Warren Buffett once said: "If you can see the bandwagon, it’s already too late", or words to that effect. It’s a good point and one you should heed at the moment. The financial media is starting to pick up on the recent surge in commodity prices — and when that happens, you know you should tread carefully.
This month platinum prices touched a 23-year high. Nickel has more than doubled from its late 2001 lows. And copper has reached its highest level for two and a half years. And it’s not just the metals. Wheat prices are up 20% this summer, timber prices are up over 60% and cotton prices hit a 33-month high. Some of these price rises can be explained by supply shortages. This summer’s heat wave reduced European wheat harvest estimates by 10%, while fires in Canada pushed up lumber prices. The low cotton crop in China is expected to provoke heavy Chinese buying in the open market, which should have a big effect on prices.
Also, some of the price increases are attributable to strong demand and an inflexible supply response. China has entered a metals-intensive stage in its economic growth, similar to Japan in the 1950s and 1960s, but on a much larger scale. The price of nickel, which is used mainly in stainless steel production, has soared above $10,000 a tonne for the first time since May 2000. That’s largely because there has been a 250% increase in Chinese nickel imports this year while there will be no major new nickel mines opening at least until 2006.
Mass speculation is fuelling commodities surge
But it’s not just movements in supply and demand fundamentals that have caused these gains. There has been a massive increase in speculative interest in commodities. Volumes traded on NYMEX (New York Mercantile Exchange) have tripled in three years and investment banks are also looking at commodities as an investment vehicle in an attempt to diversify from equities and bonds.
You may well be tempted yourself, but remember this. Like emerging equity markets, commodity markets tend to be thin compared to the very liquid bond and equity markets in mature economies. It follows that even a small foray into a commodity market by a major fund can have a disproportionate impact on prices. Volatility can be immense and dangerous to the small investor.
Moreover when investment is driven by hedge funds operating in futures markets, money can move quickly between commodity markets from yesterday’s "hot" investment to today’s. Industrial consumers of metals, such as manufacturers and carmakers, are not buying at current inflated prices, they are waiting for prices to fall.
This suggests to us that we could be entering a "bigger fool" stage. By this we mean that the main players in the market are not necessarily end users. Speculative market participants have no need to acquaint themselves with the specific properties of a commodity market but any price is worth paying for a commodity provided that there is a bigger fool to pay for it tomorrow. They’re just looking for a quick profit. Some speculators will make a lot of money but considerably more participants will lose out. That is the nature of speculative markets.
So at what stage of the speculative cycle in commodities are we at the moment? The chart below tracks the behaviour of the Reuters/CRB index of commodity futures prices.
The index comprises seventeen diverse commodities, including soybeans, cotton, livestock, precious metals, coffee, orange juice and oil, each with an equal weighting. So when the index rallies it suggests an increase in commodity prices across a broad range, indicating perhaps a heightened level of speculative interest.
Indeed cocoa is the only major commodity whose price is down sharply in the last 12 months — it’s already had its boom and bust. Meanwhile the chart indicates that we are approaching the levels at which the commodity price rallies of the late 1980s and mid-1990s ran out of steam. Recent history suggests that you should exercise some caution before piling in indiscriminately into the current rally in commodities.
Nevertheless each time there is a commodity price boom we are told this time it will be different. Commodity fans claim that if China’s emergence as a main buyer is sustained and traditional asset classes continue to offer low returns, commodities will acquire a new status. But in our view, the odds are still against a boom on the scale of the late 1970s. Of course, if circumstances change, we will let you know.
