Gold: Deleveraging Over?

"Everything else has to go right for the price of gold to fall..."

ONE OF THE MOST established names in the commodities industry, Jeffrey Christian is founder of the CPM Group, the New York-based commodities research and asset management firm focused on the fundamentals, reports Hard Assets Investor.

Also author of Commodities Rising – a 2006 book examining the long-term outlook for raw materials prices – Christian was head of commodities research at J. Aron & Company, acquired by Goldman Sachs, before founding CPM.

Here he speaks with HardAssetsInvestor.com about recent trends in Gold Prices and the commodities market, and how investors should be positioning their portfolios to take advantage.

HardAssetsInvestor.com: Let's get right to the point, Jeff. The commodities markets and commodities pricing has been crazy recently. Just look at oil, moving from $50/barrel to $140/barrel and back to $50/barrel again. What is going on?

Jeffrey Christian, founder, CPM Group: Basically what you're seeing right now is a massive liquidation of assets across all asset classes. You're seeing institutional investors and proprietary trading desks liquidate their leveraged investment positions, at any price.

They've been doing it for a couple of reasons...

1. Prices are falling;
2. Credit lines are either being pulled back or completely taken away.

So in many cases, these investors have no choice but to liquidate their positions.

The size of the paper markets for currency and commodity futures is huge. If you look at Gold Futures, silver and currencies, the ratio of underlying assets to derivatives is 100-to-1. In commodities, it's probably 40-to-1. So you have all these paper assets being sold back into the market.

Basically, everybody's running for the exits at once. That's what's causing prices to fall.

HAI: How far along are we in this process?

Jeffrey Christian: There's no way of knowing for sure. If you look at gold and silver, there has been unprecedented demand for small gold and silver products at the same time that these leveraged positions are being liquidated. You've seen very little liquidation on the Comex. A lot of the liquidations are taking place in over-the-counter products, which makes sense, as that is where the leveraged money was operating.

But there is no visibility into the over-the-counter market. There are simply no numbers. You don't know how much there was at the start of the liquidation, and you don't know what's left. The sense is that we're pretty close to the end of the de-leveraging process, but we're not quite there yet.

HAI: What happens when we do get to the end of de-leveraging?

Jeffrey Christian: At the end of the de-leveraging, you will see a divergence between Gold Prices and silver on the one hand and industrial commodities on the other. Even today we have this very strong demand for physical gold and silver globally, from India to the Middle East to America.

Once the de-leveraging ends, I think gold and silver prices could spike sharply higher, possibly as early as late November or early December. The industrial metals, on the other hand, might start building a base. I think they may move up from where they are today, but it could take a while. People will look at them through the lens of the recession, and they will assume demand for industrial metals will be less forthcoming.

HAI: Has the collapse in commodity prices scared off some of the new entrants in the commodity space? And won't that dampen any recovery?

Jeffrey Christian: What we've found is that there have been very few commodity funds that have simply closed and left the commodity space. The vast majority of fund companies are simply moving to cash. That's important because when the prices bottom out, these guys will start investing again, and prices will rise because of their reinvestment patterns.

HAI: What about the large pension funds and institutions, many of whom just got into commodities right near the peak? Will they stay the course, or will they pull up stakes and go home?

Jeffrey Christian: I think some will be scared off but the vast majority will stay. They will be chastened, and for at least the next 12 months, they will remember that the market can go both up and down. But they will still be there.

You saw a similar trend after the Tech bubble. People got in near the high and lost a lot of money, and they were scared off and didn't invest in technology for a while. But eventually they came back in, albeit in a more chastened and rigorous fashion. We're actually excited that this might mean more interest in the kind of fundamental analysis CPM provides. We think some of the people who rushed into the market and bought long-only indexes and such will say, "I'm still interested in commodities, but I want to do it more intelligently now." They might want to do a long/short approach more grounded in both macroeconomic analysis and microeconomic analysis of what's driving individual commodities.

HAI: Let's turn to some of those individual commodities. What's your take on the agriculture space?

Jeffrey Christian: We focus on the tropical agricultural commodities, and our view varies from commodity to commodity. We're more bullish today on coffee and less bullish on cocoa, for instance. Cocoa is a more price- and income-sensitive commodity. As people cut back on their budgets, given that cocoa prices have been rising over the past few years, you'll see people buying less cocoa and chocolate. Once people start drinking coffee, on the other hand, they're hooked, and they tend to be less cost sensitive and price sensitive.

HAI: What about energy?

Jeffrey Christian: On energy, we have a complex view. We think crude oil will be extremely volatile. We've moved from a period in the market where you had a very tight supply/demand balance to a period where capacity is exceeding demand. Moreover, capacity will grow more rapidly than demand over the next year or so. In that kind of environment, oil can trade from $50-$70 per barrel for a while. Eventually, I think it goes back up.

HAI: During the heyday of the commodity bubble, you cautioned investors that there would be a major supply response to continued high prices. Are we seeing that supply response, and how has it been impacted by the credit crisis and recent price drops?

Jeffrey Christian: You're seeing discussions of this in the oil market, and it's true in base metals and other commodities too. One of the ironic outcomes of the current financial problems is that it will be more bullish or commodities two-to-four years out than would have otherwise been the case.

You did in fact see a supply response to high prices in oil and other commodities over the past few years. But with the current financial constraints, the provision of financing for new development in a number of commodities is being pulled. You're also seeing mines cut back and close, in aluminum, copper, molybdenum, gold and other commodities.

So, long term, you will have a supply constraint, and that will be more bullish for prices once demand returns.

HAI: Everyone I talk to is bullish on gold. I wonder: What could go wrong? What could keep the price of Gold Bullion down?

Jeffrey Christian: The answer is that everything has to go right for the price of gold to fall. We've spent an incredible amount of time over the past few years thinking about what could cause gold prices to fall, and our conclusion is this: For gold to fall, all of the factors that have driven the price of goal upward over the past seven years would have to reverse. That means better economic conditions, a more stable and predictable currency market, reduced inflationary expectations, stronger equity and bonds markets, and a more stable political environment.

HAI: Sounds nice to me.

Jeffrey Christian: It would be nice, yes. But you really have to get back to a place where the economic, political and financial situations are less worrisome...before you see people sell gold and push prices lower. That's the most likely scenario for lower gold prices we can come up with.

HAI: One final question: Should investors be considering commodity equities here, given the pullback in those markets?

Jeffrey Christian: We don't talk publicly about individual equities. But we do, of course, look at them, and it is true that a lot of commodity equities are starting to look more attractive now.

I've been spending a lot of my time with clients talking about the difference between value and price. In the Gold Mining equity market or any other mining market, even oil and gas, you saw that the price of the equities last year exceeded what could be considered a reasonable value. Now, the prices of a lot of equities are far below what you could consider a reasonable value for the enterprise.

We're finding a lot of investors who are working really hard studying different commodity, mining and oil and gas investment opportunities. So far, though, they are not pulling the trigger. They're waiting for a sign that the commodity markets have turned, and then they will come in and buy.

On the supply side, there is a tremendous amount of money looking for good investments right now. On the demand side, you have a lot of projects that are grossly undervalued, because they are caught up in the moves of the broader markets.

HAI: Sounds like an interesting opportunity. Thanks, Jeff, for your time.