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Friday, March 28, 2008 11:23 AM


Eye on Commodity Prices


There was an interesting "buzz" on Minyanville on Thursday about commodity prices. Here goes from Minyan Peter:

Three things that caught my eye this morning:
  • The WSJ reporting that Valero (VLO) is cutting back refining output because of a surplus of supply.
  • Oil trading flat/down despite the announcement of a terrorist bombing of a major Iraqi pipeline.
  • The CME announced an increase in commodity trading marginrequirements.
While discrete events, all again raise the question of peaking consumer
commodity prices. Two things to keep in mind:

First, commodity price inflation has been cited repeatedly by the Fed as a concern. And given the view of many that the most recent price rises are a function of rampant speculation (versus fundamental demand) I would not underestimate

a) the pressure placed on the CME to increase margin requirements by banking regulators to curtail speculation

b) how stability in commodity prices (let alone price declines) opens up the Fed's ability to drop short term rates further without pummeling the dollar.

Second, while everyone will likely cheer commodity price declines as the savior of the US consumer, asset deflation, whether in housing, commodities or anything else is like Kryptonite to the banking industry. And don't forget, too, how much lending (particularly M&A related) has been done in the past five years in support of commodity related companies - particularly in Asia.

At least to me, commodity price deflation eliminates any notion of decoupling.
Death Spiral Becomes Born-Again Experience

Bloomberg is writing about a Born-Again Experience at Red Kite.
Rising prices for industrial metals and other commodities have pulled thousands of new investors into what were once illiquid markets. Money invested in commodity hedge funds surged 83 percent to about $55 billion in 2007 from $14 billion in 2005, according to estimates by Chicago-based Cole Partners Asset Management. Mutual funds tracking commodity indexes held $125 billion at the end of 2007, compared with $25 billion in 2003, according to Barclays Capital.

"The world is going through the biggest industrial revolution it has ever seen, and it's affecting the largest part of the human population ever," they [Michael Farmer, co-founder of hedge fund Red Kite Metals and his partner, David Lilley] wrote in an e-mail. "This is bringing a combination of millions of new consumers and cheap manufacturing capacity. The implications for raw materials are dramatic, and the world has to learn to value them more highly."

Not everyone agrees that commodity prices will keep rising, especially at a time when economists are predicting a U.S. recession and global slowdown.

"I think where we're really at in the commodity business - - and I've been at this since the 1970s -- is we're overvalued in a number of areas,'' says Don Roose, president of West Des Moines, Iowa-based brokerage U.S. Commodities Inc. "We're nearing a commodity bubble that is very similar to the dot-com bubble.''

Donald Selkin, director of equity research at Joseph Stevens & Co. in New York, says the commodities boom has little to do with supply and demand.

"Massively Misguided"

"The near-record prices that we are seeing come from speculators -- it's massively misguided bullishness," he says. "All economic data we have seen -- durable goods data, economic growth -- are quite negative. It will backfire one day, though I don't expect a market collapse in copper."

Though it also trades aluminum, nickel and tin, Red Kite Metal's main business is copper. It buys the metal from producers in North and South America and sells it to companies that turn the metal into wires and pipes for home and office builders and carmakers. The fund trades copper futures on the LME and buys the physical metal, holding it in warehouses around the world until Farmer and Lilley are ready to sell.

Red Kite moves markets via the huge trades it executes. According to a prospectus sent to potential investors in 2006, Red Kite Metals at that time was borrowing an average of six times its investment pool, which an investor estimated at about $1 billion.

At the March 20 price, that would buy about 750,000 metric tons of copper, or almost four times the combined total metal stockpiles currently held at warehouses registered with the Comex division of the New York Mercantile Exchange, the Shanghai Futures Exchange and the LME.

"If you buy a million tons of copper, that's guaranteed to get the market up," says David Threlkeld, president of metals trading firm Resolved Inc. in Scottsdale, Arizona. Threlkeld was the man who blew the whistle on Tokyo-based Sumitomo Corp.'s illegal effort to corner the copper market in the 1990s.

"RK holds physical stocks of metal as part of its investment strategy," Farmer and Lilley said in a February e-mail. "As a matter of policy, we don't comment on specific positions."

The kings of copper continue to believe that as long as China and India keep building, an investment in the red metal can't lose.
Commodity Speculation

When one points to commodity inventories being at record lows, those inventories do not take into account all the speculative inventories. Red Kite admits being leveraged 6 times. And Red Kite is just one such company. How many more hedge funds are stockpiling metals and/or leveraging futures? In what amounts?

Regardless of what China and India are doing, in light of a slowing economy combined with pressure on the CME to do something about speculation, it's quite a leap of arrogance to believe "investment in the red metal can't lose". With enough leverage, anything can lose, even in mostly favorable conditions.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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