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What Inflated the Commodities Bubble?

Posted by commendatori on August 2, 2008

Crude Oil has corrected over 15% from the top. Gold, Silver, Copper, Wheat and other commodities too have retreated from their respective highs. The heavy selling witnessed in last few days, has raised concerns that the air is leaking from the Commodity bubble and that a multiyear bull market might end soon. It has been pretty well established of late, that the commodity market has been exhibiting many of the characteristics of a bubble. Thus, we may be very well at the beginning of a bursting asset bubble.

Historically, price bubbles have been destined to burst under their own weight, and at a moment’s notice. No market travels in a straight line forever and what goes up inevitably comes down. And as the charts of the dot-com and housing bubbles show, the fall can be just as dramatic as the climb. Now, when the bubble in the commodity space is showing signs of cllapse, an analysis of various factors that inflated the same will make for an interesting study. Now, when the bubble in the commodity space is showing signs of collapse, an analysis of various factors that inflated the same will make for an interesting study.

Commodities prices have increased more in the aggregate over the last five years than at any other time in U.S. history. Commodity price spikes have occurred in the past as a result of supply crises, such as during the 1973 Arab Oil Embargo. But today, unlike previous episodes, supply is relatively ample: there are no lines at the gas pump and there is plenty of food on the shelves.

It can be said that what we are experiencing is a demand shock coming from Emerging economies like China and India . In recent years, the two countries, which together possess more than a third of the world’s population, have witnessed rapid economic growth. There has been a jump in national income; consumption levels and standard of living in this part of the globe on back of heightened pace of industrialization, urbanisation and benefits of globalization. It is being suggested that this particular demand factor was something which attracted new category of participant in the commodities futures markets: Institutional Investors like Hedge Funds, Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments etc. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.

According to the US Department of Energy, annual Chinese demand for petroleum has increased in the past five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels. In the same five-year period, Institutional investor’s’ demand for petroleum futures has increased by 848 million barrels. In other words, they have almost created another China in terms of demand. However, what was being ignored was that these economies are still not consumption/export driven. Also, the population and politics of these countries, unlike the western ones are quite price sensitive and any abnormal rise in price is met by demand destruction.

The rise in global food grain prices has also been attributed to the phenomena of “Agflation”, i.e., diversion of crops and land for biofuel cultivation. A large portion of corn is being diverted to produce ethanol which has emerged as an attractive substitute for Crude Oil. A leaked internal World Bank study suggested that biofuels have forced global food prices up by 75%.

OPEC, which accounts for 40% of total World Crude Oil production has also been blamed for the high Crude Oil and commodity prices. However, despite repeated pronouncements about an increase in shipments, OPEC appears to be losing its ability to influence the price of oil. According to Societe Générale economist Deborah White. “It is no longer within the power of OPEC to keep prices at $28 a barrel, OPEC can only set the floor, not the ceiling.” On its part, OPEC has repeatedly blamed financial speculation in Crude Oil, use of Ethanol as Crude Oil substitute, weaker Dollar and “mismanaged US economy” for high Crude Oil prices.

As has been the case earlier, whenever prices of anything have gone up dramatically, people readily blame it on “speculators.” It has been suggested that the “Index Speculators” have now stockpiled, via the futures market, the equivalent of 1 billion barrels of petroleum, effectively adding eight times as much oil to their own stockpile as the United States has added to the Strategic Petroleum Reserve in the past five years. However, in a free and liquid market, it would be difficult for speculators to have that much influence. While speculators may have some short-term effect on prices, most investment professionals and institutions, largely discount such notions.

Globally, most of economists are now arriving at a consensus that the skyrocketing commodity prices can be best explained in terms of “Too much money chasing too few commodities”. In recent times, monetary policy of US Federal Reserve has been seriously questioned and criticized. In order to arrest Subprime rout and Housing slump, the Fed slashed the Federal funds rate from 5.25% to 2% at a frenzied pace. Ben Bernanke, in a bid to put a floor under the housing and stock markets, cranked up the growth of the MZM money supply to an explosive 15.4% annual rate. As a result Dollar’s value plummeted, sending commodities price to sky high. Already, due to turmoil in financial markets investors had began shifting from equity to hard asset. A combination of uncertain macroeconomic climate and growth in money supply only worked in favor of a commodity rally.

Dollar’s value has special bearing on commodity space, as the chief commodity, i.e Crude Oil is priced in Dollars. “The Fed is printing money and are trying to prevent the recession, they are putting on Band Aids,” commodities investment guru Jim Rogers said. Rogers added that “as long as the US central bank and the federal government keep making mistakes, you will have a longer period of slowdown, and it will be perhaps, one of the worst recessions we have had in a long time in America .” However, Ben Bernanke cannot be entirely blamed for his act as he was merely responding to the Housing Crisis (or Subprime Crisis) brought about by a low interest rate policy of his predecessor Alan Greenspan. Alan Greenspan, on his part was forced to keep interest rate low as US economy was struggling from the IT bubble burst.

Thus, to counter the ills of IT bubble burst, Greenspan slashed interest rate and thus encouraged bubble formation in US Housing sector. When the bubble in Housing sector got busted, Ben Bernanke was left with no option but to follow his predecessor’s policy and led to the bubble formation in commodities. It is being suggested mildly now that IT, Housing and Commodities bubble are interlinked, with one leading to another. According to this view the recent bubbles have been largely an incidental byproduct of focus, policy and actions of Central Bankers, specifically that of US Federal Reserve.

Whatever may be the case, the effects of the abnormal run up in prices of commodities is now very much visible in the streets across the world. Price pressures across the world are reaching levels that may soon threaten economic, political and social stability. Global inflation levels have reached uncontrollable levels, food riots have broken out in Haiti , Egypt , Bangladesh , economic growth has moderated and even slowed, Equity market has been witnessing massive selloff and thousands of jobs across the world are being lost. Policymakers are themselves finding themselves in a fix as they are facing a lethal combination of high inflation and slowing growth, also referred to as “Stagflation. Thus, “Commodity Bubble” is certainly a bubble which everyone wants to be pricked!

By Salman Khan

Article URL : http://www.marketoracle.co.uk/Article5710.html

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2 Responses to “What Inflated the Commodities Bubble?”

  1. ICICI Bank and HDFC have increased home loan rates by 0.75 percentage points, moving quickly to preserve margins in the wake of RBI raising key interest rates. This is the second hike from the top two home loan providers in the phase of a month. ICICI Bank hiked the floating reference rate (FRR) for consumer loans, which also includes home loans, to 14.25 from 13.5 per cent, with effect from July 31. HDFC’s adjustable rate home loans will be priced at a minimum of 11.75 per cent with effect from August 1. Its fixed rate remains unchanged at 14 per cent per annum. The bad news is that a 0.75 percentage point hike will mean customers on floating rate home loans will have to pay an additional EMI of Rs 51 per lakh on a 20-year term. The good news is that the increase in interest rates may be offset by a fall in real estate prices.For more view- realtydigest.blogspot.com

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