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. Hmmm...how interesting.

2. On 07/18/2008, disruption in Nigeria causes oil price to drop $5.31 to $129.29. Hmmm...how 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 price...ad 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.

10/21: The Bottom

Let's cut to the chase. On Oct 21, somebody A will have to pay somebody B $C in cash to settle CDS on Lehman. Estimates on C range from 100 billion to 600 billion (a recent DTCC press release claims that the total net payment on Lehamn CDS is only $6B but I'll write about how misleading that is later). Group A will almost certainly include AIG, the biggest net seller of CDS, and many hedge funds, who have been using CDS selling as their cheap (HA!) financing source for the past few years. Besides single-name CDS specifically on Lehman, other credit derivatives such as CMCDS, CDS options, or Nth to Defaults, CDX indices and bespoke CDOs with Lehman in it will also settle, partially or in full.

This will be arguably the biggest cash-exchange day in human history to date. I don't care how much tax-payer's money the government will use to bail them out, somebody will fail.

Group B includes two types. One has Lehman bonds. They will be made whole by the settlement although Lehman bonds changed hands at 8.625 cents on the dollar at today's auction. The other doesn't have Lehman bonds. They bought naked CDS on Lehman. They will have a HUGE windfall -- for every dollar notional, they'll get over 91 cents. If they could collect, that is.

Back to the more immediate concern. Who is A?

You could pore over the CreditFixings' auction info and guess. I think a lot of people did just that Friday. They pounced on MS, GS, CS, and DB, who happen to be the biggest Physical Settlement Sellers (meaning they sold CDS on Lehman). JPM shot up the whole day, which happens to be the biggest buyer.

But I don't know how productive this guessing game is. The dealers could be placing orders and requests for their hedge fund clients. Short of serious insider info, there's no way of knowing how much of those requests are for themselves vs clients. More importantly, physical settlement will almost certainly be just a small portion of the overall settlement size. Today's auction had $5.7B sell orders. Cash settlement will most likely be at least 10, maybe 100 times bigger than that. People learned the lesson from Delphi. Furthermore, it'd be very unusual for banks to have a huge net position on CDS, with the possible exception being their proprietary desks and funds. Again, most likely suspects are AIG and hedge funds.

Now you know what the government bailout of AIG is for, the initial $85B and then the additional $37.8B (suspiciously precise isn't it?). Don't be surprised if the number goes up again before 10/21. Will tax-payers get the money back after 10/21? Fat chance. Is the money really for saving AIG or making sure others who bought CDS on Lehman will get their windfall? Take your pick.

On to hedge funds. They knew how much they would need to pay since Lehman bankruptcy. Reportedly JPM, GS, and MS have issued massive margin calls to their hedge fund clients, which is consistent with their sell requests (except JPM who, being the clearing bank for Lehman, may have bought protection) at the ISDA auction and my suspicion that a big part of their requests are on behalf of their clients. Some hedge funds are forced to cash out. And since Thursday some apparently went shorting in desperation, trying to make a quick buck before the doomsday. The 900 point surge Friday 3PM in half an hour showed how nervous and desperate they are.

In the meantime, of course, hedge fund investors must be withdrawing as fast as they possibly could, adding to their misery. Bankruptcy law will be the golden profession for many years to come.

WaMu CDS settles on Nov 7. Its impact is expected to be much smaller, although nobody can be sure, as for all CDS. We may get some rough idea on its auction date, 10/23. If there're high-profile bankruptcies on 10/21 (banks, AIG), then market would be spooked and all eyes would turn to WaMu; otherwise it'd likely be a non-event in comparison.

If there were bankruptcies of anything other than hedge funds on 10/21 (or 11/7, though less likely), then we could be in a serious chain reaction. But governments all over the world would band together to stop it. Governments may be stupid and inept, but they're not suicidal. Fed window will stay open late on 10/21. For banks (or AIG) who cannot post enough collateral, Paulson will be ready to buy stocks in a heartbeat. If the initial $250B runs out that day, they can let foreign sovereign funds to buy perferred stocks. It's a wonderful world.

Moreover, I suspect the pending doomsday is a big reason why banks have shied away from lending to each other over the past few weeks. Nobody knows how much anybody else owes on that day. Coming 10/22, assuming no banks fail, it'd be a huge cloud gone. Back to business as usual, or as usual as it gets nowadays.

Hedge funds' fire-sale exit may be creating a very rare buying opportunity in many financial markets (stocks, bonds, commodities, maybe even dreaded CDOs and mortgages). Two days ago I wondered if the bottom is near. Now I'm convinced the bottom will be around 10/21, if not earlier. The way back up may be painfully fast or painfully slow. But the crisis is essentially over unless we let the chain reaction take place.

Then we'll only have to deal with the massive debt, recession, and inflation. Piece of cake.

Bailout Pork Effect: Short-Term Rally, Long-Term Disaster

Defeat of the Paulson bailout plan in the house last week was nothing short of a remarkable victory of democracy. All of our political leaders were for it, future ones included, showing more unity than the Chinese Communist Party. The mainstream media were so politically aligned with the Government, they put Xinhua to shame. Yet individual voter-tax-payers, with hardly any meaningful organizing effort, fought for their self-interest and won against all odds. Wow.

If only we had done it five years ago on Iraq war and the Patriot Act, today's American citizens would be hailed as a shining example of independent citizenry of a strong democracy for centuries to come.

Unfortunately, we hardly had time to throw a party before the Senate pulled an old political trick and forced the hands of the House and the voter-tax-payers on the same plan. Only with $170 billion added pork to punish the rebelion act. That ought to teach the citizenry a lesson about respecting the Leaders.

There's no doubt SOMETHING must be done, and quickly, to stop this financial crisis from spreading to the wider world and becoming an economic crisis. The question is what that SOMETHING is. There've been many ingenious ideas floating around the internet. The Leaders have supposedly even considered some of these alternatives. Yet they chose the most costly (to tax payers) possibility and gave us two choices: are you for action or gridlock?

It's the same false choice as the one five years ago: are you for freedom or terrorism?

I used to pull this trick on my kids sometimes: who would you like to wash your hands, mom or dad? They started realizing the Possibility Universe is far larger than what I presented, somewhere around six years old. And I actually felt a bit guilty.

The Leaders have been doing this to us. And we never have the intellectual and/or political capacity to see through the same old trick. And they never have any guilt, I'm afraid.

But, we have to face reality at the end of the day -- would that be Friday?

If the Bailout Pork Package is passed, I'm willing to go with the conventional wisdom that the markets (stocks, bonds, derivatives, USD, commodities, gold) would have a broad rally, with the only exception being the treasuries as money exits the bunker and goes to work. Not too shabby huh?

Well, with $700B you'd expect more. Much more, and much more long term. But long term will be ugly.

First of all, the government has totally abandoned fiscal discipline. Well, it's abandoned it for a long time but now the world cannot pretend it didn't know any more. Foreign investors will have to stop playing suckers and buying the treasuries. They wanted to sustain the pretend game as much as we do. But now we finally killed the chance. Even a pretend game has a limit, beyond which the players simply cannot pretend any more. With the double whammy of hugely increased debt and higher interest, maybe CDS on US is not such a dumb idea (nah, it's still a dumb idea for, if...when US defaults, whoever sold you the CDS will not be around to pay).

Secondly, whereas inflation was a strong possibility in summer 07, now it's a certainty. Excess liquidity (credit) is easy to suck out as long as the Fed is determined to (which they weren't when they had a chance to deflate the housing bubble). But what the Bailout Pork Package puts into the economy is not just liquidity, but a massive amount of capital. Excess capital will stay around in the system for much longer. Capital chases return. Excessive capital chases excessive return. Excessive return at the macroscopic level can come from only two sources: asset bubble or inflation. In this case, it will be both.

Which leads to the third long-term effect: commodities bubble (yes, again, the real one) driven by negative real interest rate. The only reason that can explain the commodities bubble until a couple months ago is negative real interest rate. Supply and demand may have the right sign during some periods, but cannot possibly account for the magnitude of the surge. Amount of speculative money is an ontologically flawed argument since it by definition cannot explain why there were so much of it. When the real interest is negative, it does not make sense to hold cash (and cash there will be a lot of it now).

Real assets is one of the best places to park this massive amount of capital windfall, especially through continuously rolled futures since you don't pay the storage cost. What kind of real asset? Housing (mortgage) was the obvious choice when real interest rate became negative during Greenspan years, and especially after the massive rate cuts in 01. But now people will be careful touching mortgages for at least a few years. The only outlet left is commodities -- gold, oil, metals, rice, corn, who cares what it is. Never mind that there will only be so many taking actual delivery, demand will only increase so much and supply will only decrease so much by the mot exaggerated estimates. The $1T+ excess cash must be parked somewhere and earn some return.

While the effect of the housing bubble on inflation could be indirect and delayed, the impact of commodities is direct and immediate, as we learned with pain earlier this year. As I mentioned above, it will be commodities bubble and inflation.

Early in the year I expected the first thing the new president, whoever it may be, will do is to call up Uncle Ben and tell him to raise rates and kill off inflation. Yes, there will be short-term pain. But he could always blame that on his predecessor, however well deserved it may be, and take credit for the long-term benefits to the economy. I believe this is the main reason why the bubble contracted in the last two months.

Now, however, no matter how much the new president wants to play the game and Uncle Ben wants to be a good political lapdog, they cannot possibly do enough to kill the pending inflation without causing another crisis.

Yes, taxpayers may make money when the $1T+ toxic asset the Leaders will be buying for us matures or gets sold. But only before inflation adjustment.

Five years ago, the Leaders of both parties committed this once-great country to the Iraq war, with unspecified amount of lives and money for unspecifiedlength of time. "Imminent! Danger! We must act! Now! Don't ask questions! We don't have time for that! Just give me the power and money! Trust me!" Even if future Leaders were willing and capable, they cannot escape the commitment.

Now, the same Leaders will commit this country to years of inflation and generations of massive debt. "Imminent! Danger! We must act! Now! Don't ask questions! We don't have time for that! Just give me the power and money! Trust me!" Even if future Leaders were willing and capable, they cannot escape the commitment.

I'm still holding out hope that this Bailout Pork Package will somehow miraculously be defeated and some better alternatives will be considered with sincerity.

Nah, we don't have time for that. Let's just trust the Leaders. It's not like we have any other choice.

Don't we?