Like a fast-moving lightning storm, sudden jeopardy from the commodity markets has swept in to threaten the stock market as swift gains in metal and oil prices, as well as huge speculative inflows, have raised the overall risk level.
The possibility of a sudden meltdown in commodity prices seemed remote just a few weeks ago. And, if it occurs, it could stun the stock market. As a result, you and your clients may suddenly have urgent decisions to make about their portfolios.
The heart of the question is what type of bull market commodities are currently in: Is it going to continue for a decade or more, as many analysts assert; or is it driven by short-term factors? Nevertheless, regardless of whether the commodity boom is long or short, commodity analysts have quickly become nervous about speculation in energy and metals.
“Speculators move into the driver’s seat,” headlined a recent TD Economics commodity report, while Merrill Lynch & Co. Inc. analyst Richard Bernstein says the influence of speculators on commodities is “unprecedented.”
Royal Dutch Shell PLC’s chief executive estimates that US$100 billion of hot money has been put into oil. And at the recent Berkshire Hathaway Inc. annual meeting, Warren Buffet said: “You’re looking at a market [copper] that’s responding more to speculative than fundamental forces.”
The risk is a small slide in metal or oil prices becoming an avalanche. This risk occurs because a huge amount of hot money has been poured into commodities. It has arrived over time, but will want to leave at once if their managers decide the bets should be covered. “History suggests when a commodity rally ends, the initial downturn in prices is aggressive,” says a report by the London, Eng.-based international bank HSBC Group.
Much commodity market turmoil has been caused by short sales going wrong. Copper prices erupted last year when a Chinese state trading company discovered its commodity trader had gone short in a rising market. If commodity prices continue to gain, short-covering could trigger more panic purchases, alleviating the risk of a near-term collapse.
However, because hot money doesn’t talk, you can’t be sure how it has placed its bets.
But there is sufficient alarm to prompt the industrial metals industry to complain that the London Metal Exchange has allowed speculative money to disrupt the market’s normal supply-demand relationships.
Top executives of BP PLC and Shell say oil prices have been pushed far higher than they should be by speculative demand.
In the past, speculation has been encouraged by the structure of the futures market. Normally, futures prices for near delivery are lower than prices for more distant delivery. The opposite is the case now, and for a while this created an opportunity to roll over expiring contracts profitably.
The risk of a disruptive stock market collapse will diminish if metal and oil prices react downward slowly and by small steps. If they can handle a relatively small price drop, the pressure will come off and the alarm bell will stop ringing for these stocks. It is the speed of price rises that creates the potential for a fast, dramatic drop. Fast up, fast down is the equation.
Superman-sized leaps happened most recently in the industrial metals sector. The cash price of copper, for example, climbed 61% in six weeks beginning in early March. This lifted the LME spot price to US$3.54 from US$2.20 a pound. In the longer run, metal prices have gained more than oil but less than the extreme gain by natural gas.
Beginning with its November 2001 low, copper has risen 483%. From its January 2002 low, West Texas intermediate crude oil climbed 299% to its recent closing weekly high at US$71.89 a barrel. And between September 2001 and December 2005, natural gas priced at the Henry distribution hub in Louisiana gained 730%.
The biggest risk, though, is difficult to measure. It is Iran and its nuclear weapon program, its missile buildup and its threat to attack Israel. If the West can contain this threat without inciting violent response, the oil market may sail through without disruption. Anything else and the promise of US$100-a-barrel oil will probably come to pass.
The impact of a near-term commodity drop will be tempered by the nature of the commodity boom. If it has been a short-term upturn, the eventual downturn will be an avalanche. If the cycle is a long one, the downturn will be contained.
@page_break@Commodity prices, like everything else, run in long-term cycles. One analysis of past prices shows peaks in approximately 1815, 1865, 1918, 1945-50 and 1975. The shorter intervals between recent highs adds weight to the argument that a longer cycle rise is under way.
Supporting this belief are inflation-adjusted commodity prices, now at record lows, a point that Di Tomasso Group Inc., a commodity trading advisor based in Victoria, B.C., emphasizes on its Web site.
How the stock market would handle a commodity meltdown depends on the market’s assessment of the long-vs-short commodity cycle argument.
A commodity price collapse will hurt the resource-based Canadian market, whereas Wall Street may view lower metal and oil prices as bullish overall. IE