Commodities have become highly volatile even by historical standards, at one stage crashing by over 25 per cent in the week Osama bin Laden was killed in May, a reality check after months of surging prices.
That sell-off was prompted by growing evidence that the American economy has stalled, and while there is near consensus that the long-term fundamentals remain intact for a prolonged bull market, in the short-term slowing growth is the critical concern.
 |
| Commodities funds (CLICK TO VIEW) |
“At even moderate global growth rates we could be entering the kind of bull market for commodities we saw in the energy crises of the 1970s,” says Peter Csoregh, fund manager of Robeco Natural Resources Equities.
“But growth is very uncertain at this point, with a long list of problems looming on the horizon ranging from an end to fiscal stimulus in much of the world, to spiking oil prices due to the Middle East crisis. And if growth starts to falter we will have severe problems because authorities have run out of bullets on both the fiscal and the monetary side,” he explains.
“The volatility we have recently seen in commodity markets is a reflection of the binary nature of these two realities. With record long speculative positions in things like Nymex crude, any price moves get amplified as investors shift from one leg to the other,” adds Mr Csoregh.
Excessive speculation has also increased volatility in precious metals markets, where some of silver’s mid-May rebound was due to big investors closing out short positions. At its most basic level, customers in the real economy will reduce their demand for a commodity when its price rises, but the opposite happens where financial speculators drive up the price and then step out once it starts turning downwards.
“We see the primary driver of the recent commodity price declines as, initially, retail and non-traditional commodity investors taking profit on gains and subsequently the activation of stop-losses as prices declined,” says Jeff Holland, managing director at Liongate Capital Management.
“Commodities, especially recently, have been prone to unsophisticated speculative inflows chasing returns, driving prices higher faster and then washing out on no particular news when the trade becomes too crowded,” he adds.
Holdings in commodity funds have been hit, with substantial switching to money market and bond funds. Commodity funds tracked by EPFR experienced record outflows of $2.3bn (€1.6bn) for the second consecutive week in early May. Gold and precious metals funds bore the brunt, as a combination of profit taking, and higher margin requirements took their toll. Energy funds held up better as investors focused on tighter supplies rather than softer demand.
Long-term trends
On any long-term view, the bulls win outright, however. “We anticipate a long and sustained period of above average trend growth and demand for a wide range of commodities, of the type we saw in Japan in the 1960s, but Japan has only 120m people – tiny compared with China’s 1.2bn,” says David Field, fund manager at Carmignac Gestion.
“We believe the sheer scale of China’s population will have a longer term effect on commodity demand than some commentators give it credit for.”
“Chinese oil consumption has to rise,” agrees Richard Davis, portfolio manager in BlackRock’s natural resources equity team. “It is currently similar to the US in 1910. Or if you take copper, Chinese consumption is currently 5 kilos per person, but in the Western economy it is 15 kilos per person.”
On the supply side, there has been a massive under-investment in mining infrastructure over a 20-year period. Exploration has been poor, with no major finds in oil, copper or gold. Mining companies have cherry-picked their mines, and in 2008, many remaining projects suddenly lost their financing. The knock-on impact on successful mining stocks will be a boost in M&A activity, and higher dividends and share buybacks for shareholders.
The 18m tonne copper market is a perfect example of supply problems combined with robust demand. Existing mines face 4 per cent degradation per year, a deficit of some 400-500,000 tonnes in the next five months. No substantial new projects will be on stream until 2015.
“Miners have taken action such as firing skilled staff and removing themselves from queues for new equipment,” adds Carmignac Gestion’s Mr Field.
“In the copper market for instance, 1.5-2m tonnes in new supply has been lost compared with the growth that had been expected to come on stream in 2007. This is effectively taking 7-10 per cent of the growth out of the market. Supply will struggle to keep up for at least five to seven years.”
“Some of these industries are highly concentrated, such as iron ore, which is dominated by three producers, Rio, Vale and BHP,” adds Mr Davis at BlackRock. “This is where the pricing power is. Consumers are the price-takers and these suppliers are the price-makers.”
