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Pop Goes the Commodity Bubble

April 20 2013 -- The “commodity bubble” is the idea that we are running out of stuff. From Potash to Coal or Oil to Cerium – the newly awaken dragon -- China was going to gobble it all up as Chinese farmers leapt from making a $100 a year in the back mountains of China to relocate to the new urban China. On the way they would buy luxury SUVs, condos, yachts and Smart phones.

The flaw in that idea is that Americans would need to consume just as much stuff and China would create a second USA size market. Well neither has happened so far, the aging US population is consuming less of most things and what it does continue to consume is a lot of Oil (but more from home grown sources lately) and services. Even if American bought the same amount of physical goods, it would not change the commodity picture, US consumed metals don’t care if they are assembled in Detroit, Tokyo or Shanghai – it is a global commodity market. So new growth hinges on China becoming a consumer economy.

China’s middle class revolution is just not happening. According to traffic department statistics, at the end of 2011, China had 225 million motor vehicles, including 106 million cars. In January 2012, AP reported: “Vehicle sales in China rose a scant 2.5 per cent in 2011, the slowest growth in over a decade, as higher prices and traffic controls kept buyers out of showrooms. The Chinese economy has been growing but a large part of that has been in some crazy developments and a lot of conspicuous consumption by upper part members. Both of these have been slowing recently too. As for our humble Chinese farmer, he did migrate to the city, but he did not get a condo or an SUV, instead he found himself in a sweatshop making $2 flip-flops bound for Uruguay.  

So where is the commodity boom really coming from . . .

In the roaring 20’s the commodity exchanges were more important than the stock market. The famous trader Jesse Livermore was called the Cotton King and declared commodities more legitimate than stocks. Even when I was a kid growing up in the central prairies, the radio would, after the news, list some of the major commodities like the price of Live Cattle and Pork Bellies. In those agra-economy days, commodities were very important to the common man.

In the 1980’s and 1990’s many people forgot about the futures and commodities and concentrated on NASDAQ wonder kids like, Microsoft Apple and Yahoo. Since the big crashes in the 1920’s it was understood that it was very dangerous to let speculators rule the markets that controlled our food and basic materials of production. Before the great depression many famous traders cornered cotton and silver, driving prices wildly out of control. After the 1920’s new laws signalled that commodities became hands off for speculators and were mostly traded by farmers, big consumers and some professional market makers. That changed back with the Commodity Futures Modernization Act passed in 2000. The most significant outcome from this act was the allowance for the trading of single stock futures. The amount of leverage provided by these financial instruments has given professional traders a new way to obtain exposure to both traditional commodity and equity markets.

The real upshot was the commodities went from a bunch of farmers protecting their wheat prices in case it did not rain, to markets run by Wall Street prop desk speculators. Goldman Sachs and the other big Wall Street investment banks started buying copper, gold and oil for both clients and its own account. By making bold moves in the open outcry pits in Chicago and sneaky backroom moves on the electronic markets, these big firms could easily move the markets -- not just in volatile markets like Orange Juice but in huge markets like Brent Crude and the S&P 500 futures.

These firms brought in with them their big hedge fund and sovereign wealth fund major clients. Volume skyrocketed, and trillions more were being bet on commodities than at any other time. Most of it came in as “net long” positions. In other words many bids to buy and few offers to sell commodities. Of course all this money sloshing around was driving up prices. Suddenly to the common man on the street it looked like the world really did need way more of these basics materials than it could produce.

Meanwhile in China, you had some interesting players. Of course the communist government that would publish a plan that would say, “GDP growth shall be at 8%” then this would work it way down the system until district managers and Mayors found themselves trying to meet ridiculous targets. As I have said before this mostly resulted in a lot of empty buildings and factories beating each other over the head to sell cheaply made goods -- to a world that did not really want them. China made a never-ending mountain of athletic shoes, t-shirts and cheep Christmas lights.  All of this had been financed by a series of less than prudent loans from banks, ordered to lend, by the central government.  The government would also do some odd things, for example they found out western economist were measuring the amount of coal used by power plants as a more reliable source of GDP data than the "cooked books" coming out of Beijing. As soon as the bureaucracy figured this out -- China’s docks and power plants (even the nuclear plants)  became home to mountains of coal piled up outside to keep the foreign devils guessing. 

Add to this mix some enterprising businessmen who know how well the Chinese planning system works. For years these men have made millions out of scarcity. In China a warehouse full of copper wire is as good as money in the bank.  Sooner or later you will be the only one with any to sell and boom, instant fortune. Except lately as the economy slowed in China this trick stopped working.

As the Chinese say, “no feast lasts forever.” Various trends coincided to erode their country’s competitive advantages. First, Chinese authorities started enforcing environmental rules as citizens took to the streets to complain about metals in the soil, pollutants in the water, and soot in the air. Now, no one in China wants to live in a “cancer village,” and people are routinely blocking projects, especially in the prosperous coastal regions of the country. Many smaller foreign investors began to pull back as they realized that manufacturing in China substantially increased the risk of loss of their intellectual property. Beijing did little to stop rampant theft. Finally there is the rise up of the worker. China has a delicate problem with its unions, it dare not suppress then or the party looses it last vestige of communism, but the demand for wages is killing production. 

Six cities in Liaoning province, including Shenyang and Anshan, recently announced they are converting abandoned industrial sites to farmland. Dongguan, once a booming factory centre, is on the verge of bankruptcy as companies close, leaving the local government severely cash-strapped.

So now you know where the bubble came from – speculators around the globe, less regulation on Wall Street and misguided hoarding in China.

It all shows up in the markets.
Of course you can only suspend reality for so long. As playwright Arthur Miller once observed, "An era can be said to end when its basic illusions are exhausted." Most of the illusions that defined the last decade -- the notion that global growth had moved to a permanently higher plane.

Commodities took off in 2002 under the new trading laws, sold off in the housing crises, planned to go higher until the reality of the bubble sunk in.

China claims its growth rate to be 8% every year, but the markets don’t think so. The Chinese market ETF FXI has gone nowhere for 5 years.

Remember when “rare earths” were all the investment rage? Shareholders of Molycorp Inc. certainly do; in early 2011, shares in the company nearly reached $80 (U.S.). Today, they trade close to $5, at all-time lows.

Similar sell off have been scene in Coal, Copper, Zinc and of course the associated mining companies. Bellwether mining titan Freeport McMoran has been on a two year slide.  

Now it is Gold’s Turn
Gold has begun a major pull back after a record 11 year run up in speculation frenzy. You can read my famous bit After the Gold Rush Here.

Finally there is the biggest commodity of them all -- Oil
As I mentioned near the end of my Why I Believe in America story. Oil and gas production is evolving so rapidly—and demand is dropping so quickly—that in just five years the U.S. could no longer need to buy oil from any source but Canada and North America, becomes an exporter of energy, instead of one of the biggest importers.

U.S. Domestic output grew by a record 766,000 barrels a day to the highest level in 15 years, government data show, putting the nation on pace to surpass Saudi Arabia as the world’s largest producer by 2020. Net petroleum imports have fallen by more than 38 percent since the 2005 peak and now account for 41 percent of demand, down from 60 percent seven years ago, moving the U.S. closer to energy independence than it has been in decades.

The surge in oil output, coupled with record natural gas production, allowed the U.S. to meet 83 percent of its own energy needs in the first eight months of 2012, on track to be the highest since 1991, Energy Department data show. The last time self-sufficiency was achieved was in 1952.

At least one member of the Obama administration has begun making the case that the U.S. is building toward a crippling surplus. Adam Sieminski, head of the U.S. Energy Information Administration, the statistical arm of the Energy Department, said limited transactions with other countries might help forestall excess supplies that could undermine prices and hobble the industry. That is a polite way to say we are going to be swimming in oil soon.

Post Bubble – What Will Change.
I have travelled extensively in Europe the last few years and  I noticed a new accent on the Côte d'Azur and the shores of Mykonos  -- G’Day Mate! Australians are wealthy for the first time ever. 

Ditto for Brazil, from January 2008 to July 2012, average house prices in São Paulo and Rio de Janeiro rose by 144.1% (91.7% in real terms) and 178.2% (118.4% in real terms). Brazil is no longer considered a developing nation and is taking a role as the leader of South America. 

Finally there is Canada; the world has praised this economic miracle. Canada  being one of only five developed countries not to have housing deflation and a rapidly increasing GDP. Even the Canadian dollar exceeded parity with the US dollar for the first time since President Richard Nixon said he was not a crook.  Bank of Canada chief Mark Carney has been quick to take credit for his "near god like prowess" in his "saving" of Canada from the fate the Americas fell in 2008. Today he is paid 800,000 UK Pounds a year as England's economic leader, and it is not off to a good start.  I think there will be no encore for Mr Carney. I would feel bad for the brits, but I think of it more as pay back, they did stiff Canada with those defective submarines. (what was Canada thinking? obviously they never owned an MG or a Land Rover)

Of course Brazil, Canada, Australia and even Russia, are the kings of mining and commodities, and now is time to short on these overblown economies at least for the near term. Consider trading futures short or ETFs that short the winners of the bubble. You can get ETFs to short; the Toronto Stock Exchange, the price of oil, gold miners, the price of copper and the BRIC nations, the list is a long one. One day your wallet will thank you.

The great beneficiary of this will be the United States and I will be doing a bit on that in an upcoming post.


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