The Commodities Bubble

With Oil and metals at record highs there is a good chance that a bubble is forming, this bubble is happening as money moves into the likes of gold as a real value hedge against currency weaknesses.

So, is the next downfall going to be in Commodities? please be sure to explain the reasoning behind your view!

Goldand silver’s last “downfall” was in 1980-1999.

What is a bubble? A bubble can be defined as an asset and the perceptions the market has of it.

There cannot be a bubble in Asset X unless Asset X is hugely abundant and easy to come by. Let Asset X be dot-com shares in 1999, there were literally trillions of shares. Let Asset X be Dutch tulips in the 18th century. Let Asset X be houses in Ireland.

Can you see how there things multiply like rabbits over a short number of years?

Gold silver and oil all have one factor that the bubbles above do not: you cannot multiply the absolute output amount of it in a short number of years.

Yet, undoubtedly, in the late 90’s, all three assets fell seriously in price. What’s missing from this picture? How can I say these assets are strong when they had such a poor showing only 10 years ago?

The answer lies in looking, not at gold, oil and silver in isolation in the period 1996-2000. You have to look at the entire financial investment world in the period 1996-2000.

When you look at the big picture for the period 1996-2000, the temporary fall of gold, oil and silver starts to make sense. The three scarce commodities were eclipsed by the broadest bubble mania of all time. The mania was located in stocks and emerging markets.

Alan Greenspan’s low interest rates were pumping literally trillions of dollars into the US business world. Virtually the entire US middle class is ecouraged to invest in the stock market through tax-efficient pension funds.

Seeing their retirements looming, the baby boomers ploughed huge amounts of their incomes into their pension funds.

These funds duly inflated the living shit out of stocks and emerging markets. The Dow and S&P tripled.

And that’s why gold, oil and silver fell, back in the 90’s. There was explosive (bubble) growth in other markets. When this happens, the rational thing to do is to shift your money into short-term investments (taking profits quickly and cautiously).

How could we see gold, oil and silver falling again? If other markets start to see explosive bubble growth again.

In the absence of explosive bubble growth in other markets, gold, oil and silver will perform very well. They can’t really do otherwise.

What about people going into gold as a protectionist move? You can see the same thing happening in the Yen, is it really more about a falling dollar or will gold now go up and not come down?

Protectionist? Are you sure that’s what you meant to write?

I could say, there is a reasonable scenario where gold and oil and other commodities could fall: if government place punitive taxes on those investing in these asset classes. That would, of course, probably suffice to end the appreciation in price in gold and silver.

Oil? Maybe not so much.

chinese gold supply is now beating that of south africa, the fact is that gold is used for financial protection, because in real life its only value is jewellery or to hold for market driven reasons. the cost of extraction may have gone up but the rest of the value in gold is purely down to the market driving it up in a time of turmoil, gold is the ultimate safe haven for a lot of investors. the output of gold in the world could also change, if mugabe isn’t re-elected in Zimbabwe and they start to get a proper return on their gold stores then you could have a new super producer on the market. there is a gold/oil/dollar correlation and both of them rise as the dollar falls so what happens if oil is no longer traded in dollars? basically the bubble of the USA is being transferred onto other assets, the weak dollar which is a result of the sub-prime/structured finance mess is the same weak dollar that is giving oil new heights, thats why i think there is bubble potential. for oil to spike so fast under natural conditions would mean there was some massive and sudden demand and thats not the case (not even the harsh winters can explain this away), so it is down to the dollar more than anything no?

Have you ever thought where this bailout money the banks are getting is going? It’s not going into housing loans, but banks are going to need a return on it and what’s offering the best return at the moment - commodities.
Therefore as the central banks make more money available the higher gold,oil & food will keep going up driven by the banks, and you and me at the end of the chain pay more to survive. It can only come to an end when the central banks reverse their current course and start shoving up interest rates.

But the Chinese Communist party alone has more members than South Africa has people and springboks combined.

I’m not sure there are any interest rate scenarios where oil prices will drop.

Global oil demand is independent of our currency concerns. Whether our currency for determining the price of oil is US dollars, Euro or seaweed, oil’s going to become continually more pricey.

Commodity Investments

In a speech to the Institute of Economic Affairs on the 27th February 2008, BoE deputy governor Rachel Lomax said the outlook for the UK economy in 2008 and beyond had “changed dramatically”.

The Bank of England (BoE) warned inflation was set to “rise sharply” in the near term and there is nothing the Monetary Policy Committee (MPC) can do about it.

Lomax believes cost pressures have not yet fed through fully to consumer prices, with higher utility bills at the forefront.
While the BoE foresaw some form of correction in financial markets, Lomax said the extent of the recent reverberations was not fully appreciated. “There have been financial and banking crises before, but not on the present global scale, and this must surely be the largest ever peacetime liquidity crisis,” she said. “There may be more shocks to come.

The focus of current concerns is how far other assets may be impaired, as a result of the broader economic impact of this period of financial stress”.
All Investors are susceptible to unanticipated inflation, which may result from what economists call “externalities” or shocks to the financial system such as short-term wars (Gulf Oil War of 1990-1991), inclement weather (periodic droughts, floods and frosts), and currency devaluations (Asia in 1997 and Russia in 1998).

Through much to the 1990’s, developed economies appeared to have moved into what was described in the USA as a “Goldilocks” state, i.e. the economy was not too hot and not too cold. It seemed as if the authorities had somehow managed to remove both “boom and bust” from the economic cycle and maintained a low and stable level of inflation.
In these conditions, investment in financial instruments made perfect sense. Generally falling interest rates from the peak reached in the early 1990s, meant that Bonds represented a sound investment for much of the 1990s. Equally, many years of uninterrupted growth in the developed economies resulted in generally consistent Stock market returns at around a 20%pa return.

At the same time, the returns from raw materials and commodities were not in the same league as either stocks or bonds. Indeed, it is possible, if not probable, that the declining prices of raw materials in real-terms may have benefited the bond market and supported stock market valuations in the last decade.

However, it should be clear that current market conditions are extremely unstable with the fallout from the global credit crunch yet to fully work through the system. Our central view is that there is a high degree of “pent up” inflation within the global financial system, which has been masked by falling manufactured product costs coming out of China.

The case for commodity investment

An investment of this kind is designed to complement a typical portfolio’s asset mix to help reduce overall risk of that fund without giving up the return that similar risk reduction strategies (such as allocating from equities to bonds) would do. We believe adding commodity exposure to a portfolio’s strategic asset allocation can provide significant diversification benefits due to their negative correlation with equity and bond returns. However, as with any asset class, we believe that an investor should never invest too heavily in any one asset class.

Commodities provide diversification
The threat of inflation is a great concern to investors. Most traditional asset classes, such as equities and bonds are a poor hedge against inflation, i.e. they underperform during periods of high and rising inflation. This is typical late in the economic cycle. By contrast there is considerable evidence to show that Commodities perform at their best in such periods, i.e. that commodity prices are positively correlated with inflation. Hence an allocation to Commodities can provide a portfolio with downside protection during periods when equities are at their weakest.

In very simple terms, an economy such as Ireland that is an importer of raw materials and energy will tend to “import” inflation as a result of rising commodity prices. One way in which an investor can “hedge” the inflation risk, is therefore to directly invest into the underlying commodities.

There is some evidence that in periods of rising inflation, Commodities are the best performing asset class, and furthermore that when equities are performing at their worst, producing negative returns, commodity futures perform at their best.

Risk reduction without return reduction
Historical analysis of commodity futures returns shows they have generated a total return very close to that of equities. Research by the Yale International Centre For Finance* focusing on the period from December 1959 to March 2004 showed that the return on an equally weighted basket of commodity futures was similar to the return on equities and in excess that on bonds, returning just over 5% p.a. in real terms. As with equities, the bulk of the return from investing in Commodities coming from a risk premium.

However, subsequently, academics have challenged their paper, claiming that their entire 5% risk premium has been generated from an annual rebalancing between commodity futures and that therefore there was no intrinsic value in the actual investments. The added value from a regular rebalancing of a portfolio is well understood in investment theory but it would seem unlikely that all of the return could be attributed to this.
We feel, as in all investment matters, that investors should aim to balance these issues. We anticipate that given the continued Industrialisation and urbanisation being seen in China, India and other “emerging” economies, that demand for some commodities should continue to be well supported, and this would be the case irrespective of a slowdown in the US.

Equally, we feel that reasonably strong arguments can be made for supply inelasticity of some commodities. For example. the theory of “peak oil” suggests that humanity has already used half of the reserves of oil. Much of this is based on speculation and nobody really knows how much oil is really left. However, the fact remains that when a finite commodity is consumed, then one day it will run out.

We don’t know if commodity returns will continue to match those on equities over the long term. However, even if returns were half of the historical rate, we believe that an allocation to the asset class is still of benefit to a portfolio. This is because the real added value from Commodities comes from their negative correlation to other asset classes, i.e. they react completely differently to equities and bonds in certain macroeconomic circumstances.
*Yale International Centre for Finance “Facts and Fantasies about Commodity Futures” by Gorton & Rouwenhorst (2005)

Have I missed the boat?
Research by Seamans Capital Management shows that Commodity prices, measured in inflation adjusted terms, reached levels equivalent to their 1930’s lows in mid-1999.
Thus although commodity prices have risen sharply in recent months, we believe that they still remain undervalued in real terms.

Commodities have had five mega upmoves in the last 200 years and the sixth one is now underway. On a big picture basis, we believe that the current commodity rise is still young compared to previous upmoves and the upside potential is wide open. Each commodity upmove has also coincided with a war…

Also previous moves took place under the Gold Standard and not with money supply growth of 15 to 20% per annum being seen in western economies today. Finally, there was no Chinese or Asian Industrial Revolution in previous commodity upcycles.

We share the concerns being raised by the Bank of England and echo the warning offered by the Financial Services Authority (FSA) in the UK in 2007 regarding the faith investors and their advisers had in the benefits of asset diversification. In the FSA´s Financial Risk Outlook 2007 the regulator said ´Instruments that have been traditionally used to balance portfolios due to their low or negative correlation may no longer necessarily fulfill this role as effectively, because they now appear to be moving together.´

It is time to reappraise investment portfolios and to consider including selected commodity and precious metals investments. We believe that Investors should prepare themselves for a period of sustained volatility in financial assets combined with a high risk of inflation and that diversification into commodity investments should provide some protection. … refer=home

If you want to talk about fundamentals in soft commodities, weather related crop yield is one!

Be interesting to see what Australia and Canada do. La Nina conditions persisting in the eastern pacific should be as good for Australian yields as they were bad for US yields.

Not much soy or maize in australia of course, wheat is the one to monitor.

Anyone bored watching the steady rise in irish housing supply can monitor la nina/el nino conditions here (blue is cold) … 80302G.jpg

Forecasts (they say weakening La Nina in 2008) available here … table.html
Cramer tips Natural Gas stocks - quick sell everything you hold.

Natural gas has one unfortunate property - it can’t be cheaply stored. Once it is coming out of the ground you have to do something with it. Burn it would be my guess. There were times last year that wholesale gas prices in the UK were negative. I believe it was in March/April (it was unseasonably warm).

I question this call in a recession.

$160 Oil … Sooner Than You Think … you-think/

Don Cox … tframe.asp

Historical upward adjustment in commodities and precious metals; commodities go up; financials go down; Inflationary recession; etc. etc.

Another year, another bubble. After last year’s record prices, guess what? Farmers planted loads of corn…

We have a song for Mr. Ward, don’t we Zippy?

Gold: In China/India (Mid East also, I think) Gold is seen as “real” money for myriad cultural reasons (go to any chinatown bookies, look what the punters are wearing) I worked with HK chinese (of the 14K variety), much of their wealth was converted into 24k gold jewelry. Stroll around Southall in London - ever seen so many gold shops? I believe arabs place the same esteem on gold. That would be half the World’s population right there who want to convert their earnings into “real” wealth.

Food: say no more - you’d kill your mother after a week without grub. (I’d last 3 days, though).

Oil: This shit is oxygen for the global economy and if the consequences of peak production are unknown to you by now, well, you’re slower than Jordan’s kid.

edit: speling, init?