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Why Commodities Will Struggle in 2008

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A recent Barrons article points out that "gold and copper are each down 12% from the all-time highs seen on March 17 and March 6, respectively, while crude has fallen 11% from its March 17 high. London International Financial Futures Exchange sugar and cocoa are off 25% and 21%, respectively, from recent highs, while Chicago Board of Trade wheat has slipped nearly 20% since March 13." Is this the end of the commodity bull run?

Please understand that I'm not trying to predict any long term trends with this piece, I'm only trying to guess the direction of commodity prices over the next year. To provide focus to this discussion, I will consider the following issues:

1. How much have speculators contributed to the recent commodities rally?
2. Will increased volatility lead to more margin calls, further depressing commodity prices?
3. Which factor dominates commodity prices: the weak greenback or increased volatility? Will a greenback rebound knock down commodity prices?
4. If the U.S. enters a recession, can commodity prices continue to move higher?
5. Will supply disruptions continue to support commodity prices?

Summary:

Evidence suggests that speculators played a big role in the recent commodity bull run. It seems likely that elevated volatility will continue in 2008, increasing the likelihood of commodity speculators selling long positions to cover margin calls.

Some commodity bulls argue it would only take another banking disaster to lead to more Fed rate cuts, triggering dollar weakness and a fresh round of buying in commodities. But this argument isn't convincing, because volatility will increase if we see another banking disaster, which may increase the likelihood of commodity speculators selling long positions to cover margin calls.

Furthermore, if the next banking disaster occurs in Europe, commodities will take a double punch as the dollar strengthens and volatility increases. Major trade weighted dollar weakness will be behind investors, further limiting upside for commodity prices.

History suggests that commodity prices will move lower if the U.S. enters a recession, and historical evidence also rejects the notion that emerging market growth will continue to support commodity prices during a U.S. recession. However, supply disruptions may provide some support to commodity prices.

I have attempted to discuss each of the above-mentioned issues in detail:

1. How much have speculators contributed to the commodities rally?

Prices look vulnerable if speculators are dominating commodity markets. Margin calls on speculative positions can quickly knock down prices, as we saw on March 19. If we are discussing the outlook for commodity prices, we need to estimate the influence of speculators. Recent trends suggest that speculators are playing a bigger role in commodity markets. "Commodities have been attracting the largest share of investment lately," says Barrons. "While it's difficult to quantify the exact worth of this money flow, consensus estimates calculate that around $30 billion of fresh investment has entered commodities since the start of this year. Macquarie Bank says this potentially increases total investments in commodities by speculators in general to as much as $172 billion now, versus $142 billion at the end of 2007." But where is the speculative money coming from?

Matthew Turner, an analyst at London-based commodity research group VM Group, says commodity prices have recently benefited from "new and easier ways for investors to own the metal." As an example, exchange-traded funds account for some 10% of world demand for gold. This is an amazing figure, considering that ETFs weren't launched until March 2003. In the last five years, trading in futures and options has exploded, and commodity prices have benefited. The Futures Industry Association reports a jump from 6.2 billion contracts in 2002 to 15.2 billion last year. The increase in 2007 alone was 28%!

Even government officials are blaming speculators for surging commodity prices. The Dallas News recently reported that India's petroleum secretary has urged Washington and London to shut down commodity exchanges selling crude futures because he believes they are largely responsible for a sharp spike in oil prices.

In summary, it seems likely that speculators did play a big role in the recent commodity bull run, and this is the key assumption of the analysis that follows. If I am overestimating the impact of speculators, this piece may have little value.

2. Will increased volatility lead to more margin calls, further depressing commodity prices?

If there are heavy losses across several other asset classes, commodity positions run the risk of being liquidated to fund margin calls elsewhere. If speculators are to blame for the recent commodities bull run, increased volatility can force speculators to unwind positions. In other words, if we are trying to predict where commodities will end 2008, we need to estimate volatility trends.

It seems fair to say that most experts expect elevated volatility to continue in 2008, arising from three factors: monetary policy, fiscal policy and continued weakness in the financials sector. Horacio Valeiras, CIO at Nicholas-Applegate Capital Management, explains: "In monetary policy, the U.S. is obviously cutting interest rates, the U.K. is cutting and we think the Canadians will cut interest rates. The European authorities are concerned about inflation and the Chinese are raising interest rates. So you have some uncertainty about where monetary policy is going in different parts of the world."

Mr. Valeiras adds: "Fiscal policy, particularly here in the U.S., is related to the election and where tax rates will be heading afterward. It depends on who you think the front runners are today but the Democrats have basically all said they're going to reverse the Bush tax cuts. On the Republican side, there are more calls for making the Bush tax cuts permanent but that probably won't happen if both houses of Congress remain in the Democrats' hands. As we get closer to identifying party nominees and a favorite in the general election, the market will start to discount either higher taxes in 2009 or in 2011, when the Bush tax cuts expire."

There will be more subprime writedowns, but no one knows how far we are into the writedown cycle. Goldman Sachs is projecting $460 billion in subprime-related losses; almost four times the amount already disclosed. S&P is more optimistic, claiming that we are halfway through a forecasted $285 billion in writedowns. But it probably doesn't matter who is right with their writedown projections. Even if there is a light at the end of the subprime tunnel, rumor mongers will go out and build some more tunnel. "If the banking world has learnt anything in the past few days, it is that rumors can kill," says Siobhan Kennedy at The Times. "Bear Stearns was forced into an emergency sale not because its banks stopped lending it money but because its customers and its counterparties were so scared it was on the brink of collapse they decided - one by one and in the space of 72 hours - to run for the exit."

In summary, it seems likely that elevated volatility will continue in 2008, increasing the likelihood of commodity speculators selling long positions to cover margin calls.

3. Which factor dominates commodity prices: the weak greenback or increased volatility? Will a greenback rebound knock down commodity prices?

Some commodity bulls argue it would only take another banking disaster to lead to more Fed rate cuts, triggering dollar weakness and a fresh round of buying in commodities. On the other hand, volatility will increase if we see another banking disaster, which may increase the likelihood of commodity speculators selling long positions to cover margin calls. It might also be premature to suggest that the greenback will automatically weaken if there is another banking disaster, since the next banking disaster may occur elsewhere. The U.S. seems to be taking the lead on subprime writedowns, so profits here may bounce back sooner, supporting the dollar. If we had to see another banking disaster in Europe, commodities could take a double punch as the dollar strengthens and volatility increases.

Projecting the greenback's direction in 2008 is not that easy, but there is a case to be made that most of the bad news has already been priced into the currency. Several analysts expect the U.S. dollar to rebound in the second half of the year. A slowing U.S. economy always affects the rest of the world with a delay, they say, and most of the bad news may already be priced into the greenback. "For Euroland, historically, the delay has been one or two quarters," notes Stephen Roach at Morgan Stanley. Analysts like Mr. Roach argue that central banks that proactively cut rates to bolster growth (like the Fed) will now see their currencies rally, and central banks that don't cut rates will see their currencies weaken. The implication here is that investors will move money away from yield and turn their focus to areas of growth.

"Major trade weighted dollar weakness could be behind investors," said Citigroup in a recent note to clients. "While wary of making any foreign exchange directional forecasts, it is intriguing to see that the magnitude of the greenback's decline from its 2001 high mirrors the drops witnessed in the 1970s and the 1985-87 period. Commodity weakness and dollar strength appear to be very much intertwined and thus need to be monitored."

In summary, the greenback's direction in 2008 is uncertain. If we had to see another banking disaster in Europe, commodities could take a double punch as the dollar strengthens and volatility increases.

4. If the U.S. enters a recession, can commodity prices continue to move higher?

"Moreover, it is critical to recognize that commodity prices do go down during recessions and have done so for almost 40 years," says Citigroup in a recent note to clients. "Indeed, the average decline around recessions of industrial commodities prices has been roughly 19%. (This magnitude also was true in the 1970s to 1980's downturn)"

Citigroup also rejects the notion that emerging market growth will continue to support commodity prices, citing historical examples. "Note that Japan's economic juggernaut was already in full swing in the 1970s driving foreign demand for commodities, while inflation was also stoking interest in real assets at the time. Yet, commodity prices still fell around recessions even as the long-term trend was intact."

In summary, history suggests that commodity prices will move lower if the U.S. enters a recession. Historical evidence also rejects the notion that emerging market growth will continue to support commodity prices during a U.S. recession.

5. Will supply disruptions continue to support commodity prices?

Commodity prices will probably receive support from supply disruptions. To quote a recent article from The Economist: "Meanwhile, global copper inventories amount to only two weeks' demand. Lead stocks are closer to one week's worth. Stocks of oil are also unusually low. So even small disruptions to supplies prompt dramatic reactions from the markets. Aluminium prices, for example, have risen in recent weeks because of a shortage of power in South Africa, which has reduced output from several smelters. Fears of a shortage of hydroelectric power in Chile are helping to buoy the price of copper."

Jeff Currie, of Goldman Sachs, sees little prospect of a dramatic increase in the supply of most commodities. Nationalist governments, he argues, are impeding investment in the most promising new mines and oilfields, forcing Western energy and mining firms to spend lots of money developing less accessible and profitable reserves. Higher marginal costs of production, he believes, will sustain higher prices for a long time to come.

"On the (commodity) supply side there has been concern the rise in new production could ease current market tightness and lead to falling prices," says Catherine Raw, a fund manager on the natural resources team at BlackRock. "Over the last six years, analysts have overestimated supply and we expect this to be the case in 2008. Production increases have been slower than expected because of increased lead times for new equipment and unanticipated supply disruptions have reduced existing supply, thereby counteracting any potential increase in production from new operations. In addition, a lack of infrastructure development has led to bottlenecks at key points in the supply chain; such as at ports in Australia and South Africa."

In summary, commodity prices are expected to find some support from supply disruptions.

Disclaimer: I don't have any commodity or currency positions.