Will there be a commodity price crash?

December 3rd, 2009

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Remember, back in January 2007, in Analysing recent falls in oil prices?real vs investment demand, we discussed about the difference between investment and real demand for a commodity,

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.

Lately, we are asking ourselves the same question for the broader range of commodities, particularly base metals. In particular, we draw your attention to this news article,

London Metals Exchange (LME) inventories for most metals have been rising strongly of late. For example, aluminium LME inventories are 75 per cent higher than the prior 20 year high set in May 1994. Nickel inventories are only 6 per cent below the 20 year high set around the same time. Zinc inventories have risen six fold since the start of the subprime crisis in September 2007. Lead inventories are up five-fold over the same period. While not at a record, copper inventories have increased for 20 consecutive weeks and are up 70 per cent since 30 June.

Now, this is a curious phenomenon- as prices for base metals rebounded, so did their inventory stockpile levels. This is a tell-tale sign that much of the price rise are due to the rise in investment demand instead of real demand. This investment demand is based on the same idea in Does rising house prices imply a housing shortage?,

The belief that prices will always go up forever and ever can create its own artificial demand. The insidious thing with this belief is that it is a self-fulfilling prophecy- belief leads to increased ?demand,? which in turn leads to higher prices, which reinforced the belief, which in turn leads to increased ?demand? and so on and so forth. When this happens, higher prices lead to even higher ?demand.? Such artificial demand can act as a sink-hole for whatever quantity of supply.

So, base metal prices are vulnerable to a correction. Current prices are based on the belief on the exaggerated sense of the China (and India) growth story. If this belief is ever molested by some reality check (e.g. see Is the Chinese economy a house of cards?), chances are, base metal prices will fall. There are even reports that China is pretty stocked-up with those commodities as we speak and may be going through a de-stocking phase next year. At the very least, base metal prices may be pretty subdued next year.


P.S. Check out Economy to ride a second wave of China stimulation. The Chinese are preparing to fire a second stimulus that is aimed at boosting consumption. Our interpretation is this: the Chinese government needs to flood the economy with more money, otherwise the bubble will burst. Result: more corruption, speculation and inflation.

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