Base Metals are Melting Off the Speculative Froth

We spent a few hours mid-day yesterday listening to best - selling author and world-renowned commodities bull Jim Rogers speak at a lunch sponsored by UBS. The steak was excellent and Rogers on his game as well. "Stocks can go to zero. Lead is not going to go to zero. Neither is gold. Neither is oil. There will be corrections, but when you look at supply and demand, it's not hard to do the math... this bull-market, according to my research, will last another seven to fifteen years." Dignified gasps from some audience members ensued.

But judging by BHP Billiton's (ASX: BHP) half-year result yesterday, who can argue? The company reported over $6 billion in profits, announced its intention to spend $10 billion buying back its own shares, recommitted to over $17 billion in capacity-expanding projects, and said it will still have enough pocket cash to pursue any worthwhile acquisitions, should they present themselves. That sounds like a company confident of its future as the principal resource provider for China's steady long-march into global economic leadership in the 21st century.

 True, zinc and copper prices have come off by nearly 40% from last year's highs. But there are two ways of viewing the price falls in base metals that make them look less alarming. First, there is always a little icing baked into the cake, some premium in the market which routinely corrects as traders get overextended or take profits.

The second take is that someone made a very large and foolish bet in base metals and got caught on it and the ensuing liquidation has produced a dramatic correction back to the upward trend. Or as Michael Metz at Oppenheimer Holdings in New York puts it, "There's absolutely no reason for metals to fall this way. The decline reflects the stress on one or more leveraged players. When the locals smell a catastrophe, they liquidate. In my opinion, it's a good time to buy.''

If demand for energy and raw materials is growing and supply is not, why are futures prices correction? Why, if there is consensus on the fundamental difference between supply and demand in the base metals market (over the long-term) have copper prices fallen nearly 40% from their 2006 highs? Why is zinc plunging? What gives?

Or, as a reader put it to us a few days ago, "In your 3rd paragraph you say the problem comes from speculation. In the preceding paragraph you state that miners regularly hedge forward production. Without the speculators (problem !) willing to take on the price risk when the miners want to hedge, who do you expect to be buying from the miners?"

Good question. We hashed this out with our colleagues U.S. side at Outstanding Investments-Justice Litle, Kevin Kerr, and Eric Fry. The details of the e-mail exchange are a little thick. But what we agreed on in is this: commercial producers of commodities regularly use the futures market to hedge against price volatility. Speculators can be and usually are on the other side of this trade. The futures market is, after all, a zero sum game. Somebody wins and somebody loses.

What we saw in 2006, however, was a case in which the speculators demand for long positions in base metals exceeded, based on open interest and volume statistics, the normal supply of contracts from the commercials. In other words, if you wanted to place a bazillion lots of orange juice, but there were no 'natural' seller, who would the 'unnatural sellers' be?

Presumably, the demand for orange juice contracts would drive up the price, attracting sellers to the market. The fund's demand would create its own supply, a futures market version of Say's law. And after all, if you think about it in speculative terms, if a trader at a fund that does not really understand the cyclicality of commodity markets and price volatility wants to go long a commodity more than a few years out, there is surely a savvy speculator willing to sell him what he wants, knowing full well that prices correct. As my friend Rick Rule says, in the resource markets, you are either a contrarian or a victim.

So the counterparties in commodity future trades are buyers and sellers, or contrarians and victims. Ironically, it is the commodity producers themselves, the commercials, who tend to be contrarians. They are content to lock in profits today against the unknown of future profits. As long as they don't do so too aggressively, they end up okay.

That leaves the speculators (the hedge funds) as the victims, and this we find somewhat comforting. Not because we like funds to lose money. After all, the money really does belong to someone, with a lot of leverage kicked in. But it does raise the question of who is on the other side of these massive losing bets by Amaranth and Red Kite? Is it a market maker? A commercial? We don't really know. But a few years ago it was rumoured that John Henry, the owner of the Boston Red Sox, was on the other side of Nick Leeson's disastrous trades in Nikkei and Japanese government bond futures.

This was before Henry owned the Red Sox and explains how Henry, if the story is true, could afford the Red Sox and their $100 million plus payroll. Henry possibly spotted a trader who was clearly out of his depth, or simply addicted to speculation, and saw easy money on the table. He had to be willing to take the risk. But as long as there is a counterparty, there is a trade. The rest is history.

For the record, our educated guess is that the fall in base metals prices is the boiling off of the speculative froth. Investment demand by funds sent contract prices up, which had the affect of also cooling real demand (synchronous with a slow down in the U.S. housing market.). Then, when all the fund demand for base metals contracts dried up, the price fell. What's interesting is that the 40% correction in copper looks eerily like the 40% correction in oil. That is, it's a correction of speculative excess, without violating the fundamental upward trend in the price of the commodity.

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