Is Jim Rogers Crazy?

September 06, 2007

 Do speculators matter in commodities? Or are they irrelevant to a long-term investor?

  • Short-term vs. long-term
  • Who's driving the bus?
  • How big a role do speculators have?

“There are always corrections in every bull and bear market. If you think this will change the secular bull market, you have no clue what is going on.”

 

  • Jim Rogers, on the credit crisis and commodities

 

Two weeks ago, I emailed a handful of the smartest people I know to ask them if the current credit crunch and the ongoing vacillations in the stock market would impact the commodities market. The exact question I sent was this:
What do you think of how the credit crisis is impacting the commodities market? Should commodities investors be worried?”

The answers I got were usually well-reasoned and carefully considered, and typically focused on the impact of speculators pulling out of the market. And then there was Jim Rogers. In the way only he can do, Rogers framed the issue simply and succinctly.

“There are always corrections in every bull and bear market,” he wrote. “If you think this will change the secular bull market, you have no clue what is going on.”

You gotta love it.

I give Jim a lot of respect. But then again, I give the other people I emailed–like Hilary Till, principal at Premia Capital and co-editor of the new book, Intelligent Commodity Investing–a lot of respect too. Here’s what she wrote:

"In the short term, yes, the commodity markets were (and are) clearly impacted by the "de-risking" and deleveraging. For example, on Thursday (8/16/07), all commodity markets (that are in the DJAIGCI) were down. Then on Friday, after the announcement of the Fed action, there was a simultaneous rally of risk assets."

The obvious difference between Rogers and Till is time frame. As anyone who has read Rogers’ book, Hot Commodities, knows, Jim is a very big-picture investor. His investment thesis looks out 10, 20 or more years into the future, and his bullish position on the commodities market is predicated on a long-term supply/demand imbalance. Till, meanwhile, is a hedge fund manager who, by nature, responds to both short- and long-term trends.

But their different perspectives got me to thinking. Even if speculators aren’t driving long-term trends, how much are they influencing the short-term market? And where, exactly, do those short- and long-term trend lines meet? Moreover, don’t short-term pricing issues also impact the commodities market over the long term?

A warning to readers: This article asks more questions than it answers. But it does, at least, lay out the data and make some assumptions about how markets are moving.

Speculators Do Matter In Commodities

Let’s start with what we know.

Point 1: Speculators do matter in the commodities market, both short and long term.

History shows us that–at least in certain situations–speculators can have outsized and lasting impacts on commodities. When the Hunt Brothers attempted to corner the market on silver, for instance, they drove up the price to $50/ounce. There might be a long-term supply deficit for silver, but if you bought at $50/ounce, you’ll be waiting a long time to get back to even.

Source: Goldinfo.net

Similarly, we’ve seen price spikes on the London Metal Exchange (LME) recently that were undeniably linked to speculative moves. These cases, such as the recent run-up in tin and similar spikes in nickel, were the result of classic short squeezes: Traders sensed that physical inventories of different metals were tight, and they caught the shorts in a squeeze by buying up all the available metal. Sellers were forced to pay exorbitant prices just to get back to even.

Point 2: Over the short term, commodities have become risk-sensitive assets.

Time and again during the recent bull market, the commodities futures markets have suffered serious setbacks hand in hand with stock market pullbacks, including the May/June 2006, February 2007 and mid-August 2007 retreats. This is contrary to the broad perception of commodities, which holds that they are negatively correlated to the equity markets. Recently, they have been strongly correlated–even leveraged–to the volatile trends driving stock prices.

Consider what happened from May 10, 2006, through June 13, 2006. As investors pulled out of the stock market, the Nasdaq index fell 10.4% and the S&P 500 fell 7.3%. Over the same time frame, "hot" commodity investments like silver (down 32%) and copper (down 18%) fell further.

May 10, 2006 Through June 13, 2006–Risky Assets

Nasdaq

-10.4%

S&P 500

-7.3%

Copper

-18%

Silver

-32%

A similar pattern was revealed on August 16-17, days that bracketed the worst of the recent subprime-mortgage market pullback. On August 16, the S&P fell 1.2% and the Nasdaq fell 2.2%, but copper plummeted 7.9% and silver sold off 9.5%. In fact, everything was down … even the broad-based Dow Jones AIG Commodity Index, which fell 3.4%, netting one of its biggest one-day pullbacks ever. Gold—the ultimate “safe haven”—melted down 3%, continuing a trend of volatile performance.

The next day, the Fed cut the discount rate, and stocks and commodities alike rallied: The S&P rose 1.5%, copper gained 2.0% and silver jumped 2.8%.

Caveat emptor.

Subprime Crisis–Risky Assets

Asset

August 16

August 17

Nasdaq

-2.2%

0.9%

S&P 500

-1.2%

1.5%

Copper

-7.9%

2.0%

Silver

-9.5%

2.8%

Point 3: Speculation Has Increased…

Another thing we know for sure is that speculation has increased … dramatically. You can tell this just from the cocktail party circuit, where your buddies are as likely to talk to you about copper prices as they are the latest hot tech stock. But you can also tell it from cold, hard data.

According to the CFTC and Citigroup Investment research, “speculative” positions in commodities–non-commercial traders who typically have a short-term time frame in mindhave risen from less than $10 billion in January 2001 to more than $105 billion today.

That tenfold increase reflects both long and short positions, added together. Net, traders have gone from having essentially zero exposure to holding over $65 billion in speculative positions. But then again, part of the challenge with some commodities (precious metals) is that they are, nearly by definition, speculative. Untold masses horde gold bullion and its derivatives solely because of its expected price movement characteristics, with no real thought to what few industrial applicationswhat you might think of as utilitarian demandand real supply (mine production).

Point 4: Investment Has Also Increased

Citigroup says that investors (longer-term strategic players in the space) now have about $300 billion tied up in the commodities markets, with more than half of that nearly $160 billioninvested in commodity indexes. Commodity indexes barely existed in relative terms just four years ago: Investors held just $10 billion in commodity index assets in 2003. This incredible growth has occurred despite the fact that many commodity indexes peaked in early 2005, and have yet to regain their prior highs. (Are index investors speculative? Maybe. But that’s the way they define these things.)

Point 5: These Are Large Positions

These are massive positions; don’t let anyone tell you different. Sure, $300 billion is about equal to the market cap of Exxon-Mobil, so these investment positions are not that big. But compared to the size of the actual economic consumption of the goods themselves, they matter. Unlike Exxon stock, someone out there needs to actually consume corn. Nobody goes out and turns that Exxon stock into something else. The $50 billion invested in base metals represents something like 16% of the annual demand for copper and aluminum, if those contracts were converted to physical metal. To put that in perspective, the U.S. only accounts for 12% of global copper demand, and 18% of global aluminum demand.

Point 6: Speculators Don’t Necessarily Drive Up Prices

Are speculators driving the market? In a word: No.

Speculators are always the first thing that gets blamed when commodity prices skyrocket, but it’s important to remember that futures speculation does not actually add to the physical demand for a commodity. An investor in the S&P GSCI or DJ-AIG, for instance, never actually takes possession of oil or the other commodities in the indexthey sell expiring contracts and buy new ones each month (and as in most markets, there is a seller for every buyer in commodities futures).

Now, someone must take delivery of those contracts, and one fallout of growing investment volume must be more centralized delivery of commodities. We saw that last year in Cushing, Oklahoma, which is the delivery spot for the NYMEX oil contract. So much oil was coming into Cushing that its tanks were totally full, and prices actually fell there compared with the rest of the market. No one wanted oil in Cushing. This is, in a way, refreshing, because it implies a certain utilitarian sanity to at least local pricing.

Supply, Demand And Tight Markets

How does all that trickle down into the market and impact prices? Unfortunately, there’s little agreement. Big institutions ranging from the International Monetary Fund to the U.S. Senate will tell you that “speculation” in the commodities market is responsible for huge “premiums” and price increases. But equally august institutions and (especially) academics will argue the opposite, saying that large financial speculation allows producers to lock in future prices and therefore plan for increases in production. Without the liquidity provided by hedge funds and kindred spirits, many markets would wallow in inefficiency. Many of these folks will tell you that speculators actually reduce price spikes by facilitating long-term pricing and long-term investment in the underlying commodities businesses: If you can sell oil contracts for June 2009 at $75/barrel, you can start to make investments that are only profitable if oil stays high.

So which is it? Are speculators driving up prices, or are they capping the price spikes?

The answer may depend on which commodities you’re talking about. The thing about commodities is that they are very sensitive to possible changes in supply and demand, and to the volatility of prices. We talk about supplies of commodities being inelastic, but in some cases, so is demand: We’re not going to stop using copper or aluminum overnight. (Of course, tell a corn farmer who just plowed under his wheat fields that supply is inelastic and he'll likely kick you in the shins.)

In a market like oil, where storing the physical commodity is both costly and bothersome, the impact of speculators on short-term prices is muted. You can see this from the fact that oil markets don’t react quite as violently to changes in the stock market as other commodities. Here, the argument that speculation caps long-term pricing trends seems to make sense, by creating an environment where producers can lock in long-term prices.

But in markets like metals, which are easier to store, the impact appears to be larger. Here, speculators have a more direct impact on the price of commodities. Why? Because investors can and do hold physical metals, and that fact more closely links demand for futures to rising spot prices, because there’s always the risk that speculators could significantly disrupt supply.

For instance, we all know that the market for nickel is tight. And let’s suppose that something happens that disrupts supply in the nickel markets–a mine shuts down, someone goes on strike, etc. In that situation, speculatorsin this case most likely speculators who are in the nickel business as actual physical participantsmight flex their muscle by actually taking delivery of the underlying metal … taking it off the market … to further tighten supplies and drive prices higher. That’s one of the reasons why metals seem to be the area most impacted by speculators, and least tied to fundamentals. There’s no good reason why nickel prices soared in 2006, only to come crashing back to Earth this year. Similarly, you’d be hard-pressed to explain lead’s explosive growth this year without some participation by speculators; supply in the lead market is tight, but it’s not THAT tight to make it the best-performing commodity by far in 2007. And lead's precarious one-day drop on August 6 (8.7%) can't be considered a rational reaction to a particular piece of news: Nobody released a press release suggesting that a giant supply or demand factor had changed. Those markets moved most likely because speculators squeezed limited supplies, or at least, threatened to squeeze those supplies, and subsequently (in the case of lead) unwound.

Short-Term Prices Or Long-Term Trends?

What does this all have to do with the long-term story in commodities? Quite a bit, actually. But maybe not the way you think.

The growth of speculation in the energy markets has given producers a way to lock in long-term prices, which allows them to plan for production growth and make smart investments in growing capacity. Ultimately, that should accelerate the onset of new supplies and bring the current commodities bull market to a close faster.

In metals and other easily storable markets, the growth of speculation appears to have had a real impact on prices. The impact on long-term supply and demand is uncertain, but important. High prices will discourage demand and encourage more investment. But high and unstable prices will only serve to discourage demand, as users look to cheaper and more stable alternatives. Right now, it looks more like the latter than the former.

So here's the modest proposal: Speculators have had a positive short-term impact on prices and a long-term impact on industry investment. And that makes what happens in the speculative markets important. Because if the huge rush into commodities over the past year reverses course, and we start to see money flowing out of the sector, that could rattle producers and lead to less investment. The trick here is that a move like that would be terrible for longs in the short term, and terrible for shorts in the long term.

Makes perfect sense, right?

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