A red flag for commodity investors

One of the more confusing aspects of this market has been the comparatively muted response from commodities, as I’ve noted before.  Recall that while equities push in to new record territory - outside of Australia - commodities haven’t had it so good. 

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This is out of the ordinary. I realise that the economic discussion in Australia is obsessed with downturns and a China hard landing, etc, but the reality has been very different. Global growth is accelerating and the consensus is that it will continue to do so. Moreover, the supply gluts talked about last year haven’t eventuated and I think this is best captured by the iron ore price. Iron ore was expected by some to be around $100 by now, driven by surging supply and declining steel production, especially in China. Instead what we find is that steel production has ramped up and defies talk of a slowdown (notwithstanding talk now of a steel glut). Iron ore itself remains just over $130. 

Red tape fears

In the background though, there has been a more serious threat to investors in the commodity space - tighter government regulation.  Specifically, the Fed announced it is reviewing a 2003 decision that allowed deposit taking institutions to trade physical commodities. Indeed the Senate banking committee held a hearing on this very issue, or rather on the issue of whether banks should be allowed to own the infrastructure - warehouses, oil tankers, pipelines, rail etc on which physical commodity markets rely.  And they do.

Why all the interest? Well behind these hearings, investigations and re-evaluations are accusations by end users of commodities, that banks are manipulating prices. So for instance US brewers allege that banks are creating an artificial shortage of aluminium through their ownership of warehouses. Similarly the CFTC has investigated major investment banks, like Goldman’s Sachs JP Morgan and HSBC for manipulating markets – for example silver and gold. JP Morgan was recently accused of manipulating electricity prices in California and is nearing some form of settlement with the energy regulator. Similarly in Europe, Barclay’s and Deutsche Bank have paid fines for allegedly manipulating energy markets. And of course we know how short-term interest rates (LIBOR) were being fixed.

Recall that under the Dodd-Frank bill and the Volker rule, banks are already prohibited from proprietary trading (trading on their own account) in the commodities market. So it’s not that this latest foray into the markets by the Fed is without precedent or totally unexpected. But it is another step in clawing back past provisions which allowed banks to trade and own commodities. Up to this point a criticism of the Dodd-Frank and Volker provisions was that a bank could skirt around the edges by still taking financial positions in commodity derivatives, but relay that trade back to the underlying physical assets held by their many subsidiaries.

With that in mind, the effect of the Fed’s announcement and the Senate’s hearing could be profound, because without an actual case to hedge the underlying physical - which they would be allowed to do if they held actual commodities -  there is less of an excuse the trade the derivative financial products (futures and options and swaps).

Putting aside the individual cases of market manipulation and the apparent prevalence of it, the other picture emerging is the clear stated desire of industrialists, regulators, politicians etc to intervene in what they see as excessively inflated commodity prices. I’ve highlighted before the coordinated sabre rattling of the G7 and Saudi’s back in September last year when they deemed crude had gotten ahead of itself.  Crude has effectively been range trading since.

Against that backdrop, the Fed’s statement and the Senate hearing must be seen as just one more in a series of steps that have/are being taken to rein in financial markets and in this particular instance  the commodities market. I suspect regulators are taking much more seriously the Commodity Exchange Act which states: “Excessive speculation in any commodity…is an undue and unnecessary burden on interstate commerce.”

The great fear of policy makers, ultimately, is a repeat of the commodity boom of 2008. The view is that such bubbles pose, not only a threat to global growth, but also a systemic threat to the financial system. Previously, the policy consensus was that speculative investment or just financial investment generally didn’t really have a material impact on commodity prices. The idea was often resisted in, even in 2008 and by some by the world’s major institutions - the IMF and CFTC both rejected the idea that speculative investment was a key driver of commodity prices. So too did our own RBA as late as 2011.

More recently it has become much more widely accepted that not only is financial investment a driver of commodity prices but a key driver - and you can see this most clearly in the gold and crude markets. 

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The chart above shows investment demand for gold at 35% is almost as important as demand for jewellery. This clearly has a significant influence on the price of gold. It’s a similar case for the crude market although the ownership of physical assets by traders and banks makes it very difficult to determine the extent of speculative or even real money investment. That being the case, the experience of 2008 shocked many people including policy makers, when the crude price shot up to $145 per barrel. Peak oil fever was rife and the script was that price moves were fundamentally driven - the BRICS etc - not speculatively.

All the while, there was no material change in terms of world oil balance to justify such price moves indeed as you can see from chart 3 below, there was a surplus of crude in the market at the time. It was a bubble in every respect and I think that is common wisdom now. 

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It was only a year after, that a paper written at the James Baker Institute for public policy challenged the view that financial or speculative flows didn’t move the crude market (and by implication commodity markets in general). The authors suggested that government should take a much more active role as they did successfully in the 1990’s. The sabre rattling of last year (in the crude market) by the G7 was actually one of the recommendations made in that that paper. Otherwise you can see through the actions of policy makers  now, that the consensus has clearly changed and it is widely accepted that these markets are not only driven by investment sentiment but prone to manipulation as well. Consequently we see action on a broad-based scale to combat this.

For investors the difficulty will be in determining to what extent price moves reflect weight of money versus real fundamentals. I mean there can be no doubt that the real fundamentals are very supportive - energy demand is rising exponentially, that’s a fact. The iron ore story is also very real and the global construction upturn should support copper and other materials.  

Having said that the implications of greater regulatory scrutiny could be profound if they follow through - and that’s a big if. Lobbyists will be working overtime. Price target set by regulators are often arbitrary and not communicated to the public. At this stage, all we know is that there will be fierce resistance to further broad-based commodity price gains. Moreover, if banks are indeed restricted by the physical market and holding associated infrastructure, that’s a huge chunk of demand (weight of money) dropping out just there: and that demand really can’t be replaced by the large non-bank trading houses. They don’t have the balance sheet strength the majors do, nor the same access to capital. In any case, current trends suggest that regulators will simply move to tighten the screws on the non-banks as well, especially if they are deemed systemically important.

Either way the investment landscape has changed, perhaps irrevocably. Retail investors should be very cautious from here given the sheer extent to which governments are prepared to involve themselves. Bonds are already a no go area for retail investors for that very reason - QE, budget deficits, high debt and increasingly I think commodities might be as well. At least until we get greater clarity. With all the political interest it’s increasingly only game for the big guys I think and maybe not even for them.