Wednesday, June 11, 2008

Playing the Blame Game


Why Most Commodities Are Not in a "Bubble" No Matter Who Says So

Ladies and gentlemen: It's time once again to play the Blame Game...
Over the last several weeks, government agencies and securities regulators have been searching for somebody - anybody - to take the fall for booming commodity price inflation.
Now they're pouncing on speculators and index fund service-providers for these record prices. Even legendary hedge fund investor George Soros recently testified in Washington and blamed index funds for the rapid increase in commodity prices.
What do I say? If I had to point fingers, I'd say soaring food prices, rice shortages in dozens of countries and skyrocketing energy prices have put commodity inflation on center stage in 2008.
But it's true: Commodity index funds have been red-hot over the last several years as a new secular bull market gains momentum. So they have ALSO played a role in driving prices higher.
What Funds Have Really Done to the Market
To be sure, there's been an incredible increase in the number of commodity-based indexes since 2005. Every time they launch a new commodity index, that new fund strips commodity supplies from the market.
According to estimates from Lehman Brothers, total commodity-based assets have mushroomed over the past two years. These assets grew from US$70 billion in January 2006 to US$235 billion through mid-April 2008. And in 2000, commodity indices barely managed US$20 billion - that's a spectacular 10-fold rise in less than a decade!
Oil prices are especially causing all sorts of dislocations across world markets, including the food industry. Companies and farmers are forced to raise prices as input costs are soaring for fertilizer, feeder, and fuel, including diesel for tractors. And every time they launch another a broad commodity index, energy is always the largest part of that index.
Energy futures contracts represent a hefty 78% of the widely followed S&P Goldman Sachs Commodity Index. And they're 39% of the CRB Index and 32% of the Dow Jones-AIG Commodity Index.
Make no mistake: Those big percentages do impact energy prices. And this index love affair with energy can push prices higher as institutions raise their exposure to these contracts. But determining exactly how influential these products are - and how much these products drive oil and other commodity prices to rise or fall - is a hard science to decipher.
Bubble or No Bubble?
Are commodities in a "bubble," or is irrational exuberance causing this financial market frenzy?

Some commodities shouldn't trade at their current lofty levels based on supply and demand factors. But the majority of the complex, determined vis-à-vis futures contracts, are priced relatively accurately.
In fact, many commodities, including soft agricultural commodities and the precious metals still trade miles below their inflation-adjusted peaks since 1974 or 1980.
It's hard to accept an argument that corn, for example, is in a "bubble" when adjusted for inflation; since 1974 prices are still 54% below their peak. The same goes for soybeans - still one-third below its highs. Gold is still 60% below its inflation-adjusted high in 1980.
Tight Supplies, not Speculation, Mostly to Blame
It's simply NOT TRUE to say most commodities are in a "bubble" when compelling supply-side factors are determining price trends. That includes declining supplies, volatile weather patterns, declining output, low U.S. interest rates and of course, a plunging U.S. dollar since 2002. Also, commodity production and demand history is vital to understanding what has happened in the complex.
Since the peak in commodities markets more than 28 years ago, global production of virtually every segment of the industry either declined or stagnated during low prices and a glut for raw materials. During this time, there have been barely any new rig installations and no new mined supply. Meanwhile, we're all facing a growing demand for foodstuffs in the prospering emerging markets.
The recent bad weather hasn't helped either. We've seen devastating weather patterns continue to impact crop yields in some markets, namely Australia and the Ukraine. Bad weather equals fewer crops which equal less supply and higher prices.
It's Absurd to Blame JUST Index Funds
Super low interest rates in the United States and easy monetary policy almost everywhere else have inspired investors and speculators to invest in inflation hedges or tangible goods like commodities.
China, of course, continues to devour almost every conceivable raw material to power its wonder economy. With supplies not growing by any significant measure over the last 20 years, it's no surprise prices have skyrocketed.
It's almost absurd to blame commodity price inflation ONLY on speculators and index funds.
Futures investments of all public pension funds account for less than 5% of commodities indices - according to CALPER, or the California Public Employees' Retirement Plan, the largest U.S. pension fund.
Many commodities have also spiked over the last 12 months with no pension fund or commodity index fund participation. Many foodstuffs don't trade on futures exchanges and gains in these commodities have nothing to do with speculators.
They've Been Grilling Futures Traders
The Commodity Futures Trading Commission, or CTFC, has been grilling its members to increase trading transparency and appease regulators and government officials.
Washington is attempting to decipher what role institutional investors are playing in this surge in food and energy prices. "Institutional investors" include big names like corporate and government pension funds, sovereign wealth funds and endowments.
Unfortunately for all of us, when the government and regulators play the blame game, it usually results in some sort of increased regulations. I'm betting all this deliberating will result in higher exchange margin requirements and more transparency from commodity investors.
So yes, commodity index funds and other speculators have played a role in driving prices higher. But this dynamic is far less powerful than basic supply and demand fundamentals that brought us to this historical bull market in the first place.

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