Commodity Prices Surge, As Investors Seek a Haven

The powerful rally in commodity markets is defying a global economic slowdown because investors are fleeing battered stock and bond markets, and the impact of their cash is being amplified by new, easier ways to buy and sell raw materials.

Demand remains strong and supply tight for many commodities, helping drive prices to record heights. But, in recent weeks, institutions, hedge funds and individuals have fueled much of the surge in everything from oil to wheat to platinum by pouring money into new investment vehicles that let them quickly and easily make big bets in relatively small markets.

Yesterday on the New York Mercantile Exchange, oil surged $2.95 to $102.59 a barrel, a new high in nominal terms. After rising 12% this month, oil prices are now just below their inflation-adjusted peak of $103.76 set in 1980.

But oil has been a laggard compared with other commodities. So far this year, natural-gas prices are up 26%, coal is up 56%, platinum up 41%, wheat up 32% and cocoa up 38%.

Few anticipated the strength of the latest run-up in prices. As 2007 ended, it appeared that a slowing global economy would ease demand for commodities and push down prices. Instead, commodities have been riding a wave of investment money diverted from stocks and bonds by investors chasing better returns. A weaker dollar, lower interest rates and fears of inflation have added momentum to the rally.

“People are wondering where they should put their money. Treasury bonds are overpriced, they’re scared to death about equities, and they’re even afraid of money markets,” says Shawn Rubin, a senior adviser at Smith Barney. “So everybody is asking about commodities.”

Bubble Worries

The price run-ups are leading some analysts to declare bubbles in the hottest markets. That raises the prospect that some commodity prices could come tumbling back down as rapidly as they have risen if they aren’t underpinned by genuine demand.

“As an economist it’s hard for me to sit here and look at corn and bean and wheat prices and explain it with fundamentals,” says Dan Basse, president of AgResource, an agriculture market-research company in Chicago. “The market would suggest we’re extremely overpriced,” he says.

Trading volume in commodities futures and options contracts has soared across the globe, with the number of agricultural contracts gaining 32% from a year earlier, followed by industrial metals and energy products, which increased by 29.7% and 28.6%, respectively, according to the Futures Industry Association.

Last month, Nymex, the world’s largest physical commodities futures and options exchange, handled a record 1.7 million contracts each day, fueled by a 163% year-to-year increase in electronic-trading volume.

Index-Based Strategies

Speculative trading in commodities is nothing new, but the inner workings of the market, which is based on real assets stored in warehouses, has in the past limited its appeal. That’s changed in recent years in part because of index-based commodity strategies that allow investors to own a broad cross section of commodities all at once.

Hedge funds and small investors alike have been especially attracted to exchange-traded funds, or ETFs, that allow investors to buy and sell anything from steel to coal to broad baskets of goods on exchanges in the way they buy and sell stocks.

The big inflows of cash may be having the biggest impact in relatively small markets like those for corn, wheat and other agricultural commodities. “The grain markets are not used to the kind of levels of investment money that are coming in, whether it’s from index funds or hedge funds,” says Joseph Victor, vice president of market research at Allendale Inc., a commodities research firm in McHenry, Ill.

Commodities ETFs now hold about $30 billion, up 90% from a year ago, according to State Street Global Advisors. Traditional mutual funds are also diving into this business.

The Commodity Real Return Fund run by Allianz AG’s Pacific Investment Management Co., is the largest, with $14 billion under management. And index funds that track major commodity indexes such as the S&P GSCI and the Dow Jones-AIG Commodity Index are bigger still. Ben Dell, an analyst at Sanford C. Bernstein & Co., estimates that investors have poured roughly $175 billion to $200 billion into commodity-linked index funds since 2001.

Five or 10 years ago, “if you didn’t have a certain scale, playing in the commodity markets was very difficult,” says John Shapiro, global head of commodities at Morgan Stanley.

Even when oil was cheaper, at $20 a barrel, he says, a single oil futures contract for 1,000 barrels of oil cost $20,000. Wall Street brokers typically expected to handle orders for much more than that.

Even for bigger institutions that typically focused on stocks and bonds, trading futures was a cumbersome process. But now, a range of new financial products has made the market more accessible to both big pension funds and small investors.

“The alternative ways that people can play the commodities markets are much broader than they used to be. And the choices the retail investor has to participate in the market are much better,” adds Morgan Stanley’s Mr. Shapiro.

At the same time, electronic trading of commodities has exploded, giving hedge funds direct access to markets they previously could reach only through brokers in the trading pits of commodity exchanges.

Energy Marketplace

Nymex, the world’s primary energy marketplace, expanded electronic trading of its main crude-oil benchmark a year and a half ago. Today, 91% of all trading in Nymex’s crude contract is electronic, according to Citigroup analyst Tim Evans.

At first, this democratization of the commodities markets was concentrated in energy trading. But speculators have piled into metals and, more recently, agricultural commodities, as prices have taken off. That’s in part due to commodity-index funds, which are popular with institutional investors because they provide relatively cheap exposure to all kinds of commodities.

But the flood of cash can overwhelm markets. Today, commodity-index investors make up around a fourth of total bets outstanding in many agricultural commodity markets, figures from the Commodity Futures Trading Commission show. According to CFTC data analyzed by Barclays Capital, commodity index funds hold 31% of the open bets in wheat contracts and 23% of the soybean contracts on the Chicago Board of Trade.

Mr. Basse of AgResource calculates that commodity index funds hold contracts for about one billion bushels of soft red winter wheat, about twice what the U.S. will produce this year.

The flood of money has complicated life for the Federal Reserve and for traditional commodity investors, in particular companies that use and store grain. For the Fed, which has been cutting short-term interest rates to bolster the economy, higher commodity prices raise the risk of inflation.

Hedging Exposure

For producers and silo operators who often will try to hedge their exposure to fluctuating commodity prices by betting that prices will fall, the huge rallies have caused unexpected losses. “Right now it’s very risky to short commodities,” says Hussein Allidina, global commodities research strategist at Morgan Stanley. With inventories low across the board “your buffer is very low.”

If it persists, the commodity rally could have serious consequences for the global economy, bidding up the prices manufacturers pay for raw materials and consumers pay for finished goods. Already food prices are up sharply, and some analysts expect gasoline to top $4 a gallon in the U.S. this spring. That could put a squeeze on both household and corporate budgets.

The price of wheat used to make bread and pizza crust has risen more than fourfold in the past year. And some countries are curtailing exports. When Syria recently canceled some export contracts, an Egyptian newspaper editorial accused it of “using wheat as a weapon.”

Commodity bulls say that underlying demand from fast-growing economies and supply shortages will keep prices strong. “People had overlooked the tightness on the supply side,” says Mr. Allidina. Among industrial commodities, “inventories are very low and that keeps prices higher.” And when it comes to agricultural goods such as corn and soybeans, “there’s been two years of supply disruptions and there’s an inability to meet demand.”

But others say the prices have risen too quickly recently. “Looking at commodity prices you would think the global economy was poised to break all previous records of strong growth,” wrote Marco Annunziata, chief economist at UniCredit on Wednesday.

By Tom Lauricella and Ann Davis - February 29, 2008

Joanna Slater and Diya Gullapalli contributed to this article.

Source: WSJ