Monday, April 14, 2008

Dens of Gambling - Oil and food bubble about to burst ?

Commodities markets seem to have become a den of gambling. With commodity derivatives being packaged into financial instruments, these are now traded like stocks and behave like stock market. And will most likely fall like the stock markets.

For instance, the rise in price of crude oil to around $110 now from $ 50 a year back is not justified by purely demand-supply issues. The world production of oil as well as physical inventories are enough to meet the current consumption needs.

I believe we will hit the bottom of the economic cycle with the oil, food and real estate bubbles bursting. Crude oil bubble would most probably be the first to burst followed by others. Only then will the recovery cycle will begin.

Here is what's happening

Pure financial investors are investing in commodities, creating an artificial demand. They are not interested in buying bags of wheat or barrels of oil, but are keen to make a sell it off at a profit without taking delivery.

When inflation is on the way up, the price of commodities rise faster and become a still better avenue of investment. It just becomes a self feeding loop.

And what about the non speculative reasons.

They are absolutely there and here the key demand-supply related reasons:-

- Rising demand for commodities from countries like China and India to fuel their growth engines

- Use of foodstock as biofuels across the major economies of the world

- Increase in the consumption of meat in countries like China, resulting in lower resources being allocated to food production

- Accidents and calamities in some of the food producing areas, thereby impacting supply.

How much is real and how much speculative

So how much of the commodity price rise is 'real' and how much is speculative. Here are some rumblings across the globe that I came across by :-

- As per Commodity Futures Trading Commission, which regulates commodity futures in US speculators account for around 37 percent of outstanding contracts in U.S. crude oil.

- There is a research carried out by a researcher in Korea very recently where the researcher has tried to approximate the % contribution of key factors (speculation, demand-supply, dollar weakness and geopolitical reasons) in the commodity price rise. It seems for oil and wheat more than 40% of the price rice has been contributed by speculative interests and another approx 40% by demand-supply reasons

- Oil ministers from nearly all the OPEC countries from Saudi (the biggest) to Qatar (smallest producer) are vociferous in their statements that there is no shortage of oil, that the inventories are piling up and the price rise has been driven by speculative interests. Is anybody listening to them ?

So what's likely to happen ?

Here's my directional estimates of sequence of events :-

Step 1

Oil, food or the real estate bubble will burst, very close to each other. The prices of these commodities will correct significantly.

Step 2

Across the globe, factor price correction will take place.

- significant drop in price of real estate
- interest rates will come down
- wages would be impacted
- corporate profits would be hit
- government fiscal deficits will rise.

At this point in time the atmosphere would be absolutely dreary and it would seem as if there is no hope of recovery . Exactly the feeling at the bottom of cycles in previous recessions too.

Step 3

Inflation would be down. Consumption will slowly start picking up. Leading to a pick up in investment demand. And that's how the economic cycle will start turning upwards.