What Are Commodities Saying About the Financial Crisis?

Can you believe it’s already June? What a month May was for commodities. They are Lazarus, come from the dead to tell us all that the world will not stop turning if there is a financial crisis in the West. Or something like that.

If we were using numbers instead of metaphors, we’d say the CRB Reuters/Jeffries Index had its biggest monthly rally in 34 years. It was up 14% on the month. That was the best performance since July of 1974.

A monthly performance like that can only mean one thing. We’re just not sure what one thing it is. It could mean commodities have rebounded from being oversold, as they were in late 2008. It could mean that markets are less pessimistic about the global economy than your editor at the Old Hat Factory (though we doubt that).

It could also mean that investors increasingly prefer tangible assets as a long-term growth strategy over financial assets. Even after $1.465 trillion in realized losses by global banks and financial institutions, there are trillions more to come. Commercial real estate…the option-ARM recast period in the U.S. housing market…European banks…any or all of these things could conspire to lead to more losses and more capital raisings in the financial sector.

Perhaps that is what explains crude oil’s biggest monthly gain in a decade. July crude futures traded at $66.52 in Friday’s New York action. The U.S. dollar price of gold powered to $981.20, before sliding back a bit $975.

The Aussie gold price is fighting its way up despite the fact that the Aussie dollar keeps gaining on the greenback. While the Aussie gold price is up just $1.71 in the last 30 days (0.14%), the U.S. gold price is up nearly nine percent. We reckon the Aussie gold price will begin moving up closer to $1,500 again on a combination of events (weakness against the greenback for one.)

There are also two data releases this week that will affect the Aussie dollar. The RBA meets today to decide the price of money in Australia (set interest rates). And then Wednesday, the March quarter GDP figures come out. This will tell us how bad the recession is, although not how bad it may become.

It’s no use predicting these things, but for what it’s worth, our view is that we’re in a bit of a plateau between down moves. The “down moves” will come again in financial stocks, although they may not be as “down” as before, and employment. Mostly, the indices are going to have to price in very slow GDP growth for the remainder of the year and more job losses.

The wildcard for Australia is trade. Its proximity to Asia means that a rebound in that part of the world provides some cushion to resource companies. But then, we thought the resource stocks would be pretty well insulated from the first round of deleveraging too, and we were wrong about that. And the second time around?

Well, even if the long-term underlying demand for Aussie resources is real and growing, it still takes real money to make new projects happen. The financing of resource projects will continue to be a key issue in your stock selection. The other issue, obviously, is the direction of commodity prices.

Take LNG, for example. Last year the Australian Petroleum Production and Exploration Association said it wanted to triple Australia’s LNG output to sixty million tons per year. Meeting this weekend in Darwin, the group says 50 million is a more realistic target, given both the slump in energy prices and tight credit markets.

If LNG prices track oil prices-as they did in the big run up to $150 per barrel for crude-the economics of big Aussie projects get a lot better. Our view is that energy prices are going structurally higher anyway. Global recession aside, the big plunge in energy capital spending virtually guarantees a supply shortage in the coming years anyway.

Besides, you have to wonder why big international energy firms would be investing in conventional and unconventional Australian LNG projects if they weren’t convinced that a) oil prices were going higher, or b) more carbon-friendly fuels like gas would gain as coal gets politically demonized and punished with cap-and-trade or emissions-trading-schemes.

Obviously, if global trade continues to contract and a second round of losses in the global banking industry triggers another financial crisis, demand for energy is going to fall. And while we’re at it, stocks would probably test the 2003 lows too. We enter a new stage of grimness.

In the meantime, energy and precious metals stocks are riding higher commodity prices. And there’s a distinctly 2007 mind-set in the air. It’s vogue to be long-commodities and indifferent to risks in the financial system. It’s enough to make an investor with a short memory nervous.

Dan Denning
Daily Reckoning Australia

June 2, 2009