Commodities supercycle myth enters the end-game

Coffee, cotton Nov12.pngIf something seems to be ‘too good to be true’, then it usually is. This may be the learning for the world’s largest pension funds, as they plan their next moves in commodity investment.

Their involvement jumped from 2009 after central banks began stimulus programmes, as the blog discussed last month. The funds were looking for a ‘store of value’ to protect investment values, as they feared the Federal Reserve’s actions would increase inflation and drive down the value of the US$.

Oil markets seemed the perfect ‘escape route’, particularly as expert commentators assured them that commodities were now in a never-ending supercycle. And for a while, everything seemed to work perfectly, as the tidal wave of new cash sent prices soaring:

• A total of $439bn was ‘invested’ in commodity markets at the end of September, according to Barclays Capital. This was nearly 3 times total investment in 2008 ($160bn)
• By comparison, just $10bn was ‘invested’ in 2000

Overall, the Financial Times reports that financial speculators now account for 70-75% of all commodity market activity. Genuine industry players, seeking to hedge their future profits, are just 25%-30%. This is exactly the reverse of the position when futures were first established.

Speculators no longer just provide liquidity, but have instead taken over the market.

As always, the early entrants did best. They bought before the rush of new players, and sometimes made enormous profits. In particular they benefited from the ‘roll’ common to futures markets, where buyers tend to pay a premium for future delivery, which then disappears as the contract rolls towards the due date.

Now, the game is getting closer to an end. Total returns from commodity trading in 2012 are mostly negative, with crude oil returns down 15.9% so far. The chart shows how different markets have slowly begun to unwind:

Cotton prices were the first to tumble last year
• Coffee prices then fell, as consumers could not afford to buy
• Now crude oil is looking weak

The ‘network effect’ has helped to support crude prices until recently, as buyers abandon other markets and focus on the seemingly strongest contracts. But in the end, the speculators have killed the goose that laid the golden eggs. Today’s record high prices mean that supply and demand balances are gradually becoming more important again.

One day, possibly not too far away, buyers will realise they have been involved in something very similar to a giant Ponzi scheme. The money being paid over today has provided returns for others. It has not created wealth and secured future pensions.

Consumers around the world have also paid a large part of the price. Whilst when the remaining markets crash, the physical players will be left to pick up what pieces remain.

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