Commodity Collapse: Crash or Correction?

Last week’s collapse in commodities prices was one for the history books. Oil prices fell by 15%. Silver plummeted 27% — the metal’s largest percentage decline in more than 30 years. Even gold fell by 4.2%, after the Wall Street Journal reported that billionaire investor George Soros sold off some of its stake in the “barbarous relic.” Overall, the S&P’s GSCI Index of 24 commodities dropped 11% in five days, the most since December 2008. The losses erased all the gains in the red hot commodities market since mid-March.

Last week’s rout in commodity prices was never supposed to happen. Explaining its 8.9% drop in the value of the world’s largest commodity hedge fund, Clive Capital was at a loss to explain what had caused crude oil markets to be “annihilated,” noting that the price of Brent crude was a “five standard deviation event.” According to my back of the envelope calculation, a five standard deviation event in financial markets should happen only once in every 8,721 years. That stretches back to the time we humans began to abandon the African Savannah in favor of planting crops and launching the agricultural revolution. It was also about 8,550 years before Brent crude oil had much value to anybody.
With commodities bouncing on Friday and yesterday, the rout appears to have ended. But understanding that sharp price movements are just a part and parcel of commodity investing – and that there are powerful fundamental reasons for the commodities boom to continue — is key to riding out these increasingly regular “1 in 8,721 year” moves. And buying into the current dip in commodity prices could be one of the savvier investment moves you make in 2011.
Commodity Collapse: What Happened?
Even as global stock markets notched up solid gains in 2011, it was commodities that fueled speculative fervor among investors. With broad-based commodity indices up 13% — as 61% gains in silver, up until last week’s rout — returns on commodities had beaten stocks, bonds and the dollar for five consecutive months through the end of April. That was commodities’ longest winning streak in at least 14 years. About $9.61 billion went into commodity funds in Q1 — more than triple the $2.77 billion a year earlier. Even after the sell-off, the S&P GSCI Index stood 33% higher than a year ago, having more than doubled since February 2009.
Last week’s sell-off highlights the way in which commodities investment landscape has change over the last 30 years. Commodities were out of favor for so long that Merrill Lynch shut down its commodities trading desk at the height of the tech boom in the late 1990s. But after being ignored throughout the 1980s and 1990s by private and public pension funds, hedge funds and institutional investors, investment in commodities soared over the last decade. Merrill Lynch today estimates that investments in commodity indices alone reached all-time highs of $352 billion in April.
The advent of commodities-based exchange traded funds (ETFs) has also changed the profile of your typical commodities investor. During the last great commodities boom in the 1970s, trading limited to investors sophisticated enough to trade on futures exchanges. That in contrast to today, where commodities today play a much bigger role in many small investors’ portfolios through ETFs.
While the profile of the average investor has changed, the commodities market itself hasn’t. With derivatives – mostly in the form of futures- playing a much bigger role than in the stock markets, commodities are a still leveraged market. And that makes the booms and the busts both more seductive… and dangerous.
The combination of a greater presence of retail investors, quantitative funds, and leverage contributed greatly to sharp movements in prices. As retail and non-traditional investors took profits, quantitative funds sold — and perhaps even went short — causing a series of mini “flash crashes.” Meanwhile, futures exchanges raised the margin requirements on silver, exacerbating the move in “poor man’s gold.” To add insult to injury, the Dollar Index, a measure of the Greenback against six other major currencies, rallied 2.6% last week — the most since August. The Greenback’s rally also stacked the deck against commodities prices.
Commodities Collapse: How to Profit
Buying right after sharp corrections is one of the best strategies you can use to generate quick, short term profits in commodities investing. History is also on your side. After the last collapse in commodities in 2008, prices soared 12% in just the next week.
Bears point out that “this time it’s different,” as they often say. A slowdown in China’s growth will hurt commodity demand, as will China’s growing anti-inflationary stance. That ignores the fact that China will still look to grow at 8% per year for many years. And that overarching policy ensures continued strong demand from the biggest consumer of commodities in the world.
Look beyond China, and the case for commodities only becomes stronger. Citizens of developing countries will continue to drive more cars. They will continue to build out their infrastructure. There is arguably no stronger trend in investment today. And certainly it won’t be derailed by either Japanese earthquakes or increases in margin requirements
Then there is the downward trend in the U.S. dollar. The US Federal Reserve has pledged to keep policy rates at all-time lows for an extended period of time. That, combined with trillion dollar deficits, means the Greenback will continue on its downward path. And that downward trend is bullish for commodity prices denominated in U.S. dollars.
So how do you profit from all this?
Here’s what you need to know.
  1. Despite the speculative fervor in commodities markets, last week’s sharp sell-off in commodities was not driven by change in fundamentals. The long term case of commodities remains firmly intact.
  2. I don’t expect the commodity price correction last long. Once leveraged positions are unwound, the market will turn its attention back to commodities fundamentals.
If you want to catch the upswing in the market, I recommend buying a broad-based commodities ETF like the PowerShares DB Commodity Index Tracking (DBC).
Six months from now, you’ll be glad you did…