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Crisis remakes the commodity business

Only the brave or the foolish would make predictions about the future amid the biggest market upheaval in three generations. But it is already clear the crisis is profoundly reshaping the commodity trading industry. The mix of intermediaries, customers and financial resources are all being substantially redrawn. So here are some tentative thoughts on how the industry will be remade over the next three to five years.

The most immediate impact has been on the availability of funds. The relative importance of tightening supply-demand fundamentals and speculation in propelling real inflation-adjusted prices to multi-decade highs remains a matter of fierce debate. But there is no doubt the inrush of investment money via passive commodity indices and actively managed hedge funds since 2003 helped accelerate and perhaps exaggerate the rise.

On the way up, the steady stream of fresh investment buying helped establish successively higher floors for commodity prices, creating a ratchet effect as investors attempted to buy the dips. But with the influx of money into commodity markets slowing to a trickle, and even reversing, this floor disappeared and the markets have been selling off into a vacuum.

Index managers have responded by liquidating holdings while hedge funds have been forced to scale back long positions to limit losses and risk exposure. But the resulting sales into a market that was already thinly traded have simply made the liquidity problem worse, leading to sharp price declines as pricing becomes discontinuous and the market gaps lower.

Even when the markets settle, investment money is unlikely to return to commodity markets in such volumes for the next few years:

1. Smaller “wall of money”

The financial crisis has destroyed trillions of dollars of financial wealth. Perhaps more accurately it has resulted in the evaporation of much credit-fuelled paper wealth that was illusory in the first place. But whatever the truth, it will sharply reduce the total volume of financial capital to be invested in all asset classes, whether equities, bonds, commodities or other alternative assets.

The “wall of money” flowing into commodity and other markets as a result of demographic change, the shift from pay-as-you-go public pension systems to private funded defined-contribution programs, and shifting risk preferences will still be there. But for the time being it will be a smaller wall, and the corresponding (inflationary) impact on asset prices will be less.

2. “Vanilla” assets

The crisis will almost certainly force both institutional and private investors to adopt more cautious and conservative investment strategies until memories fade. As the overall appetite for risk falls, investors will increase their portfolio allocations to assets at the safer and less volatile end of the spectrum (including government and high-grade corporate debt) and reduce exposure to riskier asset classes (including commodities).

For the next few years, the fashion will be for simple, transparent and “vanilla” assets at the core of the financial system with straightforward cash flows and valuations (western bonds and equities) rather than complex, opaque and more exotic assets on the periphery (including commodities, emerging market securities and the whole suite of complex structured debt) which are harder to value and less liquid to trade.

3. Perception of high risk

The extreme volatility in commodity prices exhibited over the past year (with crude oil prices doubling to $147 per barrel in less than 12 months and then halving to $60 in less than 12 weeks) will reinforce reputation of commodity futures as very high-risk investments.

The steady appreciation in energy and raw material prices between 2003 and summer 2008 dulled memories of the earlier commodity boom of the 1970s, and the collapse of the 1980s. As memories faded, many investors were just becoming comfortable again with allocating a significant part of their portfolio to commodities. But recent gyrations have been a brutal reminder that commodity prices can go down as well as up, and the asset class is much more volatile and therefore riskier than equity markets and bonds.

4. No place to hide

Exposure to passive commodity indices and actively managed hedge funds has not provided the diversification its proponents hoped. Commodity prices have remained strongly pro-cyclical. While energy prices have some independent dynamics (weather, geopolitics) that provide useful diversification, most other raw material prices are driven by the same business cycle affecting equities and bonds.

More worrying, correlations have not proved stable over time. The sharp rise during each recent bout of financial turbulence (May 2006, March 2007, August 2007, January 2008, September 2008) has undercut the argument commodity exposure helps produce more stable returns overall. Commodities have proved no place to hide when the economy turns down.

5. Investment is complex

Recent enthusiasm for commodity investments has reflected the popularization of a simple proposition (urbanization and industrialization in China, India and other large developing countries will provide a structural underpinning for higher commodity demand in the long term) and a resulting investment strategy (buy and hold to benefit from long-term price appreciation). The simplicity of this theme-and-strategy is intrinsic to its attractiveness for a wide range of institutional and retail investors.

But while the central urbanization and industrialization thesis remains arguable, recent developments have been a brutal reminder the business cycle remains alive and well; any long-term uptrend in real commodity prices will be overlaid by substantial cyclical variations. Long-run returns in commodity investments depend crucially on the timing of entry and exit.

Active management strategies which seek to gain exposure to commodity prices for part of the cycle are likely to be more successful than buy-and-hold strategies. But the difficulty of timing the market makes commodity investments more complex and could limit their broader appeal to retail and institutional investors (much as it did following the boom and bust of the 1970s and 1980s).

For all these reasons, investment inflows into commodities are likely to be much smaller than they have been over the last two to three years.

Most of the growth in paper-based commodity trading since 2003 has come from investment business rather than producer and consumer hedging. If anything, the volume of hedging business has dwindled as a growing number of oil and mining companies have reduced their existing hedge books and committed to “no-hedging” strategy in future to give their shareholders full exposure to the commodity cycle (at least during the upswing).

There were some signs of increased hedging as prices peaked during H1 2008, as airlines, retailers and manufacturers all sought to protect themselves against a further escalation in energy and food prices. In most cases the upsurge in hedging interest came too late, and these hedges are now deeply under water.

It does not alter the fact most of the upsurge in futures and options turnover on commodity exchanges and in OTC markets over the last five years has come from investment-related rather than trade-related business. That seems set to change dramatically.

Trade-related business will become much more important for the next year or two as the volume of financial-related business declines. As the pattern of commodity market activity shifts, the main beneficiaries will be the banks and trading houses that can reposition themselves fastest as value-adding service providers for producers and consumers, especially in the still-growing economies of Asia and the Middle East.

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