Do you remember the commodities bubble of 2007, when oil went to US$147 a barrel (currently US$79), nickel was US$54,200 a tonne (now US$18,550) and even palm oil was US$1200 a tonne against US$600 now?
Well those days could return if 'hot money' goes back into the resources sector.
The Financial Times recently noted that hedge funds and other large investors are investing more and more in physical commodities rather than in futures contracts. This raises the spectre of worse supply shortages and higher prices if such demand overwhelms production capacity.
UK-based commentator Martin Hutchinson notes that the availability of capital for speculation and investment is much larger than that of those who buy and use commodities. The amount of money invested in hedge funds and sovereign wealth funds totals tens of trillions USD.
"Since the available inventory of commodities is a fraction of their annual production, we could end up with an extreme case of too much money chasing too few goods."
This would not matter much if investment were concentrated in futures markets, he says, because the trading of contracts does not interfere with the movement of commodities. Normally, commodity investment is confined to futures markets because it is much more convenient. The cost to a hedge fund or other financial investor of holding stocks of a commodity is quite high, normally sufficient to deter investors from attempting to buy commodities.
"When investment moves to physical commodities, as it may now be doing, it potentially disrupts trade flows. A ship laden with copper ore that would normally have sailed from Chile to a smelter on the US West Coast is instead parked in a holding area in order that investors can profit from the rise in value of that copper. That reduces the available ore.
"Since the balance between supply and demand of most commodities is quite delicate, and supply cannot be ramped up by more than a modest percentage at short notice, that could result in a physical shortage of the commodity at the smelter, shutting down the smelter for a period and depriving its customers of the copper products they need for their own operations."
He believes disruptions of commodity flows of this kind can potentially cause both hyperinflation and a major recession. The value of copper to a smelter and its customers is much higher in a shortage because the cost of closing their own operations is massive.
A spike in the price can cause a drag on economic activity as so many products require resources like copper. The effect of a gross liquidity surplus is thus quite similar to that of a sudden shortage. In cases when shortages occurred as in 1837-41 in the USA and 1929-33 globally, prices declined by up to 25%.
Economic activity is hugely reduced as businesses are unable to obtain financing and workers are laid off. The resultant decrease in demand causes producers to lose money, eventually closing their doors, as well as bankrupting the financial system.
In a gross liquidity surplus, in which investment capital disrupts commodity trade flows, inflation rather than deflation results, probably very rapid inflation rather than the moderate 5% - 10% inflation we became used to in the 1970s. If the so-called 'hot money' comes back into resources, which appears likely, the only question from an investment perspective is whether the rises will be substantial (if confined to the usual futures trading) or the dramatic (if storing physical assets becomes a trend).
David McEwen is Chief Investment Officer of Investment Research Group. He can be reached by email at david@irg.co.nz and a disclosure statement is available free of charge on request by calling 0800 474669 or visiting the website www.irg.co.nz.
