The more things change

By Gerry van Wyngen –
The biggest commodities boom in more than 20 years is under way, but there are dangers for investors.
Investors with long memories may remember 1979 and 1980, when gold prices raced to $US850 an ounce, then tanked. Concurrently silver prices went through the roof, then collapsed, bankrupting the Texan billionaire Nelson Bunker Hunt. It is now well known that Hunt tried to squeeze the market. What is not generally known is that a similar operation was going on in gold, with a big European bank leading the charge.

Even less publicised was a squeeze on base metals being exerted by the commodities funds that flourished at the time. Long after supplies exceeded demand by an increasing margin, copper was one of the metals still being propped up by speculators, especially the funds.
Twenty-five years later everything has changed, and nothing has changed. Commodities funds have largely been replaced with hedge funds that hold assets totalling almost $US1 trillion.
If that seems gigantic, it’s only the beginning. When George Soros made his famous raid on sterling, a couple of big international banks lent him billions on a 2.5% margin: for every $100 million of equity he invested, the banks lent him $4 billion. If the currency moved in his favour that increased his equity. If it moved adversely, he had to make up the difference.
Such high gearing is part of the modus operandi of the hedge funds. It is not an exaggeration to estimate that $US1 trillion of equity gives an astounding $10 trillion of buying power in many financial markets.
Which brings us to the present: the biggest commodities boom seen since 1979-80. The rules are more refined now, and regulatory authorities attempt to prevent false markets and blatant squeezes. Obviously there are limits, as it is usually difficult to state what a false market is.
That many funds and speculators are heavily bought in commodities is undoubted. Some have bought hard assets to protect their investors from depreciation of paper money. Others are momentum players, buying if a commodity breaks upward in price, and selling if it breaks down. Others still buy to take supply off the market and force up prices.
Whatever the motive, the result is often the same. An example may be copper, where there are sound reasons to believe the current trade shortage would probably be a surplus now, were it not for the action of investors and speculators. Two documents published by the highly reputable International Copper Study Group (ICSG) support this belief.
In its analysis of the year 2004, the ICSG states that refined copper production increased 6.2%. Usage in 2004 increased by 5.6%. The big consumers were: United States 5.5%, European Union 2.1%, Japan 6.4%, and China an astoundingly low 3.6%. The ICSG suggests that China’s usage could be complicated by unreported stock changes. For 2005, the ICSG predicts production to increase 8.5%, but usage to increase only 5.3%. This is still projected to result in a small copper deficit.
The unreported stock movements in China are of course the proverbial tip of the iceberg. Buying of physical metal by funds and speculators in the US, Britain and Europe has taken large amounts of metal off the market, giving the appearance of consumption by trade buyers. The apparent copper deficit is by now, in all probability, a growing surplus.
Within that perspective, the closeness of a supply crisis may surprise. The total copper stock held by the London Metal Exchange, the world’s largest, would cost less than $A200 million to buy. A larger market than the base metals is steel. Earlier this year miners extracted a 71.5% increase for iron ore from steel makers, and an increase of more than 100% for coking coal, for deliveries beginning April 1.
Steel manufacturers see a different picture. Corus Group, Britain’s largest manufacturer, says European steel demand will rise 2% this year (3% last year), and US demand 3% (9%).
At the coalface, figuratively speaking, it looks worse. Speaking at a steel conference in Luxembourg last month, a representative from respected steel trader Koch predicted that prices of hot rolled coil, which traded at E515 a tonne in February, would decline to E465 in the June 2005 quarter, and E422 by February 2006.
Presumably, the predictions by ICSG and Koch were based on normal demand/supply projections. That leaves open some fascinating variations. It is now generally agreed that further increases in interest rates in the US are in the pipeline, which will dampen building construction and therefore copper’s main usage in the US. Steel demand will also be cut.
Of course, China will still exert strong demand, but will it be of the level generally believed? Copper stock movements in China suggest that there may be some large metal inventories, and some unexpected changes ahead. As well, there is the danger that the hot US dollars currently going into property speculation in China may lessen as US interest rates rise.
Commodities are only part of the story. The Australian dollar is most closely linked to commodities prices, more so than interest rates, which raises serious questions about where it will be trading in a year’s time.
Gerry van Wyngen is an investment banker and chairman of CPI Group
Source: BRW Magazine