Price fluctuations and hoarding

March 25th, 2008

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Continuing from yesterday, we observed the recent volatile movement of commodity prices. In today’s lightening speed of Internet trading at the click of a mouse button, how much do these price movements reflect changes in underlying demand and supply? This is the issue that we brought out in Analysing recent falls in oil prices?real vs investment demand,

What makes up the demand for oil? There are basically two types of demand for oil: (1) The physical demand where the real side of the economy uses for its everyday needs and (2) The investment demand where the financial side of the economy shifts the money here and there from one asset class to the other. We need to ask ourselves the following question: Has the physical demand for oil changed?

In today’s context, does a sudden fall in the price of a commodity (e.g. oil, iron, grain, wheat) mean that its underlying demand has suddenly fallen or its supply has suddenly increased? Obviously, the answer is no.

Over the years, through the developments of financial ‘innovation,’ commodities have become the playground of hedge funds and other money shufflers. So much so that we had to categorise demand into basic underlying demand and ‘investment’ demand. As we think about this issue more and more, how can commodities really be ‘investments’ in the first place? As we said before in Is gold an investment?,

But in reality, since gold is a boring, inert metal that does not have much pragmatic use and does not pay dividends, income or interests, it is completely unfit for ?investment.?

In the same way, commodities are tangible things valued for their pragmatic use. But they do not pay dividends, income or interests too. So, how can they be ‘investments’ and therefore, have ‘investment’ demand associated with them?

Today, we had thought of a better way to describe those ‘investment’ demand- hoarding. In essence, those hedge funds and money shufflers who ‘invest’ in commodities are hoarding. They hoard commodities in anticipation of increased demand in the future. As their anticipation changes, they hoard and dis-hoard accordingly, resulting in irrational price movements. Worse still, some of them borrowed money to hoard, thus accentuating the violence of price changes. With central bankers like Ben Bernanke increasing the floodgates of more easy credit (see Marc Faber: Bernanke Policy Will ?Destroy? U.S. Dollar), no wonder much of these borrowed money goes into hoarding in anticipation of higher prices.

All these hoarding activities distort price signals, which can even confuse the experts on the state of real underlying demand and supply. As long-term investors, do not let the hoarders confuse you.

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