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The Rise and Fall of Commodities: An Introduction

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Becoming a consistently profitable trader isn't easy, but it isn't synonymous with chasing the proverbial end of the rainbow either. With the proper background, hard work, and the experience that comes with inevitable tough lessons, Carley Garner shows how long-term success is possible.

It was nothing less than breathtaking to witness the grain complex shatter all-time high price records and continue to climb during the 2007/2008 rally. However, by late 2008 the party had ended. Many retail traders and fund managers watched in horror as the grains made their way relentlessly lower. The selling pressure and losses in the commodity markets was so profound that hedge fund managers experienced unprecedented numbers of redemption requests, which added fuel to the already raging fire.

Ironically, the same asset class that investors swarmed to for "diversification" from stocks later played a role in the demise of equities. As investors pulled money from hedge funds, margin issues and client redemptions forced funds to liquidate positions in both commodity-related and noncommodity-related speculative bets.

A Commodity Rally for the History Books

Several theories attempt to explain the now infamous commodity rally, including ethanol demand, long only hedge funds, ETFs, shear market exuberance in the absence of an attractive equity market, and sidelined cash looking for a home. One thing is certain...the euphoria caused the agricultural, energy, and metals markets to overshoot their equilibrium prices.

In the midst of the excitement, the lure of the commodity rally clouded the judgment of many. Looking back, it seemed obvious that expecting market fundamentals to maintain $7 corn, $13 wheat, $17 soybeans, and my favorite, $148 crude oil, was simply unrealistic. However, nobody knew just how high prices might go before coming to a more rational level, and those that entered the market "early" with bearish strategies likely paid a high price. Yet, when the tides turned they did so in a vicious fashion; the stunning fall from grace was even steeper than the preceding rally.

The Perfect Storm of Fundamentals

The perfect storm is a term used to refer to a series of simultaneous events that, if occurring individually, would have little impact on their surrounding circumstances. However, by chance combination of such events, the net result can be dramatic. I believe this to be the best explanation for the magnitude of price volatility in the commodity markets during the 2007/2008 rally. Under the influence of increasing demand, tight supplies, roaring energy costs, and a weak dollar among others, logic had little control over the outcome.

The Demand Side of the Equation

The commodity rally that began in 2007 and evaporated in 2008 was originally sparked by considerable increases in global demand for agricultural and energy products. Much of the fundamental price support was the direct result of a swiftly growing Chinese economy, combined with technological advances and rapidly growing infrastructure in developing countries. Furthermore, improved diet and nutrition in the emerging markets, along with U.S. mandates for biofuels such as ethanol, were catalysts for soaring prices in markets such as corn and soybeans.

The Supply Side of the Equation

Along with increased demand for commodities due to global economic growth and modernization, many commodities suffered from tight supplies and this aggravated the upward price pressure. For example, the wheat harvest suffered from freeze, drought, and flood throughout various growing regions. The odds of such widespread damage to crops were rather minute, but as we have said, this was the perfect storm of fundamentals.

Additionally, floods and droughts plagued other agricultural commodities such as corn and soybeans; whereas petroleum products began to feel the supply pinch on OPEC manipulation and dwindling sources of fuels. Consequently, tight supplies along with unprecedented demand gave investors the green light to pour money into the sector, and they did so in droves. Nonetheless, what I believe to be the silent culprit behind a rallying grain market was the implications of higher energy costs.

The Crude Reality

According to many analysts, the world is said to be beyond peak oil, which is the point in time when the maximum rate of global petroleum extraction is reached. Beyond peak oil, the rate of production is said to be terminally in decline because the supply of fossil fuels is limited and is no longer being naturally formed.

As you can imagine, in an environment such as 2007 and early 2008 in which undeveloped nations quickly crossed over into industrialization, declining supply can be a significant issue. Specifically, as the population in China and India have begun looking toward motorized transportation, a dwindling supply of crude oil grows increasingly critical. For instance, the global consumption rate for crude oil was roughly 80 million barrels per day in early 2009. Many reports suggest that production near 75 million barrels per day could easily drop to 60 million per day should OPEC (Organization of Petroleum Exporting Countries) dramatically cut output.

OPEC is an oil cartel consisting of twelve countries that are large exporters of crude oil and believed to maintain a significant amount of price control. This reputation is deserving; OPEC countries account for about two-thirds of the world's oil reserves, and a disruption of their production, or an intentional decline in the amount produced, can have a considerable impact on crude oil prices.

Another undeniably bullish factor in crude oil pricing is the political unrest in many of the world's largest oil producers such as Iran, Iraq, Venezuela, and Russia. The high demand for energy experienced in 2007 and 2008 created a situation in which any disruption of production could have a noteworthy impact on already tight supplies, and in such a volatile political atmosphere, disruptions seemed likely. Accordingly, speculators bid the price of crude oil higher to compensate for the risk of such an event actually occurring. For traders that were involved in commodity speculation in the 1970s, it seemed like the beginning of what might have been a repeat of the now infamous oil embargo in which OPEC refused to ship oil to western countries that supported Israel in the Yom Kippur War.

It is easy to see how all these factors combined could have triggered a large rally in the energy markets. However, what might not be as obvious is the impact that higher crude oil and gasoline prices had on other commodity markets.

Many grains that were considered viable candidates for alternative fuel gained strength as scientists and consumers scrambled to find "cheaper" and domestically produced sources of energy. Some of the largest gains were witnessed in the corn market, which happened to be the lucky beneficiary of the ethanol hype.

Ethanol is a fuel created as an alternative to gasoline and is derived from purely renewable resources such as sugar, corn, and even potatoes. Although it was later determined that the use of corn in producing ethanol isn't necessarily efficient, as it turns out, sugar is a much better alternative to producing ethanol. Similarly, the sudden interest in biodiesel fuels created from plants with high amounts of vegetable oils, namely soybeans, paved the way for new all-time highs in soybeans and bean oil.

In addition, not only did ethanol and other bio fuel hopes increase the demand for grain products, but higher crude and gasoline prices also amplified the costs associated with growing agricultural products. For instance, if farmers must pay more in fuel costs to operate their tractors and other necessary farm equipment, they will then be forced to charge more for the goods that they produce.

Furthermore, many farmers dedicated relatively more acreage to crops that could see higher demand and prices due to their alternative food uses. Meanwhile, the price of commodities unrelated to energy or bio fuel, such as cotton, benefited from tighter supplies resulting from less dedicated acreage.

Plummeting U.S. Greenback

There's more. Along with supply and demand fundamentals, the U.S. dollar witnessed a significant devaluation. The Dollar Index, now traded on ICE (IntercontinentalExchange) but previously traded on the NYBOT (New York Board of Trade), fell from a value above 90 in late 2005 to the low 70s by the end of the first quarter in 2008 (see Figure I.1).

Figure I.1

Figure I.1 A lower domestic currency makes goods and services produced in that country more affordable for foreign buyers and, therefore, increases the demand and price for such.

A declining greenback offers underlying support in grain prices because it makes U.S. grain exports more competitive on the world market and, in turn, increases demand for those products. Likewise, crude oil is quoted in U.S. dollars and cents and reacts positively to a cheaper dollar.

With this simple rule in mind, it is important to realize that grain prices are extremely complex, and price movements can't be attributed to any single factor. Grain prices are highly dependent on weather and growing conditions; at times they will be minimally influenced by currency fluctuations. Equally, crude oil is often driven by geopolitical tension. With the dollar considered a "flight to quality" currency, it is likely that crude and the greenback can move higher together if Middle East turmoil occurs. Nonetheless, in general, commodity traders should keep the strength of the U.S. dollar in mind when constructing their analyses because it is part of the equation. During the 2007 commodity rally, it appears as though dollar weakness played a significant role.

The Overflow

The commodity bull overflowed into the precious metals markets, namely gold and silver. Although, cash market supply-demand fundamentals weren't necessarily as intriguing as the others, the market psychology was.

Conversely, industrial metals such as copper were seeing incredibly high levels of demand as China and India raced to modernize. Thus, investors were convinced that the fundamental picture was supportive of $4 copper. We now know that this wasn't necessarily sustainable.

The New Investment Fad

In addition to the swirling newscasts and financial newspaper editorials regarding the emerging opportunities in the commodity markets, an enormous amount of unallocated funds were looking for investment opportunities. At the time, the stock market had essentially made little to no progress over the span of nearly a decade. Frustrated investors were easily intrigued by the commodity story and began allotting large amounts of capital to commodity hedge funds, commodity equity products such as electronic traded funds (ETFs), and Commodity Trading Advisors (CTAs). The simplicity of participating in this alternative asset class with the advent of ETFs greatly benefited the industry and likely played a part in the relentless rally. In many cases, money flowed into commodities from both retail and institutional investors with little experience in the futures of markets and limited knowledge of the high levels of risk involved in participating.

Not only do I believe that many speculative investors were relatively uneducated about the futures markets, I argue that many of the money managers were as well. There were a few things that many of them failed to recognize, such as the fact that the commodity market isn't as deep as equity markets, and prices normally trade in envelopes as opposed to ongoing inclines as stocks tend to do. In the aftermath, these simple concepts seem obvious, but at the time commodity newcomers ignored the red flags, and the concerns of commodity veterans were going unheard.

In some of the smaller commodity markets, such as rough rice futures, it is possible for prices to make substantial moves on the buying or selling of a moderate number of contracts. In other words, it isn't difficult for deep-pocketed speculators to temporarily alter the price of a commodity. With droves of cash making its way to the long side of commodities, it is easy to see that it didn't take long for things to get out of hand.

It is important to realize that this is my personal perception, and it is in stark contrast to the opinions of some other analysts. In fact, well-respected and known analysts believe that the commodity boom was purely the result of tight supply and high demand. Although I agree 100% that this was the initial cause of the skyrocketing prices, I am not convinced that it was fundamentals alone that blazed the trail for such unprecedented high pricing.

Unfortunately, markets and their participants are complex, and this often makes it impossible to pinpoint the driving force behind any price move.

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