Wednesday, April 23, 2008

Commodity Inventories

Learning more about the commodities markets has been just fascinating, and being a bystander in the blogosphere debates between various economists has so far proved to be the best resource for this knowledge. Continuing in this vein, Jim Hamilton has an interesting post today that goes along with a post over at Naked Capitalism that responds to Paul Krugman's earlier question (also well put here) namely: if there's is a speculative bubble in commodities, then where are the inventories people are using to speculate with? To summarize, the basic idea is that between the supply and demand curves for these things being very steep (meaning that a large price change could be driven by small inventories), and the inflows of pension fund money creating such large dislocations in the market (meaning that some inventories are not being counted) you can still argue that there is some speculative froth in these markets even though apparent inventories in many commodities are at historic lows. The nice thing about Hamilton's analysis is that it combines two factors that seem important. First, there is a real supply demand imbalance causing these prices to spike, and second, people are taking advantage of that run-up to make speculative profits in the new hot sector.

What does all this mean for investing in commodities, and how does it dovetail with the things I was hearing today in the commodities fund manager's speed-dating bonanza? Well ...
  1. We may really only be part of the way through a longer bull market in commodity spot prices. Even with an economic slowdown, demand from China can continue to grow. New supply is extremely slow to come on-line. Dwight Anderson from Ospraie suggested today that while he sees a point towards the end of the decade when supply and demand growth cross again, he is net long currently.
  2. We may see a major correction in commodities if the Fed gets it together and quits cutting rates and inflating the money supply. That sort of reflation is obviously not working as a solution to the credit crisis anyway. The correction may not mean the end to the long-term bull market, though it may be serious, and many people speculating on negative interest rates may be taken out on stretchers.
  3. There are serious dislocations being created in the commodities markets. Someone clever will make money off of them. I think it is unlikely that it will be purely financial money -- that is, I think the arbitrage will have to be done by someone that can actually deal with the underlying physical commodities, and not just options and futures. These people will make a profit and expand the commodities markets infrastructure to counterbalance the flood of institutional and ETF money that will continue to come into futures.
  4. The academic results about total return futures indexes may still be valid over the long-term, though we may be at exactly the wrong moment to start investing money in these strategies from a market-timing point of view. The current situation of low inventories, contango, negative real rates, dollar weakness and large spot increase smells just like the 70's. Beware inflation.

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