored?
Let's go into the world of futures contracts and remember that these are deliverable contracts. What do commodity fund managers do when they get an inflow of investor (safe haven) money? They go out and buy futures contracts, (or derivative contracts based on commodity prices, oh brother more counterparty risk here) usually using the front month contract, which is the closest to delivery.
When the front month contract gets close to delivery, they roll it over (sell the soon-to-expire contract and buy the next front month contract). As a result, the front month contract can have a lot of demand (open interest) that never has any intention of taking delivery because the investors don't physically have the storage tanks.
If you look at various commodities (crude, wheat, soybeans), you'll see the front month contracts are much higher in price than the back-end months. Why so much demand for the front month contracts? Could it be that investors are having a crisis of faith in the paper currencies and are fleeing to real tangible assets while inducing price inflation across the commodity complex?
Won't this just make life more difficult for the U.S. consumer/homeowner as more income gets sucked up in paying for food/energy causing even more problems with loan defaults/delinquencies (think credit cards here)?
But the bigger question I'm pondering is whether or not this price spike in commodities is a temporary spike after the safe haven flow stops. I think so, but I wouldn't want to be the Fed and have to bet on that, especially if it were to lower rates further and pour even more gasoline (Lowering T-bill rates further) on the commodity/safe haven trade.
Interesting times indeed.
No positions in stocks mentioned.
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2008-02-26 15:26:21
Roll over commodity contracts?
So what happens if the contracts cannot be rolled over close to expiration?
We've seen other short term investments with a sudden and unexpected disappearance of buyers.
Could this happen here?
We've seen other short term investments with a sudden and unexpected disappearance of buyers.
Could this happen here?
2008-02-26 15:50:02
housing debacle redux
Commodities have all the same problems that the housing market had; extreme leverage, speculators, too much money, and a lot of people that should know better suddenly treating them like they are T bills.
In fact, if you don't understand the term 'limit down' you don't understand how fast this can go in the other direction. That's right, these markets have circuit breakers that prevent the market for opening - sometimes days at a time while your money disappears...
Good luck.
In fact, if you don't understand the term 'limit down' you don't understand how fast this can go in the other direction. That's right, these markets have circuit breakers that prevent the market for opening - sometimes days at a time while your money disappears...
Good luck.
2008-02-26 18:05:21
Nothing more than momentum at work here as EXCESS ALLOCATABLE CAPITAL looks for its next crack whore. All the hedge fund dollars and spec trading (think Goldman, Bear, et. al), as well as funds and firms that focus on this sector sending it ever higher. And yes, on top of this I am sure the little guy is contributing as well through some of the aforemention enablers as well as via their own accounts.
But it primarily is the hedgies and large trading desks that are driving this nonsense in the comods. This is the fictious shadow capital that was previously being used for carry trades, MBS, CDO, CDS, SIV, etc.
Does anyone out their really buy into the nonsense CNBC and other idiots have been spewing over the course of the past few months?
Examples:
- Once people taste meat, they don't want to go back to just rice.
- Infrastructure in China and India is taking off. Oh really!?!?? No shit! It has been "taking off" for years now. That doesn't justify as step-function pricing change in the cost of steel and aluminum.
- Does anyone out there believe that the demand for wheat has changed so much IN JUST THE PAST FEW WEEKS that it realistically needs to trade lock limit up almost every day?
Long story short. You are witnessing the next stop on the bubble parade that started with the internet stocks back in the late '90's, then moved to housing and now has moved to the comods. It will end just as the others did....with a splat... as the level of fictious shadow debt wind down (I'm a deflationista in training) and excess allocatable capital (or what is left of it) moves to the next "under-valued" asset. Wash, rinse, repeat.
But it primarily is the hedgies and large trading desks that are driving this nonsense in the comods. This is the fictious shadow capital that was previously being used for carry trades, MBS, CDO, CDS, SIV, etc.
Does anyone out their really buy into the nonsense CNBC and other idiots have been spewing over the course of the past few months?
Examples:
- Once people taste meat, they don't want to go back to just rice.
- Infrastructure in China and India is taking off. Oh really!?!?? No shit! It has been "taking off" for years now. That doesn't justify as step-function pricing change in the cost of steel and aluminum.
- Does anyone out there believe that the demand for wheat has changed so much IN JUST THE PAST FEW WEEKS that it realistically needs to trade lock limit up almost every day?
Long story short. You are witnessing the next stop on the bubble parade that started with the internet stocks back in the late '90's, then moved to housing and now has moved to the comods. It will end just as the others did....with a splat... as the level of fictious shadow debt wind down (I'm a deflationista in training) and excess allocatable capital (or what is left of it) moves to the next "under-valued" asset. Wash, rinse, repeat.
2008-02-26 18:19:35
Roll over commodity contracts?
Commodity futures can always be rolled over shortly before expiration (except for a few products that are cash-settled). The owner of the contract can hold onto it into the delivery period and demand delivery of the physical product. Because the product can then be redelivered on the subsequent futures month, a carrying charge relationship between the two months exists. (A buyer can purchase the first future and sell the second at the carrying charge premium, thereby arbitraging away the risk of ownership of the product.)
Where this can be problematic is in the situation where the front month future is at a premium to the second month. The front month future will have to fall sharply relative to the second month before this carrying charge bid can be found.
The current wheat market gives a good example: In mid-September 2007 the March '08 Chicago wheat contract was trading at $1 per bushel premium over the May '08, reflecting fears of super-tight supplies prior to the arrival of the 2008 winter wheat harvest. (As we all know now, those fears were not unfounded!) Nonetheless, here we are three days before March wheat enters delivery, and the futures are trading at a DISCOUNT to the May of about 15 cents. This 15 cents is near to the actual cost of carry for two months (the actual figure is about 19-20 cents). The $1 premium was lost because holders of remnant supplies likely will choose to deliver these inventories on the March rather than hold them into a time period where the wheat is worth less. Fear of these deliveries has pushed March under May despite the tight overall wheat inventory position.
This sort of arbitrage exists in all futures contracts that are settled by physical delivery.
Where this can be problematic is in the situation where the front month future is at a premium to the second month. The front month future will have to fall sharply relative to the second month before this carrying charge bid can be found.
The current wheat market gives a good example: In mid-September 2007 the March '08 Chicago wheat contract was trading at $1 per bushel premium over the May '08, reflecting fears of super-tight supplies prior to the arrival of the 2008 winter wheat harvest. (As we all know now, those fears were not unfounded!) Nonetheless, here we are three days before March wheat enters delivery, and the futures are trading at a DISCOUNT to the May of about 15 cents. This 15 cents is near to the actual cost of carry for two months (the actual figure is about 19-20 cents). The $1 premium was lost because holders of remnant supplies likely will choose to deliver these inventories on the March rather than hold them into a time period where the wheat is worth less. Fear of these deliveries has pushed March under May despite the tight overall wheat inventory position.
This sort of arbitrage exists in all futures contracts that are settled by physical delivery.
2008-02-26 18:23:08
Supply and more
Look, commodities are volatile, but Paul Riley et al (above) ignore fundamentals. Simply study the demand and the supply side response. In every bull move those out of the ride blame speculators. Yes, it is a bull market. After the S&P tripled within a few years by 1985 the comments were the same, well it went on to rise 7 fold from there because of fundamentals.
And yes, once people add protein to their diets they do not, in general, reverse course. The evidence of that is everywhere.
I would suggest that economic history is all but lost on a few people. Examine the last several instances of a middle class formation - for example here in the US, Canada & Japan between 1946-1960 for starters. What was the demand? What was the supply side response? What were the newly formed population numbers in that bull market compared to what they are today?
This is no bubble yet. It will be, but when warehouse inventories have gone from 3 months down to 3 days for many commodities, no this is not a bubble. In fact a food crisis is clearly here already.
As for the last few weeks of price advances, well what do you need? Yeesh look at seasonality for a lot of these commodities - do you understand that summer is construction season? again seasonality - history. Look at what the dollar is doing. Look at inflation expectations. The world is roaring ahead in Asia. If only a few people in the US would get a passport so they could witness it first hand. Instead they think everyone must be experiencing a slowdown.
Yes, a gigantic deflationary threat is here and a cascade in derivatives could derail things, but so far we have seen financial coupling and economic decoupling.
When the giant miners like BHP are still trading at PEs of 12, only those out of the bull market say this is a bubble.
And yes, once people add protein to their diets they do not, in general, reverse course. The evidence of that is everywhere.
I would suggest that economic history is all but lost on a few people. Examine the last several instances of a middle class formation - for example here in the US, Canada & Japan between 1946-1960 for starters. What was the demand? What was the supply side response? What were the newly formed population numbers in that bull market compared to what they are today?
This is no bubble yet. It will be, but when warehouse inventories have gone from 3 months down to 3 days for many commodities, no this is not a bubble. In fact a food crisis is clearly here already.
As for the last few weeks of price advances, well what do you need? Yeesh look at seasonality for a lot of these commodities - do you understand that summer is construction season? again seasonality - history. Look at what the dollar is doing. Look at inflation expectations. The world is roaring ahead in Asia. If only a few people in the US would get a passport so they could witness it first hand. Instead they think everyone must be experiencing a slowdown.
Yes, a gigantic deflationary threat is here and a cascade in derivatives could derail things, but so far we have seen financial coupling and economic decoupling.
When the giant miners like BHP are still trading at PEs of 12, only those out of the bull market say this is a bubble.
2008-02-26 22:52:19
Commodities
Oil, and other commodities are mostly controlled by demand. Sure, speculators do move the maket a little (and actually help by adding liquidity to it). They are not like stocks, they are real things that are fueled by surplesses or shortages. I don't think speculators are driving oil up over $100. It's demand and the fact that we can't get oil out of the ground or elsewhere cheaply anymore. Just read Roger's "Hot Commodities". All commodities go in cycles. It sure is a good question that what if there are more speculators than buyers and they start to move the market more than demand. I don't know if that can ever happen, but maybe someday. I doubt it, since trading commodities is not for the faint of heart and not everyone is about to try it.
2008-02-27 00:43:45
price action, spec money, etc.
Not being a guy that follows commodities much (but gaining an interest due to the occasional Gartman Letter I see), it seems you have several things that may be at work which (for some of us) seem to be taking the prices of commodities far higher in less time.
One fundamental reason you could point to in oil has been our country's increase in SPR levels. If you take a chart that shows the level of oil in the SPR over time and overlay a chart of oil's price, the correlation is scary - especially since 2003. Meanwhile, China and India are importing more oil at a faster rate so it seems there's some hoarding going on here.
As for the corn and grain contracts, I'd have to believe there's a certain amount of spec money flowing in, and it's not a small amount. My question is this: If the banks that are lending margin money out to the specs become capital impaired because of other problems, how violent a move would we see from that margin money being called back in? I suspect it may be more violent than we think.
Needless to say, I can see reasons for supporting both sides of the trade here. In some cases you may have strong fundamentals, but when I see some of these charts pointing skyward the way they are, I'd be leery about setting up an entry point.
One fundamental reason you could point to in oil has been our country's increase in SPR levels. If you take a chart that shows the level of oil in the SPR over time and overlay a chart of oil's price, the correlation is scary - especially since 2003. Meanwhile, China and India are importing more oil at a faster rate so it seems there's some hoarding going on here.
As for the corn and grain contracts, I'd have to believe there's a certain amount of spec money flowing in, and it's not a small amount. My question is this: If the banks that are lending margin money out to the specs become capital impaired because of other problems, how violent a move would we see from that margin money being called back in? I suspect it may be more violent than we think.
Needless to say, I can see reasons for supporting both sides of the trade here. In some cases you may have strong fundamentals, but when I see some of these charts pointing skyward the way they are, I'd be leery about setting up an entry point.
2008-02-27 01:52:37
COT Reports Suggest an impending top in commodities?
Generally, when spec players are net long in a big way and commercial hedgers are net short on stuff like crude, metals etc...it signals an imminent top..
Let's hear some comments as this is obviously not a holy grail rule!
Let's hear some comments as this is obviously not a holy grail rule!
2008-02-27 10:39:23
In today's WSJ...again, not demand but spec....
-----------------------
State-Run Funds See Gold
As Profits Increase,
Investors Pour Cash
Into Commodities
By SPENCER SWARTZ
February 27, 2008; Page C8
LONDON -- With juicy profits from rising exports of raw materials, government-run funds in Asia and the Middle East are now investing billions of dollars directly into crude oil, copper and other commodities in a development that could reshape markets globally.
Total commodity investments by what are known as sovereign-wealth funds are around 1% of the funds' total assets of nearly $3 trillion -- an average based on estimates by Morgan Stanley, Global Insight and other analysts. That amounts to a sizable $30 billion worth of state funds in commodities, up from a fraction of that amount five years ago.
But state-run fund investments in energy, agricultural and other commodity markets are expected to get even bigger due to rapid economic growth in China, Saudi Arabia and other emerging markets and related high commodity prices.
Sovereign-wealth fund commodity investments, which are also aimed at diversifying funds' investments, are expanding trends started by U.S. and European private-equity groups, secretive hedge funds and even pension funds, which have piled into commodities the past few years amid the run-up in raw-material prices.
A commodity favorite among a number of state-run funds has been gold, which investors have traditionally used to defend against rising inflation and a weaker U.S. dollar.
Middle East funds have a particular appetite for gold because of rising prices and the declining value of the dollar, to which many Gulf countries peg their currencies. Gold futures yesterday rose $8.50 per troy ounce, or 0.9%, to $946.10 on the Comex division of the New York Mercantile Exchange -- matching the recent Comex record, hit on Feb. 21.
Total sovereign-wealth fund assets are forecast to quadruple to around $12 trillion by 2015, making the funds the biggest grouping of investors in the world, according to U.S. investment bank Morgan Stanley.
"We've seen more and more investments by sovereign-wealth funds into commodities, like gold, and we're still at an early stage," says Boris Shrayer, head of investor coverage and strategy for commodities at Morgan Stanley.
But the financial muscle of state-run investment funds may pose new challenges for market participants and regulators because it opens the prospect of state funds moving prices in futures markets like corn or copper, which are much smaller relative to more capitalized markets like crude oil.
Similar to many individual and corporate investors, sovereign-wealth funds are mainly investing in commodities through exchange-traded funds, which offer investors exposure to a commodity like gold or wheat without accepting the delivery of products.
Commodity investments can also be a double-edged sword for state-run funds. Some countries, like China, are big commodity producers and consumers and also fork out a lot of cash to import large quantities of products such as coal and copper. Being too aggressive with their investments could contribute to higher prices for a given commodity and push up a country's import bill.
-----------------------
State-Run Funds See Gold
As Profits Increase,
Investors Pour Cash
Into Commodities
By SPENCER SWARTZ
February 27, 2008; Page C8
LONDON -- With juicy profits from rising exports of raw materials, government-run funds in Asia and the Middle East are now investing billions of dollars directly into crude oil, copper and other commodities in a development that could reshape markets globally.
Total commodity investments by what are known as sovereign-wealth funds are around 1% of the funds' total assets of nearly $3 trillion -- an average based on estimates by Morgan Stanley, Global Insight and other analysts. That amounts to a sizable $30 billion worth of state funds in commodities, up from a fraction of that amount five years ago.
But state-run fund investments in energy, agricultural and other commodity markets are expected to get even bigger due to rapid economic growth in China, Saudi Arabia and other emerging markets and related high commodity prices.
Sovereign-wealth fund commodity investments, which are also aimed at diversifying funds' investments, are expanding trends started by U.S. and European private-equity groups, secretive hedge funds and even pension funds, which have piled into commodities the past few years amid the run-up in raw-material prices.
A commodity favorite among a number of state-run funds has been gold, which investors have traditionally used to defend against rising inflation and a weaker U.S. dollar.
Middle East funds have a particular appetite for gold because of rising prices and the declining value of the dollar, to which many Gulf countries peg their currencies. Gold futures yesterday rose $8.50 per troy ounce, or 0.9%, to $946.10 on the Comex division of the New York Mercantile Exchange -- matching the recent Comex record, hit on Feb. 21.
Total sovereign-wealth fund assets are forecast to quadruple to around $12 trillion by 2015, making the funds the biggest grouping of investors in the world, according to U.S. investment bank Morgan Stanley.
"We've seen more and more investments by sovereign-wealth funds into commodities, like gold, and we're still at an early stage," says Boris Shrayer, head of investor coverage and strategy for commodities at Morgan Stanley.
But the financial muscle of state-run investment funds may pose new challenges for market participants and regulators because it opens the prospect of state funds moving prices in futures markets like corn or copper, which are much smaller relative to more capitalized markets like crude oil.
Similar to many individual and corporate investors, sovereign-wealth funds are mainly investing in commodities through exchange-traded funds, which offer investors exposure to a commodity like gold or wheat without accepting the delivery of products.
Commodity investments can also be a double-edged sword for state-run funds. Some countries, like China, are big commodity producers and consumers and also fork out a lot of cash to import large quantities of products such as coal and copper. Being too aggressive with their investments could contribute to higher prices for a given commodity and push up a country's import bill.
2008-02-27 11:18:37
Commodities
Sean: "Moving the market more than demand" is a pretty good description of what we're seeing now in a number of futures markets.
A key point to understand about futures markets is that they are zero-sum. When a big inflow of spec money comes into a market, it pushes the price above where it needs to be to clear the physical market. This opens the window for the commercials to purchase additional cash supplies and to hedge those previously unobtainable supplies with short futures. This is where the sell-side liquidity in the futures comes from. No spec player has the capability to put on a directional short as large as the inflows we have witnessed the last couple of years; the selling can only come from this source.
What happens is the market stays elevated as long as the spec inflow continues. The moment the flow slows or stops, the market falls back to the level where it finds a commercial bid for the product. It is not necessary for the specs to liquidate their longs for the market to break. All that needs to happen is for the buying to stop to enable the market to fall back toward the level of commercial demand.
This also explains why the phenomenon Faysal describes in his comment occurs. The commercials will ALWAYS be short futures at times of high futures prices, because those prices enable them to secure physicals at an attractive basis. Inevitably when the spec buying slows, the commercials will be hugely short the futures, and the market will collapse. Happens all the time in these markets.
A key point to understand about futures markets is that they are zero-sum. When a big inflow of spec money comes into a market, it pushes the price above where it needs to be to clear the physical market. This opens the window for the commercials to purchase additional cash supplies and to hedge those previously unobtainable supplies with short futures. This is where the sell-side liquidity in the futures comes from. No spec player has the capability to put on a directional short as large as the inflows we have witnessed the last couple of years; the selling can only come from this source.
What happens is the market stays elevated as long as the spec inflow continues. The moment the flow slows or stops, the market falls back to the level where it finds a commercial bid for the product. It is not necessary for the specs to liquidate their longs for the market to break. All that needs to happen is for the buying to stop to enable the market to fall back toward the level of commercial demand.
This also explains why the phenomenon Faysal describes in his comment occurs. The commercials will ALWAYS be short futures at times of high futures prices, because those prices enable them to secure physicals at an attractive basis. Inevitably when the spec buying slows, the commercials will be hugely short the futures, and the market will collapse. Happens all the time in these markets.
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