12 May 2008: Corporation: Time to trim exposure to commodities?
By Daryl Liew

Rampant commodity-driven inflation has claimed a new "victim", with rice joining the likes of crude oil, gold and wheat, in hitting the headlines following a sharp run-up in prices. The doubling of the price of rice over the past year on the back of fears of a global shortage, caused a rush to empty supermarket shelves of their rice supplies. Singapore government officials then had to reassure the public that there was sufficient rice in reserve to last two to three months.
We at Providend have been commodity bulls over the past few years, believing that the coupling of strong global demand with unstable supply has created a fundamental shortage in many types of commodities. As a result of this positive view, we have maintained an "overweight" allocation to commodities in our portfolios for the past year. While this position has benefited our portfolios, we have become increasingly concerned by the sharp and sometimes unfathomable rise in some commodity prices. With crude oil flirting with the US$120 a barrel mark, corn reaching a record US$6.16 a bushel, and soybean touching an all-time high of US$15.87, the big question in our minds is, "Are we seeing a commodity 'bubble' emerge?"

Why we like commodities
To start, let us recap why we think commodities as an asset class is in a secular bull-run that will likely last several years more.

Infrastructure spending
Infrastructure spending is probably one of the key drivers of demand for many commodities. Several developing countries have committed large sums of money to infrastructure projects that require the use of many different types of commodities. China, for example, is spending a huge amount on roads to improve the accessibility of its inland cities. India is doing the same kind of spending, as the government has realised that the country's roads, ports and airports are simply incapable of supporting future development.
Latin American countries like Mexico and Brazil have also announced plans to develop domestic infrastructure. Even Singapore, although not a developing country, is joining the party with her plans to develop two integrated resorts and a new sports hub.

Rising middle class; rapid industrialisation and urbanisation
Rapid urbanisation and industrialisation that is happening in many developing countries is creating a huge demand for property — both residential as well as commercial. This is best typified in China, where large streams of rural folk flow into the cities every year in search of a better life. Besides boosting demand for property, rapid urbanisation also causes a shift in consumption patterns. With higher incomes and rising affluence, meat starts featuring more prominently in everyday diets, thereby causing a huge increase in the demand for meat.
As a reflection of this change in consumption patterns, China and Asia-Pacific now produce three times more livestock than they did 20 years ago. The Middle East, North Africa and Latin America come close with 1.6 times more livestock production. Implicit in higher livestock production is an increase in grain demand (corn, wheat, soybean, rice) for feed. The world's growing livestock supply is thus turning the focus of grain-planting efforts from feeding humans to feeding livestock. Indeed, the shortage and subsequent price rise of many grains today is arguably due to the world's growing taste for meat.

Supply-side issues
One of the key problems with commodities is the fact that most of them suffer from lumpy supply. This basically means that producers cannot instantaneously react to demand increases by raising supply, as supply in many commodities markets can only be increased after a time lag. This is particularly true in agriculture and mining. For the former, crops have to go through a normal growing cycle before they can be harvested. As for the latter, exploration efforts to locate metals or minerals to be mined require much time and money.
Some history: Because of low metal and mineral prices in the preceding decades, there has been a drastic underinvestment in exploration and development of new mines. This lack of investment has kept supply from keeping up with the strong surge in demand, thus contributing to the current shortages. Current high prices have, however, sparked a large influx of money into exploration. This should result in new supply coming online in the next few years, thus helping to alleviate the global deficits.

Weaker US dollar/inflation hedge
The steadily depreciating US dollar is probably one of the main contributing reasons for the sharp appreciation of commodity prices in the past year. The greenback has been weakening against practically every other currency in the face of interest-rate cuts and looser US monetary policy. Since many commodities are priced in US dollars, commodity producers have seen their revenues drop in local currency terms. As a result, producers have raised prices to compensate for the lower amount received in domestic currency terms. A case in point is that of Opec, which increased its US dollar target price for oil.
In addition, commodity prices seem to have developed a "hedge" function. While gold has a reputation for having a negative correlation with the US dollar, this inflation-hedging quality now appears to have spread to all commodities, with speculative money now treating commodities as a hedge against further greenback weakness. As looser US monetary policy puts upward pressure on inflation, commodities are benefiting from this higher inflationary environment as real assets like property and commodities are seen as traditional hedges against higher prices.
Now that we've covered all the reasons we like commodities, it's time to discuss what has changed and sparked a rethink of our commodity positions. While we are still long-term commodity bulls, we have some short-term concerns.

Rise in speculative monies flowing into commodities
Since the beginning of the year, a flood of money has flowed into commodities, owing to a build-up in speculative positions. This surge in speculative money has reportedly been to hedge against the US dollar. However, as anecdotal evidence suggests, non-commercial trades now constitute more than half of all commodities-trading activity, with hedge funds being the biggest players.
Indeed, this thesis is backed by price movements in commodities over the past few weeks. Commodity price movements have depended primarily on the performance of other asset classes. For instance, when the spreads of asset-backed securities narrowed and equity markets rallied, commodity prices saw profit-taking; when spreads widened and equities fell, commodity prices rebounded. These price movements suggest that hot money is treating commodities as simply another investment class to reside in, another investment idea until the next best investment opportunity comes along. This treatment is definitely creating considerable risks as a rebound in equity markets may reverse the capital flows into commodities, thus leading to a further and possibly sharp correction in commodities.

Stabilisation of the US dollar
As the depreciation of the greenback has arguably been a major factor in the commodity price rally, no analysis would be complete without looking at whether this declining trend will persist. On a fundamental purchasing power parity basis, there is no doubt that the US dollar is now severely undervalued against major currencies like the euro. If history is any guide, currencies traditionally fluctuate around their fair value, and always revert to the mean over time. Thus, the big question is when, and not whether, this trend will start reversing.
The US Federal Reserve has been the biggest culprit in the sell-off in the US dollar, as it has focused all its attention on solving the credit crunch and jump-starting the US economy. With credit concerns abating and the Fed approaching the end of its series of interest-rate cuts, it does appear that there should be lesser downward pressure on the US dollar. In addition, the recent G-7 meeting in Washington highlighted the fact that global leaders are increasingly aware of the risk of currency volatility. As such, we do expect to see a firmer greenback in 2H.

China shutting down factories
The third reason for our concern about commodity prices in the short term is that China has started closing factories in the areas surrounding Beijing in preparation for the Olympics. The poor air quality in Beijing is causing much consternation among the sporting fraternity and the Chinese authorities seem willing to take all action necessary to ensure that conditions for the games are perfect. We understand that China plans to shut even more factories in the lead-up to August and these several months of inactivity are going to affect commodity demand. China is one of the biggest players in the commodity markets, and we do think the shutdown of many of the manufacturing facilities in the north will likely lead to a build-up in inventories, and thus put downward pressure on prices.

Trimming commodity exposures
While we remain long-term commodity bulls, believing that the long-run cycle is intact, we do think commodity prices are currently prone to a sharp, temporary correction because of the abovementioned reasons. Thus, we have taken the pre-emptive step of trimming our exposure to this asset class with a view to reinstating this position once prices have come back down to more realistic levels.
Daryl Liew, a chartered financial analyst, is chief investment strategist at local independent wealth management firm Providend. He is a contributor to The Edge Singapore.

12 May 2008: Corporate: Commodity boom may come to an end
By Lim Shie-Lynn

Last Monday, Goldman Sachs predicted that oil prices could hit US$200 a barrel within two years. With commodity prices trading at record highs, there seems to be no indication of where they will stop. But prices cannot soar forever and the end draws nigh for a commodity boom, some experts opine.
A recap on last week's record highs: crude oil on the New York Mercantile Exchange soared to US$124 a barrel on Wednesday, as speculators rushed into the market concerned about a potential supply disruption.
Goldman Sachs had accurately predicted three years ago that oil would surge to US$100 a barrel. That prediction came true in January. So, could the US investment bank be right again with its forecast of US$200 a barrel? And if commodity prices soar even higher, how high will food prices go?
As it is, the rise in agricultural commodities has led to soaring food-based inflation rates, famine and social unrest in nations around the world. This in turn has challenged governments to adopt or revise policies to curb rising food prices and rein in high inflation rates.
There are several views on the rising food prices. Paul Krugman, prominent economist and columnist for The New York Times, wrote about three competing views on rising food costs.
"The first is that it is mainly speculation, that investors looking for high returns, at a time of low interest rates, have piled into commodity futures, driving up prices. The second is that soaring resource prices do have a basis in fundamentals in the face of rapidly growing demand, but given time, we will drill more wells, plant more acres and increased supply will push prices down.
"The third view is that the era of cheap resources is over for good, that we are running out of oil, running out of land to expand food production and generally running out of planet to exploit," Krugman wrote in his column.

Speculative frenzy
Some experts and analysts opine that the speculative element and the sheer volume of funds moving into commodity markets have led to the jump in commodity prices. "Honestly, it is hard to quantify the sheer size of speculation in the market," an analyst with a local brokerage firm says.
"Fundamentals in crude oil do not indicate that prices should be aiming for the sky and yet they are," she says.
"With the slowdown in the US economy, logically, demand should ease. So, this rise in crude oil (prices) that we have seen in the past weeks is not logical."
But Goldman Sachs has a different view on commodity speculators. The investment bank reckons that contrary to general perception, commodity investors are helping to solve the energy crisis by speeding up the process of inducing higher capital spending on a wide range of energy projects. At the same time, speculators, in a way, "encourage" lower demand for oil. Simply put, the high commodity prices, brought about by speculators, would force people and companies to be more efficient and careful in their use of such commodities.
Goldman Sachs also opines that commodity speculators should be applauded for speeding up the message to both oil companies and consumers that energy markets are tight.
"The fact that tight oil supply and demand fundamentals are attracting large amounts of capital is a good thing. Higher oil prices signal to oil companies the need for greater investment, and to consumers the need to demand less," it says.

What goes up must come down
Notwithstanding the existing enthusiasm for the current commodity bull market, some experts are advising everyone to be prepared for a fall in commodity prices. "Rising prices of commodities will not go on forever. We are in for a correction. It is only a question of when," an analyst says.
And there is also a pressing need to ease the food crisis. With the UN Food and Agriculture Organisation projecting world population to grow to 9.2 billion by 2050, the world's food production would need to double.
Rising prices may improve the trade balance of major food exporters, but can consumers afford to pay? Maybe, if our disposable income rises as well, but that is wishful thinking.