Another Commodities Bubble?

Between mid-2007 and late 2008, the price of all tradeable commodities skyrocketed, headlined by oil reaching nearly $US150 per barrel in July 2008.

At the time, fundamental economic forces and demand and supply were being blamed for the sharp rise in commodities prices. Take, for example, this explanation from Jeffrey Harris, chief economist of the CFTC, the US commodities futures regulator on 15 May 2008:

“All the data modeling and analysis we have done to date indicates there is little economic evidence to demonstrate that prices are being systematically driven by speculators in these markets”

“Simply put, the economic data shows that overall commodity price levels, including agriculture commodity and energy futures prices, are being driven by powerful fundamental economic forces and the laws of supply and demand”.

Yet, as it turned out, the 2007-08 commodities bubble wasn’t primarily the act of fundamental real-world factors, such as growing demand from China. Rather, it was caused mainly by speculation on a huge scale from hedge funds, pension funds, governments and other institutions. The extent of this speculation is explained in the excellent book, Meltdown: the End of the Age of Greed, by Paul Mason:

The total value of commodity futures contracts rocketed from under $US2 trillion in 2004 to $US9 trillion in 2007. The number of commodities futures transactions rose from 150 million a year in 2005 to 450 million in 2007.

…An American hedge fund manager called Michael Masters spilled the beans about what was happening: in May 2008 he testified that the price of oil could be halved if speculation were banned. He produced graphs to show that the spike in commodity prices was being driven by a new kind of speculator: pension funds, governments and other big institutions.

…To give a sense of the scale of this big investor speculative rush, the money invested into commodities indexes grew by a staggering 2,500 per cent, from around $US10 billion in 2002 to $US250 billion by March 2008.

By October 2008, commodities prices had crashed as the speculators rushed to close-out their positions. Again, Meltdown describes how the situation unfolded:

From a peak of 238 in July 2008, the Dow Jones AIG Commodity Index would plummet to 122 by October; that the value of the Dow’s food index would halve in the same period; that the price of aluminium would fall from $US93 to $US51; that sugar would halve in price; that wheat and crude oil would both lose two-thirds of their market price – all in the space of the few months after commodities peaked. Had ‘powerful’ fundamental economic forces really changed so much in such a short space of time?

Certainly, by the autumn of 2008 the futures market for commodities was reflecting the expected onset of recession. But it is also clear that billions of dollars were pulled out of the commodities markets as the meltdown of September-October forced both hedge funds and large institutions to deleverage – that is, to call in and pay back the loans that had been fuelling one speculative bubble after another.

The bursting of the commodities bubble was met with a deafening silence from regulators, politicians, and journalists, who claimed that its was all down to supply and demand. They had blamed everything, from the growth of China, to the virulence of wheat field pests and the intransigence of OPEC. They were wrong on all counts.

So why am I telling you this? We already know that regulators and so-called ‘experts’ often don’t know what they are talking about and that ‘fundamental economic forces’ and ‘supply and demand’ are often wrongly blamed for rising asset prices (e.g. the ‘Great Australian Housing Bubble’). No, I’ve provided this history lesson because it looks like the world may be in the midst of another speculative commodities bubble. Consider this article from last week’s Australian newspaper:

COMMODITY prices are breaking records in an investment stampede inspired by extreme weather, demand from China and rising speculation.

The price surge is sweeping almost all commodity markets — both minerals and farm goods — and raises the prospect of government and Reserve Bank forecasts proving conservative.

Copper hit a record $US9392 a tonne yesterday, while cotton is also at record levels and sugar is at a 30-year high.

Australia’s big export commodities are being swept along, with spot prices for iron ore reaching $US172 a tonne at the end of last week, up from $US152 a month earlier, while thermal coal prices have risen from $US100 to $US117 a tonne in one month.

Citigroup commodities analyst Alan Heap said it was possible to mount explanations for the rising prices in each market, but there was also a rising tide of speculative investment.

The net speculative position in commodity markets is through the roof, and is way higher than it was during the peak immediately before the global financial crisis,” he said.

Speculative investors are looking to diversify away from currencies, where there remain fears of inflation and collapse of the euro.

Consider, also, this report from the Wall Street Journal, highlighting some of the huge speculative bets being undertaken:

As commodity prices soar to new records, the ability of a few traders to hold huge swaths of the world’s stockpiles is coming under scrutiny.

The latest example is in the copper market, where a single trader has reported it owns 80%-90% of the copper sitting in London Metal Exchange warehouses, equal to about half of the world’s exchange-registered copper stockpile and worth about $3 billion.

The report coincided with copper prices reaching record highs Tuesday. Commodities prices rallied along with stocks…Crude oil jumped to its highest level in more than two years and topped $90 a barrel in late electronic trading in New York. Corn and soybeans rose amid worries about hot weather in Argentina.

…Single traders also own large holdings of other metals. One trader holds as much as 90% of the exchange’s aluminum stocks. In the nickel, zinc and aluminum alloy markets, single traders own between 50% and 80% of those metals, and one firm has 40%-50% of the LME’s tin stockpiles.

…At the same time, thousands of new investors are flooding into the commodities markets, either directly or through exchange-traded funds, seeking to take advantage of an expected rise in prices of raw materials as the global economy continues to recover.

…Holding ready-for-delivery metals on an exchange isn’t a cheap undertaking for traders, who are responsible for paying insurance, storage and financing costs. And “the end game is to find somebody to buy something you have already bought for a higher price”.

The recent boom in metal prices has enabled traders to purchase the physical metal, sell a futures contract at a much higher price and still make a profit after paying for storage and insurance.

Certainly, if the below RBA chart is any guide, it appears that the prices of Australia’s commodity exports might have also been caught up in the speculative rush:

Consistent with the 2007-08 commodity bubble/bust described earlier, Australia’s commodity prices peaked in 2008 before losing nearly one-third of their value in the wake of the Global Financial Crisis (GFC). Now they are back to their pre-GFC level.

The question, then, is: how much of the rise in Australia’s commodities prices is due to fundamental economic forces, such as demand from China? Or are prices being elevated by rampant speculation?

I cannot say since I am certainly no expert on the commodities market. But if speculation is the main force driving prices upwards, then Australia could sooner or later find itself at the mercy of a sharp commodity price correction irrespective of what happens to China’s economy.

Food for thought.

Cheers Leith

Unconventional Economist

Leith van Onselen is Chief Economist at the MB Fund and MB Super. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.

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Comments

  1. Great perspective and food for thought Leith. The fundamental story behind commodities is a great sell to skeptical laymen such as myself, but if one can't understand the influence of futures contracts, it's easy to be deceived. It makes physical metals look more attractive and caution regarding related equities and currencies.

  2. Leith,

    Are commodities going up? Or, are currencies going down?

    In the case of Dr Copper I have read that JP Morgan have secured around 90% of the copper stock available through London…in advance of a copper ETF to be launched, so that makes sense. Aluminium apparently likewise. Food, well specs were quick to jump on to poor harvests that were apparent earlier this year, (and Mexico has locked in corn futures); Oil, the US reserves were significantly less than consensus a few weeks ago so, again that got the specs excited.

    Silver may not be a commodity, I see evidence of it being re-monetised. Its ratio to gold has gone from 80:1 or so to under 50:1… historically it has often been 15:1 and occurs naturally at 17:1.

    Gold is money, nothing else.

    The common thread is Dr Bernanke's actions. For those that have not followed his track record it is perfect so far: every major call of his has been wrong. He wants inflation. He is getting it, just not where he wants it, (apart from US equities). The US bond markets are starting to respond…interesting times.

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  4. Thanks Anon,

    Quite gloomy overall, but hard to argue with.

    11 year bull market in gold, historic and in my opinion it has not started. Still less than 1% of "investment assets" are in gold bullion.

    I'm not sure the silver short squeeze is on, open interest on the Comex has been increasing until the last close, and then not down by much. My understanding is that if the shorts were covering open interest would be falling. I get what I can from Harvey Organ's blog and used to follow Lance Lewis' Daily Market Summary closely.
    Jesse Cafe is good as are many others…a new one I like, in case you don't know it, grew out of Zero Hedge:http://tfmetalsreport.blogspot.com/

    Thanks and good luck to all.

  5. Hi Leith

    It may be warranted that there was rampant speculation on oil leading up to 2008.

    But with oil prices at record highs, why did this not spur continued expansion of oil drilling? (thus increasing supply and easing oil prices?)

    How much oil was extracted leading up to 2008, and how much is extracted now?

    Reading the latest 'World Energy Outlook' from the International Energy Agency (a decidedly optimistic organisation tasked with preventing another 1970's energy crisis) we find that that conventional oil supply peaked in 2006.

    http://www.worldenergyoutlook.org/docs/weo2010/key_graphs.pdf

    We will now probably have to wait another 5 years til they acknowledge that the PEAK OF ALL LIQUIDS (conventional, LPG and tar sands) occured in 2008.

    This is very significant. The only way to stop soming using a resource as critical as oil is through high prices and significant demand destruction. And signficant demand destruction has come in the form of US and European recessions.

    High prices of energy (and particularly oil) and the bursting of housing bubbles throughout the world are therefore hardly contradictory.

    Can I suggest further reading at
    http://www.energybulletin.net

    Regards