Daryl Guppy

Why commodities tumble

By Daryl Guppy (China Daily)
Updated: 2011-03-21 14:37

It's partly because speculators are unloading futures contracts

The rebuilding of Japan after the devastating earthquake and tsunami will increase demand for a wide range of raw materials and industrial metals.

In the short term there is a fall in demand for materials used in industrial production. This is soon replaced by an increase in demand for the raw materials needed for the reconstruction. Japan, the third largest economy in the world, must import almost all of these resources in addition to the normal demands of ongoing industrial production.

The performance of the Japanese Nikkei Index following the 1995 Kobe earthquake provides guidelines for how the economy will recover. The Nikkei Index fall in 1995 was 27 percent from near 20000 to near 14500. The market fell quickly below support levels and then developed a temporary rally prior to testing the previous downtrend low near 14500. Then the market rose with a 55 percent recovery in the next 12 months.

This recovery was a significant boost to the Japanese economy and very bullish for the suppliers of commodities and industrial metals. If the demand for raw materials and industrial metals, such as copper, is going to increase then why have commodity prices, such as copper, nickel and zinc, been falling so dramatically, losing between 8 percent and 16 percent in the past few days? This does not seem to make sense if markets expect an increase in demand in the longer term. The answer in part lies in the changed structure of the commodity markets.

Commodity futures markets allow producers and users to agree on future prices for the commodity. Futures traders use hedging methods to manage the risk. They provide the liquidity for the smooth operation of the market and stable pricing that reflects underlying demand and supply.

Many commodity markets now have a high degree of participation from investment speculators. Some of these are commodity funds using Exchange Traded Notes (ETNs) which are based on extended futures contracts. These investors use a gap in the trading regulations to hold on to short-term futures contracts for an extended period.

This is called the swaps loophole. The investment speculators take liquidity out of the market when they buy because they buy and hold futures contracts. This helps to push up prices because genuine hedgers must bid more aggressively in a market with limited liquidity.

When investment speculators decide to sell they can overwhelm the market with liquidity, selling many futures contracts. This increase in liquidity rapidly depresses prices.

A futures contract does not always involve the delivery of the physical commodity. Most futures contracts are settled for cash and this is very different from the activity of some new participants in the commodity markets.

A new feature of commodity markets has been the increasing participation from Exchange Traded Commodity Funds (ETCFs). Many of these funds buy physical commodities when their investors tell them to buy. This physical buying, or hoarding, helps to push up prices because it removes the physical product from the supply chain. When the ETCF investors decide it is time to sell then the fund sells the physical commodities on the market. Their selling helps to push prices down because it adds surplus capacity to the supply chain.

Figures from the BlackRock Inc fund issuer track the net asset flows and trading volumes in seven families of ETCFs in Europe. For the week ending March 11 the largest sector ETCF outflows were in basic resources followed by utilities. This is an increasingly large component of market activity but its influence is often ignored or underestimated. Currently there is around $11 billion invested in the European STOXX sector ETCFs, which is almost double the $6.7 billion open interest in the sector futures.

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The important feature of the ETCFs is that their buying and selling is not related to the actual supply or demand for the commodity. It is related to the ETCF fund investors' assessment of the commodity market and this may have little to do with the underlying commodity.

Many investors are very worried about the situation in Japan. In this situation American and European investors take their money out of foreign markets. They also take their money out of their home market and this has contributed to the more than 6 percent fall in the Dow Jones Industrial Average. They sell because they are worried about the general economic and world situation. They do not sell because they think the demand situation has changed for the commodity. They sell because they are frightened of other events in the market.

The result of this investor selling in ETCFs is that the ETCF fund management must sell the physical commodity. Commodity funds use ETNs to sell their futures contracts for the same reasons and this adds to the downward pressure. The fear of these investors forces ETCF and ETN selling even though the logical economic analysis suggests there will be increased demand for commodities of industrial metals such as copper, zinc and nickel.

As these groups leave the market it will help to remove some of the speculative pressure so, in the long term, commodity prices can achieve a better balance between supply and demand.

The author is a well-known international financial technical analysis expert.