What inning of the commodities boom are we in?

Commodities show clear price cycles, and for obvious reasons; even though over the long-term increasing supply has always won out over demand, in the short-term, demand is relatively inelastic and new supply takes a long time to come online. We are in year 5 of a commodity price boom every bit as spectacular as the one we saw in the 70's, and it's wise to question how long it will go on. Let's try to break down the forces at work here:

Supply -- prices for most commodities have been so low for so long that there's been very little investment in new supply. As a result, production and inventories are quite low. To get a handle on the future of supply, you would need to know:

• What level of prices justifies investing in new production?
• How sensitive are the price levels of other commodities to the price of energy?
  
• How long does it take to realize this production?
• How far along are we already in the process of expanding supply?
• What might the impacts of increased protectionism be on supply growth? Some commodity exporting countries are attempting to control exports and separate their domestic markets from the world market. The politics here feeds back unpredictably on the first question, of what price level signals to the market that new supply is profitable.
  

Demand -- commodity demand is clearly driven by economic growth minus the efficiency of that growth. Recently, the big growth in demand has come from the least efficient economies, namely China and India. In trying to evaluate whether this growth might soften, a few questions spring to mind:

• What percentage of demand growth has China represented over the last decade in each of the three main categories of commodities: energy, agriculture, and metals.
• What part of that emerging market demand growth was dedicated to feeding the never-ending desire for cheap plastic shit in the developed world. If we see a consumer led recession in both the US and Europe as the availability of credit declines, might this not curtail China's demand for commodities?
• What impact would it have if China became even marginally more efficient? Imagine if this efficiency came in the form of lower energy use per dollar of GDP. The resulting fall in the price of oil, might make the supply of all other commodities cheaper.
  

Commodities Fundamentals

Two articles in the FT came to my attention, both of which deal with hedge funds getting into the farming business. "Hedge funds farming?" you say. Yes, given the strong supply and demand fundamentals for some commodities in the short to medium term, and the dislocations caused by pension funds and other purely financial players in the futures markets, there appears to be a great arbitrage opportunity that requires a player with both financial and operational savvy to exploit.

Hedge funds muck in down on the farm
Agricultural land

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.
   

More Market Mayhem

I don't really understand what's behind this problem of the futures prices of commodities not converging to the spot price (though one always suspects that it's the massive allocations of people like Calpers to the asset class) but free money is a rare enough phenomenon to merit my attention.

What's driving commodities

Commodities are a particularly interesting corner of the financial world right now because of the way food and oil have been making headline news over the past 3 months. There's lots of Malthusian talk about supply and demand and China and the limits of growth, some of which may even be right. At the same time, I find the evidence increasingly convincing that a lot of the recent movements in commodity prices are due to much shorter-term factors, namely negative real interest rates. Econbrowser puts it in the simplest terms, and proposes (with the help of the Fed) a test of the hypothesis.

I nevertheless am not persuaded that any of these news items is the primary explanation for the recent highs in oil prices.

The reason is that we're seeing similar increases since the start of the year in the price of virtually every storable commodity. The 12% increase in oil prices this year is in fact just the median for the group of 15 commodities graphed below. It seems to me we should be looking for a single explanation behind the common behavior of the group, rather than try to develop a separate theory for aluminum, barley, coffee, cocoa, copper, corn, cotton, gold, lead, oats, oil, silver, tin, and wheat.

Instead I believe that the price of oil, like the price of all the other storable commodities, and for that matter the dollar cost of a euro, is primarily responding to the Fed's decision to move the real interest rate strongly into negative territory.

But once again the Fed has a golden opportunity to prove me wrong. Fed funds futures prices currently reflect an expectation that the Fed will make one more cut to 2% at the meeting at the end of this month, and then stay there. Here's a prediction for you. If the Fed surprises the markets by holding steady at 2.25%, all those commodities will begin to crash within hours of the news.

I might also add that this speaks to a question I have been pondering: where can macro level thinking can add some value for an investor. Financial markets are complicated places. You do you homework and you invest your money, and even when you get it right, you are not necessarily sure why; were you a genius or were you simply lucky? Considering some of these macro issues helps you to sort out whether there was some underlying force you benefited from yet remained unaware of.

Ethanol Insanity

Politics is really the root of all evil, especially when the Republicans want to starve some folks in Nigeria to get a few votes in Ohio. There's more detail here from whence the quote below, but I think this chart makes it relatively clear at a glance.

As a result of ethanol subsidies and mandates, the dollar value of what we ourselves throw away in order to produce fuel in this fashion could be 50% greater than the value of the fuel itself. In other words, we could have more food for the Haitians, more fuel for us, and still have something left over for your other favorite cause, if we were simply to use our existing resources more wisely.

Market valuation redux

File this one in the E category of the PE ratio:

Analysts are currently estimating 2008 profit growth of 11 percent for S&P 500 companies, down from 15 percent at the start of the year, according to Bloomberg data. The index has declined 15 percent since reaching a record in October...

After-tax corporate profits relative to U.S. gross domestic product are ``well above sustainable levels,'' Morgan Stanley strategist Gerard Minack wrote in a report today. He said a U.S. recession and increased competition will cause earnings to decline.

These guys are bloody geniuses.