Size is Important in Commodity Markets

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Did you see the story that Red Kite Metals, a $1 billion hedge fund, lost 30% in January on a bad base metals bet? The problem here, we submit, is not the fundamentals of the base metals market, which are bullish, but the nature of the base metals trades made by traders.

The London Metals Exchange allows copper contracts 63 months forward, a little over five years. Firms wishing to hedge the huge capital-cost of new production projects in base metals can hedge that development risk by selling future production to lock-in some predictable profits today. It is done all the time, with different degrees of success.

The big problem in these markets comes from speculation. A big firm that makes a large bet on the short-term movements in resource prices, say, like Amaranth, introduces so much money in to the futures market that the volume of activity skews the prices away from the fundamentals. Or as Kimberly Tara, CEO of FourWinds Capital Management in Geneva puts it, “size is important in commodity markets. If you assets are large in relation to the markets you trade in, you have to take big positions. Those positions become transparent, and expose you to larger risks in the market.”

Sixty three months is a long time. A lot can change…in just sixty three seconds. Big firms with lots of cash (remember Goldman’s Alpha fund) and little knowledge about the resource markets they trade in can easily get sucked into long-term bets which quickly turn against them. What’s interesting these days is that funds can blow-up quickly, but without apparently jeopardizing the rest of the capital market. After all, someone is on the other side of the trade usually.

The takeaway from all this, from our perspective, is that it’s better to be an equity investor in the shares of resource producing companies than it is to be a money-manager playing the resource boom from the futures market. When you buy stocks, you have earnings to go on, management to query, and above all, no leverage to worry about. When you trade futures or other derivatives, you’re gambling.

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. In your 3rd paragraph you say the problem comes from speculation.

    In the preceeding 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 ?

    Peter Schluter
    February 6, 2007
    Reply

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