Wednesday, March 26, 2008

Reassessing Commodities Run

When global share prices were rocked by the Bear Stearns debacle, prices for most commodities corrected as well. Is this the peak for commodity prices? We learnt at school at commodity prices do not move as one with other assets. In recent months that has proven to be very true as commodity prices continued to climb even as major corrections were seen in property, shares and bonds. However, last week saw commodity prices giving a wobble as if it is on very shaky ground.

Let's re-examine that fateful day when commodity prices literally plunged. We had oil breaching a new record of US$111.80 a barrel before collapsing to US$103.23 — the biggest drop during a single day in 17 years. The Goldman Sachs's main commodity index fell by over 4%. At the Chicago Board of Trade, wheat, corn and soyabean futures fell by as much as the exchange's rules permitted. The price of coffee dropped by 11%. Even CPO tumbled like a poor Jenga player.

That singles day itself sent many analysts to pull back their BUY and Overweight ratings on plantations to Neutral or Reduce within the next couple of days. It was important for them to do so because plantations had remained one of the last bastion of buys left. Were these houses too early? Short answer: YES. Long answer: Hell YES.

It was very clear that the fall in commodity prices was due to funds and investors seeking to cover losses in other markets. We must remember that although the Dow has regained substantial ground after the BS sale to JPMorgan, prior to the deal, the US markets nearly collapsed on a confidence crisis among the banks. Hence the Fed's US$200bn and backing the BS deal were critical albeit theoretically flawed. With that scenario, many funds and big time investors, hedge funds etc... sought to cash out of positive investments in anticipation of a "collapse and probable big redemptions from affected funds".

The economic outlook for America is weak but there is stronger evidence by the day that emerging markets will continue to grow relatively strongly. The decoupling view looks to have more credence - though its still more of decoupling in country economics, not decoupling in financial markets.

Look at the facts. Global copper inventories amount to only two weeks' demand. Lead stocks are closer to one week's worth. Stocks of oil are also unusually low. So even small disruptions to supplies prompt dramatic reactions from the markets. Aluminium prices, for example, have risen in recent weeks because of a shortage of power in South Africa, which has reduced output from several smelters. Fears of a shortage of hydroelectric power in Chile are helping to buoy the price of copper. The demand factors for CPO still outstrips the supply factors - its still a seller's market.

While companies and governments have reinvested heavily to bring up supply in most commodities - it is not easy and there is a huge time lag. The dollar's decline also seems to be fuelling commodities' rise. Gold, in particular, has risen as investors seek a hedge against inflation and turbulent markets. The falling dollar also pushes the prices of other commodities higher as they are priced in dollar while most sellers demand local currency trades.

Weaker dollar = Higher commodity prices = Sustained emerging economies = Inflationary pressures = Emerging countries subsidise prices heavily to ward off inflation = Demand for commodity still strong. From that chain of events, we see many governments trying their best to absorb the inflationary pressures, and at the same time allowing their currency to rise as well. As many of these emerging economies are still experiencing strong growth and surpluses, they can still subsidise many products to ward off the commodity price jumps and related inflationary pressures (so far). Hence this is still for sustainable demand despite the very high commodity prices.

The very sharp rate cuts by the Fed will have the immediate effect of averting the confidence crisis in banks. It would also have pumped a lot of liquidity to save dubious debts and questionable assets. More importantly, it would have the effect of promoting even more sustaining growth to the emerging markets. The dollar, despite recovering last week, should be trampled in the coming months - which as argued will lead to higher commodity prices again.

Hence those houses which downgraded plantations, may have been too trigger-happy. Stick with the commodities. In which case, Tenaga better be buying their coal requirements quickly rather than wait for better levels.

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