Thursday, October 30, 2008

Supply and Demand Have Little Relevance to Commodities Price

Commodities price is driven by supply and demand. This is as true as the law of risk and reward.

Except the law of risk and reward hardly applies for the last few years. As such, so does the law of supply and demand since the commodities bubble started last year (arguably earlier) and ended a few months ago. If you need any proof, here're two pieces of news, randomly selected sources from a blind google search (not intending to target the sources in any way), to illustrate my point:

1. On 04/29/2008, disruption in Nigeria causes oil price to surge $1.50 to a then-record of $119.93. interesting.

2. On 07/18/2008, disruption in Nigeria causes oil price to drop $5.31 to $129.29. interesting...wait, WHAT?

The oil run-up of last year bothered me a great deal. So I decided to make an effort in making sense of it. Back then everybody was talking about supply and demand, peak-oil production, Saudi's exaggerated oil reserve, etc. etc. But I couldn't understand how these slow-moving variables could possibly cause the insanely fast-moving price. Then I read about how a new breed of speculators have joined the market and driven up price. That makes perfect sense, just as explaining why water boils by saying the temperature is 100C -- it provides absolutely 0 information. Why did all those speculators all of a sudden swamp into commodities?

Then somewhere along it hit me. Real negative interest rate. When the real interest rate is negative, it doesn't make economic sense to hold cash. Real assets that people need have a much better chance of holding value through inflation. (I know, I can't be even the millionth one realizing this.) With real estate out of question last year, commodities was a logical place to park your money. And it's a self-fulfilling proposition and yet another positive feedback -- the higher the commodities price, the higher the inflation pressure, and therefore the higher the commodities nauseam.

Did supply and demand have anything to do with the equally dramatic burst of the commodities bubble since July? No more than the run-up. I have a theory on why but it's off-topic so I'll leave it out. And the last leg of plunge was no doubt a part of the Great Unwind by hedge funds and banks, primarily triggered by Lehman CDS settlement.

It's primarily inflation, both real and expected (but probably not the nominal, systematically understated CPI), in relation to interest rate. Similar commodities bubbles driven by negative real interest rate have happened before. But this time it's amplified by the massive amount of concentrated capital, from individuals, corporations, and governments, created through years of internationalization, as well as the dramatic increase in capital flow and leverage through fantastic progress in capital markets and regulations such as securitization and Basel II.

Over the longer term, years and decades, there's no reason to believe the law of supply and demand will break down. But in the shorter term, in a market swamped by speculators who never intend to take delivery, supply and demand have little relevance.

In the very short term, minute-to-minute and day-to-day, supply and demand will have relevance, but only in a nominal and deceiving way. Imagine a fallen autumn leaf in water, a very smart one with a PhD in fluid dynamics, with access to a massive cloud of blades running Linux and models coded in A+. She can explain every minute movement from the molecular level up. Supply and demand. But there's a problem. When demand goes up 1%, sometimes the price goes up 0.1%, sometimes 10%, and sometimes even -1%. She doesn't understand. But Reuters reporters call her anyway and dutifully report on how supply and demand drove the price in their obligotary end-of-day headline.

Enough with cynicism. What will happen to commodities?

On 10/3, right after the passage of the Bailout Pork package, I said commodities would have another long-term run-up. On 10/13, I said the market would have an intermediate-term bottom "before or around 10/21". In retrospect, I was a bit early on both accounts, as I am usually. I didn't see the delay effect of the Great Unwind of forced hedge fund liquidation and bank deleveraging. But I wasn't too far off.

I still stand by them today, only with more conviction. Bernanke's Fed has totally lost its mandated independence from politics. He'll be bullied by Washington and Wall Street into keeping the interest rate below real inflation. The next President, no matter who, will probably not have the political will to call Uncle Ben to tackle inflation until it's too late (this is a change from what I said in my 10/3 article), unless the economic appearance improves drastically in the next few months (unlikely). So we'll have yet another asset bubble, in commodities, and commodities-driven inflation, starting from somewhere between yesterday and mid-2009.

The inflation driven by housing bubble in the last few years was stealth. Those who hitched a ride, the homeowners, didn't complain. Those who missed out, the homeless and the renters, complained but were completely drawn out by the party noise. But commodities-driven inflation will be direct and apparent. So my hope is it wouldn't last too long. And that would be a good thing for society.

Until the good thing happens, enjoy your ride on commodities.

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