Warning Signs about Commodities

The recent run up in commodity prices seems to an anomaly (or are they harbinger of more dangerous times). The reaction of the governments' to the financial crisis have been to inject unprecedented monetary stimulus (about US$12.8 trillion by official count) as well as various other unorthodox measures. This invariably led to an immediate complete meltdown. While some may claim that it would lead to inflation down the road, the immediate consequence has been asset inflation. Stocks and commodities have shot up. Copper for instance has more than doubled since its March 2009 low. Lead recently hit a 16 year high. The list goes on...

This post will essentially try to grapple with the Question: Are Commodities in a Bubble? The short-answer is "may be" (which is akin to saying the glass is half-full). There are some traders who believe that they are in middle of their multi year upward super cycle. If that is true then we should be relived that, at least they are not in a bubble. Even if they were in a bubble, the rising prices may have a long way to go over a period of time.

The following factors should be kept in mind.

• A reason for the rally is that there is invariably more amount of money flowing into commodity funds. Till date about US$200 billion dollars have flown into commodity funds against US$160 billion during the first half of the year. The funds are expected to attract another US$20 billion in funds. More importantly, the impact of these funds at sharply lower values (than last year first half, when they were at their peak) would be much. In other words, a fund could buy more quantum of commodity in the first of this year than they could last year.
• The growing financialisation as can be seen from the debate about the role of the US Natural Gas Fund (an exchange traded fund under the symbol UNG) about it cornering about 20% of the natural gas futures market only indicates the importance of financialisation (and expansion) of trading.
• Fears of inflation and decline in value of fiat money may be driving investors to commodities.
• Commodities as an asset class may be under-owned and investors are now diversifying.

Despite the above important factors, it is important to keep some important contrarian signs which may or may not be indicating a commodity bubble but at they do indicate that it is the time for caution.

• Technically most of the the commodity charts (especially metals) are showing what are called Negative divergences, which normally harbinger sharp falls. How sharp? Nobody knows.
• More problematically, the inventories of all the commodities are rising (as per LME data)
• Bullish analysts who have been bidding up copper prices claim that since the 'economic recovery' the total inventories are sufficient for only about 4 months of production. If that were the case, then why are the mines not investing and producing more. They should normally be increasing production if the economy really were so good. I have taken copper because it has widespread applications.
• Worryingly, Pig farmers and other speculators in China may have amassed nearly 50,000 metric tonnes of copper (according to London based Sucden and reported by Bloomberg) which is about half of the total inventory tallied in the Shanghai Futures Exchange.
• Often a contrarian signal is one that comes when we open the daily newspapers (non financial ones). There is an increased coverage of the new high's that gold is hitting.
• The managed money long positions on the US Futures exchange were exponentially high. (See a previous post about Long/Short statistics)
• Baltic Dry Index does not reflect the optimism of the prices of commodities. It indicates indecision at best and stagnation in the demand for commodities at worst.
• According to the IEA, more than 60 million barrels of fuel is stored on tankers offshore.
• It has been reported that oil producing nations are producing about 600,000 barrels more than we need on a daily basis.

Conclusion of all that: Be cautious. There could be wild swings.