Thoughts on Commodities

The more I look at commodities, the more I think there is no fundamentalreason for oil to be rising. Consumer demand hasn't changed significantly,and supply is ample. The only real thing that has happened in recent months is that suppliers have tried to manage the price of oil (for example) to drive up the price of oil (same case with other commodities).

So why is oil rising? Let's incorporate the role of speculators in commodities. What I think has happened, in addition to suppliers curtailing production, is that speculators have seen a bottom in the pricing of oil. Because they can see a turn, they have decided that it's an appropriate time to accumlulate oil, thus helping to drive up the price of oil. I don't think anyone is consuming the oil. It is, as it did last year, sitting in tankers somewhere in the ocean.

The role of speculators also helps explain another thing that's been bothering me. Demand is flat, and by themselves, producers can't cut production enough to drive up the price of oil from $45 or so to $60. No one thinks that OPEC is an effective cartel and with Russians, Brazilians, Venezuelans and the like in the mix, there is no effective coordination of supply. The only explanation left is that speculators help limit supply and drive up the price of oil.

A similar example would be China stockpiling commodities. I never accepted the argument that a) China's economy was excelling while the rest of world was in crisis; or b) that China could save us from recession. China is wayto export dependent for a) to be true, and China's economy is not large enough to do b). So the stockpiling argument is the only one that made sense. So in effect, China is being a commodities speculator. Like the oil speculators buying oil and holding them off in tankers at sea, China is stockpiling needed commodities when they are cheap and holding them in storage. And you see the effect that it's had on the markets; if speculation is large enough, it can drive up the price of commodities, the way China helped drive up the price of copper and coal.

Add one other factor to the mix: the price of the dollar. As the dollar weakens, as it did today, the speculators (traders and china both) will buy and stockpile more because the lower dollar drives down the price of these commodities for some of these players.

So what does it mean? First, in terms of a model for understanding what is happening with commmodities prices, that would mean we have to take intoaccount the following:

1) "true" demand - what people are actually consuming

2) supply - and this could be OPEC; other countries; and the US reserves,such as the petroleum reserve (the US could release oil and increase supplyto drive down prices); and supply disruptions (violence in Nigeria)

3) speculators - China, traders, as mentioned above

4) the price of the dollar (lower dollar = higher commodities)

5) inflation (which is actually related to 4)

And in terms of what this all means for investing, it means the following to me:

1) Commodities require caution because volatility will be higher and not based on fundamental demand.

2) if this explanation is correct, this means that we have to TRADEcommodities rather than INVEST. Meaning we have to buy and look to sell and take profits when we think the speculators have stopped buying. For example, this means that the copper trade based on china's buying cannot last forever. It might last because the dollar weakens or inflation hits, but not because china is in economic recovery.

3) and it means that we can't assume the economy is recovering. Which I think is the more accurate picture. I think the recovery will be long and slow. That makes more sense to me than the idea that people will spend more and we'll recover sooner.