Saturday, August 1, 2009

Speculators are positioning themselves for the next boom. They may be jumping the gun, but they're following China's lead

Peter Koven, Financial Post

If you read the news every day, you would swear there is a recession going on. But commodity prices are telling a different story. From oil to copper to zinc, resources have staged a stunning rally off their bottoms early this year, with some of them effectively doubling in value.

In a recession it would seem logical that people would need fewer commodities, not more. And that is indeed the case. Despite some pick-up in the past few months, demand has been very weak in much of the world.

Yet prices continue to rally. Copper is back above US$2.50 a pound after bottoming out around US$1.30 last December. Oil kept its momentum above US$60 a barrel in July despite overflowing inventories. And other commodities like nickel and zinc, which were left for dead a few months ago, have staged dramatic recoveries.

Media reports often try to explain daily commodity moves based on macroeconomic factors. But that is just part of the story. Like most investments, commodities are driven by speculators. And right now, the speculators are shrugging off the bad economic news and deciding that commodities are a pretty good place to be.

"A lot of traders missed the boom last time and they're building positions on the assumption that they don't want to miss the boom this time," says Aaron Fennell, senior market strategist with Lind-Waldock, a division of MF Global Canada. "

They're trying to anticipate the exit out of the recession to beat the crowds and set up their long positions."

The question is whether they are jumping the gun.

Throughout much of the world, the economic data continues to be dreadful. In the United States, the world's biggest economy, the unemployment rate is nearing 10% and the Conference Board's consumer confidence reading fell to 46.6 in July, its lowest level since April. European data is also very poor. But there is one major bright spot: China.

The Chinese government has moved heaven and earth to keep its econony booming throughout the global recession. In June alone, it is thought Chinese banks lent out a ridiculous US$225-billion, building massive speculative bubbles in just about everything.

When you're a one-party dictatorship and you really set your mind to something, you can get results: China's gross domestic product rose at an annual rate of 7.9% in the second quarter, completely defying the Western world.

Commodity traders are seeing that and they are responding to it, but there are real doubts that it is sustainable.

"What the Chinese government has done [through lending] is allow people to speculate in cars, homes, commodities," says Eric Sprott, Canada's most high-profile economic bear.

"One can't imagine that would be sustainable. It's too much of their GDP."

Just as important is the fact that the Chinese government has imported massive amounts of commodities. Using its estimated US$2-trillion of currency reserves, it has scoured the world for hard assets such as copper, coal and gold. That demand bolstered prices.

"It's probably a good idea to turn their currency reserves into commodities, because then they're no longer subject to the U. S. Federal Reserve," Mr. Fennell said.

"When Tim Geithner goes over there [to China] and tells them, 'Don't worry about the dollar falling,' they probably think there's a problem."

In copper, for instance, China has been importing about 300,000 tonnes a month, including a record 379,000 tonnes in June.

Much of that material is needed to build infrastructure as part of the country's US$585-billion fiscal stimulus package, which it has implemented with incredible speed.

Chinese buying was virtually the only thing keeping commodities afloat early this year, when the global economic outlook was even worse than it is today.

But unfortunately, it now looks like the China party could be ending. Experts believe the country has stockpiled enough material that it can slow down its buying for the rest of 2009.

The numbers suggest this is already happening. Copper inventories on the London Metals Exchange increased in the second two weeks of July, the first back-to-back weekly rise since February. And in China itself, copper inventories on the Shanghai Futures Exchange have doubled this year (they increased 51% in a single week back in June, a move so extreme that it prompted cries of manipulation from the conspiracy theorists).

If China decides that its buying binge is truly over, then traders and speculators will have to find another reason to keep prices elevated.

Right now, they are jumping on any kind of positive economic data they can find, especially around increased commodity demand. After U. S. jobless claim numbers came in better than expected last Thursday, for example, prices increased.

But if a global economic recovery does not happen soon, experts say inflation could be the theme that keeps the commodity trade alive, whether or not it materializes.

Many economists have warned that the monetary easing going on around the world could lead to massive inflation down the road. Gold has traditionally been the inflation hedge of choice, but in the last decade, oil and other metals have been seen in the same light -- as real assets that cannot be devalued so easily.

In a presentation at the Prospectors and Developers Conference in Toronto back in March, famously bearish economist Marc Faber summed up that prevailing mood: "You want to own commodities in the ground, not derivatives at Citigroup."

pkoven@nationalpost.com © 2009 The National Post Company. All rights reserved. Unauthorized distribution, transmission or republication strictly prohibited.