Commodity prices are not all that they seem

THERE’S a tiny corner of pessimism in the commodity investment world. Amid a multitude of bulls, a few bears are pointing at what they think might be the unnoticed elephant in the room: large institutional investors. With the possibility of that demand reversing, should contracts for difference (CFD) traders perhaps be a little worried?

Certainly it seems unwise to ignore the amount of speculative money in commodities. Hedge funds, pension funds, and other institutional investors have been accumulating long positions in commodities for a while now, anticipating that quantitative easing and expanding emerging market demand will continue to drive prices up.

Mike O’Rourke, an analyst with BTIG, says, “Commodity inflation talk has finally hit a feverish extreme”. He argues that a “mistaken” understanding of the likely effects of quantitative easing drove the recent rally. O’Rourke argues that quantitative easing is unlikely to have the inflationary effects that many investors are expecting, and a little downward pressure could throw the markets off.

As he puts it: “When that much money is in position for a trade, especially after significant gains have been registered, little things like increased margin requirements or a stronger dollar can and will send fast money running.” If institutional investors start unwinding their positions, then the price of everything from copper to corn could fall very quickly.

That already appeared to be happening last week, as the combination of high Chinese inflation and the Irish sovereign debt crisis scared many investors. Metals were hit particularly hard, with the price of copper and aluminium falling by around 12 per cent, but the price of a barrel of crude oil also fell by $7.37. According to a poll by Royal Bank of Scotland, more investors expect to move into equities in 2011, while commodities should get less popular. Next year could well see further unwinding of speculative positions then.

So should CFD traders go short on commodities? Well, possibly not. While the “massive passives” – large institutional investors – may start selling, the demand for most physical commodities, and especially industrial metals and energy commodities, is likely to keep increasing faster than the supply. According to analysts at Goldman Sachs, the fundamentals are strengthening faster than the Chinese government is tightening, and so commodity prices ought to keep increasing.

In the meantime, however, CFD traders should watch out for further corrections. As last week’s sell-off demonstrated, commodity prices are highly vulnerable to the sentiment of institutional investors. There are still an awful lot of those around, and no one wants to get trampled by a frightened elephant.

Additional reporting by Thomas Hamed