With due apologies to Commodity Bulls like Jim Rogers, we might have just created a monstrous bubble that will blow away off its own weight, says a study by Lehman.
The reasons are simple, 40 feet containers carrying Bulk Loads from Chinese ports to Eastern North American ports, now cost $ 8000, up from $ 3000 last year. If Crude were to go to $ 200 per barrels as most analysts now agree, this fare will rise to $ 20,000.
The result; increased domestic production in the US, reduction in trans China-US bulk trade and possible stress on pan Asian Commodity trade.
Simply speaking, the Commodities bubble is unsustainable and will collapse under its own stress. If not, there cannot be a one-sided move in Commodity prices without that being reflected in the fundamentals of Commodity producers.
-Commodity index investors bypass speculator position limits set by the CFTC
-About $90 billion has flowed into commodity indices since 2006
-Commodity markets are much smaller and illiquid compared with equities & bonds
-Dollar weakness and inflation expectations are behind fund inflows and this causes a substantial price effect for some commodities.
-Fundamental loosening can be disguised by Saudi Arabia and China.
-Equities go up long-term with human progress; not always true for commodities
Past performance, dollar weakness, and inflation expectations have driven substantial financial inflows to commodity indices, potentially feeding into higher prices.
~Financial Inflows to Commodities
Oil prices this week reached all-time highs above $125/bbl, topping off a $50+ run-up since September 2007, perhaps the most visible increase of the across-the-board rise in commodity prices.
A fierce debate has erupted over the permanence of this bull run: some analysts argue that the massive price increases are the rational market response to tight supply-demand fundamentals, while others point to speculator activity as proof of its bubble-esque nature.
The debate also carries a political dimension, as OPEC has resisted calls to increase production by blaming speculators for rising prices.
Undoubtedly, financial investors have made huge commodity investments in the past five years. One channel for this flow has been commodity indices such as the GSCI and the DJ-AIG Commodity Index. These indices bypass traditional speculative position limits imposed by CFTC regulations, allowing pension funds and other investors to assume massive long positions in hitherto untouchable markets.
It is difficult to ascertain the exact size and effect of these indices, but based on their known positions in certain commodities and their reported cross-commodity weightings, one can estimate their overall size.
We estimate that total assets under management (AUM) in commodity indices ballooned from about $70 billion at the beginning of 2006 to $235 billion by mid-April this year (Figure 1). Of this $165 billion increase, about $90 billion is accounted for by financial inflows into these indices, with the other $75 billion stemming from price appreciation of the original underlying investment.
These figures may seem miniscule compared with the trillions of dollars sloshing around in global bond and equity markets, but commodity markets are comparatively small and illiquid. Even a $1 million inflow, as we shall see, can have a major effect in certain commodities.
Inflows have seen a major spike since December last year, with the lion's share of the contribution coming from the energy-heavy GSCI index.
What Causes Index Inflows?
Financial investment in commodities is commonly considered a hedge against two concerns: dollar weakness and inflation. Another reason might be a general flight away from the underperformance of more traditional asset classes such as equities.
Regressing our estimates of financial inflow against past 1-week returns on the dollar and breakeven inflation on 5-year T-notes, we find that dollar weakness and breakeven inflation indeed predict inflows for both GSCI and DJ-AIG, both at high levels of significance.
We also find that underperformance of the S&P also predicts inflow, although at weak significance levels (Figure 3). But perhaps most interesting, we find that the performance of the GSCI and the DJ-AIG over the past month also strongly predict inflows to the indices, suggesting a significant amount of momentum-chasing.
Do Index Inflows Affect Prices?
Given these substantial financial inflows to commodity indices, can we measure their effect on prices? Unfortunately, this analysis presents considerably higher obstacles. Ideally, we would want to measure the true liquidity-adjusted inflow to capture the true market impact, but outside noise from fundamentals, the annual reweighting of the indices, and unobserved over-the-counter activity cloud the picture.
There seems to be substantial variation in the market impact of index inflows across commodities, likely because of differences in liquidity. For WTI, a relatively large and liquid market, a $100 million inflow appears to cause a +1.6% rise in price at the 0.1% level ofsignificance, whereas a $1 million inflow alone into cocoa appears to cause a 3.2% price jump.
Furthermore, inflows to the GSCI seem to have a substantially higher effect on commodity prices than similar inflows to the DJ-AIG index, possibly reflecting the higher share of GSCI-mimicking lookalikes in the index universe.
Ingredients of a Bubble
Given the aforementioned causes and effects of financial inflows, we see many of the essential ingredients for a classic asset bubble. Performance-chasing financial inflows to commodities cause prices to rise, thus delivering good performance and, in turn, attracting even more inflows. This phenomenon can be self-fulfilling, especially in an environment in which lack of information about the true state of inventories in China or spare production capacity in Saudi Arabia delays any fundamental market correction.
But in the buzz around commodities, investors may have forgotten the obvious:
Commodities are inherently cyclical assets whose prices fluctuate around some longterm (but potentially changing) equilibrium level, while equities are shares in the future cash flow of dynamic firms providing long-term returns from technological progress.
For commodities, technological progress increases both demand and supply, making long-term price appreciation, even for non-renewable commodities, uncertain at best. Adjustment to a higher equilibrium price may mimic superior returns in the short term, but they are unlikely to last forever.
The reasons are simple, 40 feet containers carrying Bulk Loads from Chinese ports to Eastern North American ports, now cost $ 8000, up from $ 3000 last year. If Crude were to go to $ 200 per barrels as most analysts now agree, this fare will rise to $ 20,000.
The result; increased domestic production in the US, reduction in trans China-US bulk trade and possible stress on pan Asian Commodity trade.
Simply speaking, the Commodities bubble is unsustainable and will collapse under its own stress. If not, there cannot be a one-sided move in Commodity prices without that being reflected in the fundamentals of Commodity producers.
-Commodity index investors bypass speculator position limits set by the CFTC
-About $90 billion has flowed into commodity indices since 2006
-Commodity markets are much smaller and illiquid compared with equities & bonds
-Dollar weakness and inflation expectations are behind fund inflows and this causes a substantial price effect for some commodities.
-Fundamental loosening can be disguised by Saudi Arabia and China.
-Equities go up long-term with human progress; not always true for commodities
Past performance, dollar weakness, and inflation expectations have driven substantial financial inflows to commodity indices, potentially feeding into higher prices.
~Financial Inflows to Commodities
Oil prices this week reached all-time highs above $125/bbl, topping off a $50+ run-up since September 2007, perhaps the most visible increase of the across-the-board rise in commodity prices.
A fierce debate has erupted over the permanence of this bull run: some analysts argue that the massive price increases are the rational market response to tight supply-demand fundamentals, while others point to speculator activity as proof of its bubble-esque nature.
The debate also carries a political dimension, as OPEC has resisted calls to increase production by blaming speculators for rising prices.
Undoubtedly, financial investors have made huge commodity investments in the past five years. One channel for this flow has been commodity indices such as the GSCI and the DJ-AIG Commodity Index. These indices bypass traditional speculative position limits imposed by CFTC regulations, allowing pension funds and other investors to assume massive long positions in hitherto untouchable markets.
It is difficult to ascertain the exact size and effect of these indices, but based on their known positions in certain commodities and their reported cross-commodity weightings, one can estimate their overall size.
We estimate that total assets under management (AUM) in commodity indices ballooned from about $70 billion at the beginning of 2006 to $235 billion by mid-April this year (Figure 1). Of this $165 billion increase, about $90 billion is accounted for by financial inflows into these indices, with the other $75 billion stemming from price appreciation of the original underlying investment.
These figures may seem miniscule compared with the trillions of dollars sloshing around in global bond and equity markets, but commodity markets are comparatively small and illiquid. Even a $1 million inflow, as we shall see, can have a major effect in certain commodities.
Inflows have seen a major spike since December last year, with the lion's share of the contribution coming from the energy-heavy GSCI index.
What Causes Index Inflows?
Financial investment in commodities is commonly considered a hedge against two concerns: dollar weakness and inflation. Another reason might be a general flight away from the underperformance of more traditional asset classes such as equities.
Regressing our estimates of financial inflow against past 1-week returns on the dollar and breakeven inflation on 5-year T-notes, we find that dollar weakness and breakeven inflation indeed predict inflows for both GSCI and DJ-AIG, both at high levels of significance.
We also find that underperformance of the S&P also predicts inflow, although at weak significance levels (Figure 3). But perhaps most interesting, we find that the performance of the GSCI and the DJ-AIG over the past month also strongly predict inflows to the indices, suggesting a significant amount of momentum-chasing.
Do Index Inflows Affect Prices?
Given these substantial financial inflows to commodity indices, can we measure their effect on prices? Unfortunately, this analysis presents considerably higher obstacles. Ideally, we would want to measure the true liquidity-adjusted inflow to capture the true market impact, but outside noise from fundamentals, the annual reweighting of the indices, and unobserved over-the-counter activity cloud the picture.
There seems to be substantial variation in the market impact of index inflows across commodities, likely because of differences in liquidity. For WTI, a relatively large and liquid market, a $100 million inflow appears to cause a +1.6% rise in price at the 0.1% level ofsignificance, whereas a $1 million inflow alone into cocoa appears to cause a 3.2% price jump.
Furthermore, inflows to the GSCI seem to have a substantially higher effect on commodity prices than similar inflows to the DJ-AIG index, possibly reflecting the higher share of GSCI-mimicking lookalikes in the index universe.
Ingredients of a Bubble
Given the aforementioned causes and effects of financial inflows, we see many of the essential ingredients for a classic asset bubble. Performance-chasing financial inflows to commodities cause prices to rise, thus delivering good performance and, in turn, attracting even more inflows. This phenomenon can be self-fulfilling, especially in an environment in which lack of information about the true state of inventories in China or spare production capacity in Saudi Arabia delays any fundamental market correction.
But in the buzz around commodities, investors may have forgotten the obvious:
Commodities are inherently cyclical assets whose prices fluctuate around some longterm (but potentially changing) equilibrium level, while equities are shares in the future cash flow of dynamic firms providing long-term returns from technological progress.
For commodities, technological progress increases both demand and supply, making long-term price appreciation, even for non-renewable commodities, uncertain at best. Adjustment to a higher equilibrium price may mimic superior returns in the short term, but they are unlikely to last forever.
