Say It Isn't So: A Commodity Bubble?

The Barrons cover story this week tries to uncover the reasons for the current commodity boom. Immediately mention is how index funds account for approximately 40% of all bullish bets on commodities, with cash commitments running about $211 billion on the buy side. Given the growth in ETFs and funds in the area (growing but still a small percentage overall), they have no doubt added to the buying pressure on commodities as they build a sufficient position. We certainly saw some of this with gold ETFs.

On the other hand, commercial players (those that sell the actual commodity grown/extracted/mined, and buy the actual commodity for use ...... imagine that), are "heading for the exits," with "net short positions .... running more then 30% higher than their previous net-short record, in March 2004."

A regulatory anomaly may also be fueling the bullishness. How so? Much of the index money is not traded on the exchanges, but goes through dealers that belong to the International Swaps and Derivatives Association (you know where this is going). The swap dealers lay off their risk by buying futures while operating as market makers for the index funds. Since the swap dealers are theoretically hedged, they are currently exempt from position limits. An ISDA letter to the CFTC highlighted that the top four swap dealers account for over 70% of trading, with only one dominate trader in some lower-volume markets. With this level of concentration, it may be difficult for these dealers to make margin calls given a sudden sell off or correction.

What could trigger a sell off? Possible catalysis include lower international demand (China and India), a US recession, or a turnaround in the dollar. The market itself could also be the trigger. A rally in the market may produced a shift from commodities to stocks. A further drop could cause margin calls, forcing commodity selling.

Steve Briese sees a possible 30% drop from current levels, with up to a 50% swing as commodity prices overshoot while correcting. On his website (CommitmentsOfTraders.org), Briese further points out that small investor trading in commodity index funds may a minor part of the problem. He is estimating that less than $40 billion is in these index funds, leaving $300 billion unaccounted for. Pension funds, endowments, and the like may be making up some of the rest.

Briese also makes and interesting analogy on his site: "The total open interest (market cap) of US commodity markets peaked out recently at less than Microsoft stock reached during the tech boom ($600b). What would happen to Microsoft stock today if you tried to accumulate $200b in stock on the open market. It would go through the roof, just as commodities have done. These markets are just too small to absorb the “investment” they have attracted."

Unfortunately, commodities may not be the whole problem. Derivative trading is concentrated among a few US investment banks. The Comptroller of the Currency noted:
“Derivatives activity in the U.S. banking system is dominated by a small group of large financial institutions. Five large commercial banks represent 97% of the total industry notional amount, 78% of total trading revenues and 87% of industry net current credit exposure (http://www.occ.treas.gov/deriv/deriv.htm)." Briese estimates the derivative holdings of these banks aggregate to more than 30 times capital. Since most of it is OTC, it is hard to accurately price (just ask the sub-prime players). Briese estimates that "exchange traded futures ..... is $16 trillion notional value, for which they [banks] typically put up 5% or less margin deposit."

Commodities may just be the start.