Buying Commodities on the Dips

It has been a brutal couple of months for commodities investors. Prices may have temporarily overshot fundamentals on the upside in June. But the opposite situation now exists. The commodity sector wipeout of the last two months has obliterated any froth or excess. And now, prices may overshoot to the downside. One thing is clear; fear and forced selling are driving the commodity markets right now…not underlying fundamentals.

A few days ago, Ospraie Management, a large manager of commodity hedge funds announced the closure of its largest funds. It will return capital to shareholders in stages. Ospraie’s funds had been performing well for years, until some wrong-footed trades in natural gas and copper futures led to deep losses in July and August.

Ospraie had a big presence in commodity futures, so its heavy selling has clearly intensified the recent price declines. Rapid price declines have fueled speculation that the commodity bull market is over. I very much doubt that it’s over, because in most cases, commodity supplies are too tight to meet strong, long-term demand from a growing world population — a population governed by politicians who can create both deficits and unlimited amounts of paper money. Governments and central banks will not sit idly by and allow a debt liquidation to destroy the banking system.

On the supply side of the equation, which most headline writers and pundits totally ignore, some commodity producers are shutting down projects that cannot produce at a profit. In a few commodity markets, prices are falling below the cost of production!

The fundamentals of supply and demand will matter again once current fears ebb. They always do. Energy and commodities have solid long-term fundamentals that rest on a foundation of human need. By contrast, financial companies are still facing ugly fundamentals, like plunging collateral values, rising defaults, and capital shortages.

Central banks will prevent the worst-case scenario of uncontrollable, self-reinforcing defaults. But their money-printing efforts will not bring about a re-inflation of the housing and credit bubbles. We probably won’t see another credit bubble for at least a decade. Once the fall in housing and mortgage securities slows down, excess liquidity created by central banks will find its way back into inflation hedges like gold and oil, potentially creating a future bubble in commodity-oriented investments.

As for the rest of 2008, my research leads me to the following most likely outcome: The stock market remains weak until the Federal Reserve totally abandons its “inflation fighting” stance. The Fed may even cut rates further as unemployment rises. At that point, commodity-oriented stocks will probably regain their position of leadership.

The recent decline in commodity prices allows the Fed to conjure up another “deflation” scare. This would provide cover to slash rates and inject reserves more aggressively into the banking system. Then, the U.S. dollar would resume its descent, while gold and commodities would resume their ascent.

The Fed’s current inflation campaign has been very modest thus far. Rather than expand its balance sheet and flood the banking system with liquidity, it has concentrated on swapping U.S. Treasuries for dodgy mortgage securities.

Central bankers on the other side of the Atlantic, though, seem to care more about what’s backing their currency. The European Central Bank just announced that it’s going to limit its role as a dumping ground for impaired mortgage securities. The Financial Times explains:

“[ECB President Jean-Claude] Trichet announced a series of measures to increase the cost of using asset-backed securities to obtain ECB funds and to exclude some such deals when underlying mortgages or other loans are not denominated in euros. The announcement follows comments by ECB council member Yves Mersch last month. He said there were still cases where ‘you see dangers of gaming the system.’

“This year, it emerged Macquarie Bank had constructed a deal backed by Australian car loans that could be used at the ECB and Lehman Brothers had formed a huge collateralized loan obligation of risky buyout debt to use at the central bank.

“Mr. Trichet said the ‘general character’ of its broad-based operations remained unaffected. ‘We’re not changing it, we’re refining it,’ he said.

“Only a ’small fraction’ of collateral would be affected. Banks’ ability to take part in its financing operations would be unimpaired, the ECB president said.

I see the ECB’s decision as a tactic to convince savers and investors that the euro will not be forever backed by securities of dubious quality. But European politics may eventually overwhelm the ECB’s fairly disciplined monetary record. Voters will demand easy money.

In the U.S., fiscal and monetary policy will likely be influenced more and more by big investors and foreign creditors. Bill Gross, manager of a huge bond portfolio, is concerned about the potential for “financial tsunamis” and “debt liquidations.” He thinks that the Treasury Department (i.e., taxpayers) has not done enough to stop the bleeding in mortgage securities. In his latest “Economic Outlook,” Gross describes how institutional mortgage buyers may sit on their hands until the Treasury Dept. initiates a new, huge bailout.

Whether taxpayers like it or not, Gross’ plea for a new bailout will probably be answered. The leverage in the banking system has grown beyond the point of no return. There’s no way the Fed and Treasury would allow a spiraling liquidation of debts. One way or another, mortgage losses will be partially “socialized.” Most of the burden will fall on savers because over the next decade, more paper money will be created than would otherwise have been created.

Think of paper money as a shock absorber for losses in the financial system. In times of crisis, central banks try to calm fears about bank runs. They spread losses from bad loans around to everyone who holds paper money. This game can keep going until the holders of that paper money lose confidence in its function as a store of value.

But don’t interpret a new bailout plan for mortgage investors as a sign that the financial stock bear market is over. It’s not — at least not for banks holding the worst credit exposures. Over time, these institutions will have to confess losses; take write-downs; and raise new, dilutive capital. Many will be taken over by the FDIC, which wipes out shareholders.

During times like these, investors do well to remember that the commodity sector never requires a “lending facility” from the Fed or a bailout plan for the Treasury.

Dan Amoss, CFA
September 17, 2008