Commodity Trading Fraught With Peril

You’d be hard-pressed to find a “hot commodity” lately.
With the U.S. housing market giving investors a scare, China’s building boom facing some restraint, Iran apparently less of an immediate threat to oil supplies, and hurricanes failing to howl, commodities have been slipping since early August.

Crude oil futures on the New York Mercantile Exchange have fallen more than 20 percent since reaching a record $78.40 a barrel on July 14. Stockpiles are rising.
And hedge funds reportedly have been growing more cautious about commodity bets since Amaranth Advisors LLC, a Connecticut hedge fund, made national headlines last week after a bum move in natural gas cost the company billions of dollars.
As the hurricane season passes without destruction, natural gas prices have slipped almost 70 percent from a record high of $15.78 per 1,000 cubic feet in December.
With each day, prognostications about commodities have been turning more negative.
Although the long-term view held by many analysts, including those at the Goldman Sachs Group Inc., is that this is a lull in a multiyear global growth drama, others are starting to warn investors that the five-year bull market in commodities may have run its course.
In a recent report titled “Whither Commodities,” Morgan Stanley analyst Stephen Roach said: “For the second time in five months, commodity markets are coming under serious selling pressure. I don’t think this is a fluke.”
If the downturn becomes more than a short-term correction, the pain could be widely felt.
Individual investors have grown fond of commodities, and new mutual funds and exchange-traded funds covering such commodities as oil and gold are an easy investment, even in some 401(k) plans.
Pension funds, searching for alternatives to stocks and low-interest bonds, have developed an appetite for commodities.
Roach noted that virtually every pension-management operation he has visited lately has a department that deals specifically with commodity investments.
“The recent multiyear upturn in oil and materials prices has legitimized commodities as a serious asset class,” he said.
Assets being managed by commodity advisers have tripled during the past three years. The advisers, officially registered with the Commodity Futures Trading Commission as commodity trading advisers, manage about $70 billion, and Morgan Stanley’s Roach said they likely represent a small portion of the asset class.
The flood of investor money chasing commodities during the past few years has skewed prices so that they are not being driven strictly by fundamental demand, Roach said.
“Just as return-hungry investors chased these markets on the upside, they could well run like lemmings to get out on the downside,” he said.
Wells Capital Management strategist James Paulsen is warning investors to be leery of expectations for higher oil prices.
He said many investors believe that the decline in oil prices to slightly more than $60 is temporary. But he noted that recent events suggest otherwise.
Just before Hurricane Katrina, oil was at about $70, and even a host of unnerving events – hurricanes, terrorist attacks, nuclear concerns about Iran and North Korea and pipeline problems – have not propelled oil much above $70. Paulsen said that suggests a peak.
Although he does not see oil going back to $30 a barrel because the world economy is growing, Paulsen said the price could turn down quickly, based on speculation. And, he noted, although investors might think oil has been one of the hottest investments of the past year, oil stocks have been underperforming the market.
Roach said commodities will remain under pressure because of slowing worldwide growth.
China has been the most significant driver behind the growth in commodity consumption between 2002 and 2005. Roach attributed China’s demand for 48 percent of the growth in aluminum, 51 percent for copper, 87 percent for nickel, 54 percent for steel, 86 percent for tin and 30 percent for crude oil.
But the Chinese government now is trying to slow demand through monetary policy and administrative changes, he said. August data out of China point to some cooling, with industrial output up 15.7 percent, compared with 18 percent in June and July.
One month, of course, provides little evidence of a trend. But Roach said that if China’s output growth slows to 12 percent to 13 percent, there will be a “major downturn in global commodity demand.”
Meanwhile, a slowing U.S. housing market is also a “distinct negative for U.S. commodity demand,” Roach said.
The Copper Development Association, for example, estimates that 46 percent of total copper use worldwide is earmarked for buildings.
“When housing starts to drop, then every material will feel it,” said Andrew Kireta, president and chief executive of the association.
In addition, Roach said a downturn in the value of homes will make Americans feel less wealthy and affect their willingness to consume.
“As China slows and the U.S. property bubble bursts, a broad and protracted downturn can be expected in most economically sensitive commodity markets, including oil,” he said.
And a decline triggered by those factors could be amplified in defensive strategies by nervous commodity investors.
Meanwhile, Goldman Sachs said in a recent report that there is “a need for a cautious medium-term outlook on commodities demand.”
The moderate slowdown in the global economy could increase the risk of energy surpluses and allow base-metal supplies to catch up with demand, Goldman analyst Allison Nathan said.
“Further, as short-term investors are less motivated to hold commodities in a slowing growth environment, the potential for unwinding of speculative length exacerbates the downside risk,” she said.
Yet she and the Goldman commodities team think recent investor reactions have been “overdone.”
As worldwide growth continues, the team is maintaining its 9 percent total return forecast for the Goldman Sachs commodity index during the next year.
Contact Gail MarksJarvis at or leave a message at 312-222-4264.

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