"D" is for Demand

Is Asian demand or Western money-supply driving the price of commodities...?

A STORY by Gene Epstein in Barron's last weekend warns that
commodity prices could fall by at least 30% and as much as 50 per cent, writes Dan Denning for The Daily Reckoning.

   Epstein's article highlights what he believes to be the influence of
index funds on commodity prices. He goes on to list a number of factors
which a handful of analysts argue will result in much lower commodity
prices this year.

   "By one estimate," Epstein writes, "index funds now account for 40%
of bullish bets on commodities. The speculative juices are even more
plentiful-nearly 60% of bullish positions-if you count the bets placed
by traditional commodity 'pools'."

   The argument that there is a bubble in commodities prices is not a
new one. It is based on the hard evidence the index funds which track
commodity prices account for some US$200 billion in bullish positions
on the commodities options and futures markets. While the funds have
given retail investors a simple way to go "long" resources, Epstein
argues that the "smart money," the commercial traders and producers
themselves, are betting for a fall in prices.

   The position outlined in the Barron's article claims that the rise
in commodity prices owes more to speculation than Chinese demand
growth-at least since September of last year. According to Epstein,
analyst Steve Briese's, "Analysis of commercial hedger positions leads
him to believe that commodities in general were fully valued in terms
of the fundamentals as of early September 2007. Based on the
24-commodity S&P Goldman Sachs Commodity Index, that would mean
about a 30% collapse from present levels."

   Other factors which could lead to falling commodity prices,
according to Epstein: a rally in the U.S. dollar (reducing demand for
dollar-denominated commodities), a non-recession in the US economy
(leading to a rotation out of resource shares back into other stocks),
less buying by the index funds as falling Gold and oil prices lead to a
reallocation of institutional money, and a fall in Chinese demand.

   All of these scenarios are possible.

   Yet it is hard to reconcile the commodities "bubble" theory with the
reality that prices for tangible goods in the real economy are going up
because of real demand and scarcity, not financial speculation. For
example, prices for medium-grade Thai rice have risen from US$360 a ton
last year to US$760 a ton last week. There are other examples:

• Russia's Agriculture ministry has slapped tariffs on mineral
  fertilisers containing nitrogen, phosphorous, and potassium. The
  tariffs are designed to make more fertiliser available local grain
  growers in the face of high global grain prices.
• China's government raised spending on agriculture by 36% over
  last year in an effort to curb politically destabilising rising food
  prices. The government raised wheat and rice prices by ten percent to
  encourage local production and prevent hoarding. China's Premier Wen
  Jiabao called agriculture the "priority of priorities".
• Indian rice traders have begun hoarding rice from sale, banking
  on much higher prices. "Rice prices are likely to increase...with major
  rice exporters Vietnam and India yesterday confirming that they will
  curb overseas sales in an effort to combat food inflation," according
  to Arabnews.com.
• And from today's Herald Sun, "Global food prices, based on
  United Nations records, rose 35 per cent in the year to the end of
  January, markedly accelerating an upturn that began, gently at first,
  in 2002. Since then, prices have risen 65 per cent. In 2007 alone,
  according to the UN Food and Agriculture Organization's world food
  index, dairy prices rose nearly 80 per cent and grain 42 per cent."

   When countries start imposing export tariffs on key commodities, it
has two consequences. First, prices rise as the global tradability of
the commodity declines. Second, it highlights the essential physical
nature of key commodities: you either have them or you don't. If you
don't have enough of them, you limit their export abroad.

   Rising food prices or an out-and-out shortage of food and cooking
oil are serious political issues for governments all over the planet.
This suggests to use that the ceiling for grain prices-given
historically low grain supplies-is very high.

   To argue that a decline in industrial commodities like base metals
and oil is a dress-rehearsal for a decline in the soft commodities and
grains ignores the physical component of high prices (and 2.3 billion
people who need to be fed).

   Instead of arguing for an across-the-board decline in commodities as
a result of reduced financial speculation, we'd be a lot more selective
and say you have to be choosy about which resource prices are
sustainable and which may be subject to a larger correction.

   It's possible you could see a massive unwinding in the long
positions commodity index funds have established. But if commodity
prices do fall by 50%, it is far more likely to come from a collapse in
demand brought about by real shortages in food and fuel instead of a
shift in financial demand.

   A China collapse remains the real threat to
long-term resource prices. But a China collapse-barring some escalation
in Tibet-related tensions-would almost undoubtedly be related to
soaring inflation in food and fuel prices (and not a collapse in
financial markets).

  
Still, the shift that drove investors away from broad-market index
funds and into commodity-based funds to begin with is still on. That
shift reflects decades of under-investment in productive capacity for
real goods and a decade of over-investment in real-estate and
hosing-related assets.

   
You should certainly be aware of and be prepared for volatility in
resource prices. Just witness what's happened to Gold Prices so far in 2008. But we'd argue the shift to tangible assets and away
from financial assets is a reflection of the times we live in, where
assets that inflated because of the credit bubble will now fall in
value. To argue that commodities are just the latest beneficiary of the
credit bubble is to ignore the real growth in demand that's far
exceeded the growth in supply over the last ten years.