Are Commodities Heading Lower?

One of the main reasons I have been concerned about inflation is the incredible price spike across a variety of commodities. However, according to this week's Barron's cover story (subscription required) this may be the result of a speculative bubble. Here are some pertinent excerpts:

Here's the problem [with all of the bullish bets on commodities]: The speculators' bullishness may be way overdone, in the process lifting prices far above fair value. If the speculators were to follow the commercial players -- the farmers, the food processors, the energy producers and others who trade daily in the physical commodities -- they'd be heading for the exits. For right now, the commercial players are betting on price declines more heavily than ever before, says independent analyst Steve Briese.

For example, in the 17 commodities that make up the Continuous Commodity Index, net short positions by the commercials have been running more than 30% higher than their previous net-short record, in March 2004.

Briese, author of the recent book The Commitments of Traders Bible and editor of the Website CommitmentsOfTraders.org, was one of the first to recognize that information on the bets made by the commercials could provide rare insights into how the "smart money" views the price outlook. These days, the data suggest, the smart money clearly believes that the market's exuberance has turned irrational.

Indeed, the great commodities bubble started springing its first leaks two weeks ago: Oil, gold and other major commodities posted their steepest weekly drop in half a century. Though prices have since firmed, they could eventually drop 30% as speculators retreat. The only real question is when.

.....

Commodities index funds, which arrived on the scene in the late 1990s, have come into their own in the past several years. The biggest index fund, Pimco Real Return (ticker: PRTNX), has seen its assets swell to $14.3 billion from $8 million since its inception in January 1997.

Index funds offer investors an easy, inexpensive way to gain exposure to a segment of the commodities markets or a broad-based basket of commodities. Result: The funds have drawn many private investors who have never ventured into futures, along with pension funds and other institutional players looking to diversify. But for all the virtues that the funds hold as a way of spreading bets across commodity markets, they take only long, or bullish, positions, avoiding short-selling. In other words, they trade on the naïve and potentially fatal assumption that commodities have the same tendency as stocks to rise over the long run.

The short version of all this is that a technical abnormality relating to large investment funds is seriously distorting the true picture of commodities prices. Whether this is true or not I have no idea. I've never bee a big fan of economic models in general and am generally more suspicious of models that say "X% of this price goes to Y variable."

That being said. there is a strong possibility that the loophole in the futures market's rules is allowing a price distortion to occur that is not based on simple supply and demand of particular commodity.

According to the article, there will be a big meeting on April 22 to see how this plays out. Keep your eyes on that meeting.