Forget Supply and Demand its the Financialization of Commodities

Forget Supply and Demand its the Financialization of Commodities

Forget Supply and Demand its the Financialization of CommoditiesThis article from the WSJ reflects the current thinking by many that commodity prices are set by economic Supply/Demand. I have to disagree with this interpretation.

The market has become more complex the past 20yrs as commodities have become financialized and information has become instantaneously globalized. You may remember seeing reports of farmers in China, Malaysia or India using a smart phone to get updates for his crop prices. Globally everyone has become sensitive to commodity prices and at the same time everyone wants to produce greater capital for themselves, to raise their own standard of living as well as preserve capital.

The Net/Net as I have read in many reports over the past 15yrs is that individual producers have become speculators worldwide. Chinese/Indian cotton producers have used their bedrooms to store their cotton helping to force prices higher in an attempt to get higher prices. Some Chinese/Indian business people have bought ingots of copper and stored them in closets as a liquid store of value to protect against inflation and currency exchange rate fluctuation and fear of banking restrictions. Nearly all commodity prices have risen and fallen on expectations of Supply/Demand but also on expectations of currency fluctuation coupled to fears that rampant inflation or economic collapse would force commodity demand and prices to much higher levels. That coffee doubled in price a couple of years ago in the face of excess supply, that oil has persisted at high levels even in the face of excess global production speaks to the financialization of commodities, i.e. turning commodities into financial products in reaction to expectations of government failure, currency collapse and rampant inflation. Global financialization of commodities has developed since 1995 in my estimation! Yet, we still interpret commodity price change as if it is in response to fundamental economic

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Supply/Demand when it is not!! A quote from the WSJ article reproduced below reveals that current thinking has not kept pace with market reality.

Quote: “A particular worry: The economic malaise comes just as producers have ramped up production and stockpiles of many raw materials are near record highs.”

Current thinking clashes with today’s economic fundamentals which are in good uptrends without any indication of a slowdown. The Supply/Demand equation has gone awry with so much attention and capital placed into commodity investing as a hedge against economic/political failure. The fact that we are solving our financial excesses of the past is in my opinion beginning to enter the psyches of investors. The result is that capital is leaving the “Global Commodity Hedge”. Capital is leaving commodities and entering the equity markets!!

There is not enough information to be able to identify who is making a short term bet on the direction of commodities, how much of a commodity’s price is due to simple hoarding and what is the actual level of economic Supply/Demand. What can be identified is the strength of the economic cycle using the many data points we have available. We can tell if economic commodity demand is at a high by monitoring housing and automotive sales which consume commodities directly. In short the global economy is not working at a level justifying a high level of commodity economic demand. But, the economic evidence does indicate that we are headed toward higher global economic demand for commodities. The eventual peak in economic demand coincides with economic maturity which is still ~3yrs-5yrs ahead as best as I can estimate.

In Summary:

My interpretation of today’s slumping of commodity pricing is that this is due to the reversal of the commodity financialization as investor fears of global collapse subside. Solutions to global financial issues are being gradually developed and some capital is moving to the equity markets.

I remain quite positive that equity prices should rise as further solutions are developed to the financial issues we face today. There is no indication of economic slowing. Economic expansion remains a strong positive for Natural Resources as an equity asset class.

by: valueplays

Todd Sullivan is a Massachusetts-based value investor and a General Partner in Rand Strategic Partners. He looks for investments he believes are selling for a discount to their intrinsic value given their current situation and future prospects. He holds them until that value is realized or the fundamentals change in a way that no longer support his thesis. His blog features his various ideas and commentary and he updates readers on their progress in a timely fashion. His commentary has been seen in the online versions of the Wall St. Journal, New York Times, CNN Money, Business Week, Crain’s NY, Kiplingers and other publications. He has also appeared on Fox Business News & Fox News and is a contributor. His commentary on Starbucks during 2008 was recently quoted by its Founder Howard Schultz in his recent book “Onward”. In 2011 he was asked to present an investment idea at Bill Ackman’s “Harbor Investment Conference”.
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