Commodity Prices Nearing a Turning Point

Driven up by speculators, the ballooning prices of oil, as well as of many metals and farm crops, will begin to lose altitude in coming months.

By Jim Ostroff, Associate Editor, The Kiplinger Letter

April 9, 2008

Commodity prices are unsustainably high, and the bubble is about to burst. The day of reckoning is not far off. Our best estimate is that the balloon will deflate by midsummer.

Commodities are way out of whack with the dynamics of supply and demand. The froth in oil, for example, accounts for about one-quarter of its current $108 a barrel price on the futures market. Copper is a good 35% above logical levels; platinum, 30%; tin, 50%; nickel, 25%; zinc, 20%; corn, 15% to 20%; and soybeans, 20%.

What's behind the commodity bubble? Mainly investors chasing high returns. They're pouring cash into commodity futures because other choices seem less attractive. The Standard & Poor's 500 stock index lost 10% in the first quarter, its worst quarterly performance since 2002. Interest rates keep falling. Foreign producers of oil, metals and farm products want to keep prices high to offset the dollar's descent to record lows. And no one can guess when home prices might hit bottom and rebound.

Commodity gains add to herd behavior. With every price spike, more investors jump in, afraid they'll miss the score of a lifetime. Hedge funds and other big investors do most of the speculating. But more little guys are also getting in on the act by buying exchange-traded funds. ETFs trim the risk by diversifying, are easy to get into and out of and have a much lower admission price.

"Clearly, we are in a bubble situation where values get way out of line, just as they did with the tech bubble at the decade's start and the current one with home prices," says John Mothersole, a principal with the pricing and purchasing service of Global Insight, an economic consultancy.

A number of factors could burst the commodity balloon: A cut in worldwide commodity demand, big stock market gains, a more stable dollar or tame inflation signals. Prices will drop by about 30% if all these factors come into play at once, but declines will be smaller and gradual if signals are mixed. Oil will slide to $85 a barrel, with a smaller reduction at the pump, because risk is still a factor.

In any case, the bottom isn't going to fall out of the commodities market. Supplies are tight, and demand for many products will remain high, particularly with growth in China and elsewhere. There is little chance that deflating commodities futures prices will result in financial problems across the economy, such as the dislocations caused by the ongoing credit and housing messes. Unlike the hybrid financial products that packaged bad loans with little or any value, commodities are tangible and retain a real value. The commodities exchanges periodically boost margins needed to buy commodities futures and stop trading altogether to dampen the wildest speculator fervor, says Phil Flynn, a vice president with Alaron Inc., a commodities trading firm.

The bubble's pop will be good for businesses and for other regular buyers of commodities. So put off major purchases if you can. The pain will be limited to big speculators and small investors who failed to diversify plus producers who'll lose outsize profits.

There is one glaring exception to the commodity bubble: natural gas. Demand for natural gas for industrial, heating and other uses is sure to remain strong, and prices, currently around $9 per million British thermal units, may top $10 per million British thermal units next winter. Natural gas supplies are roughly adequate for normal weather, but harsh conditions are likely to cause real stress. Fading quickly: hopes that liquefied natural gas will increase supplies. LNG is going to Asian and European buyers, who are outbidding U.S. purchasers.

Laura Kennedy and Andrew C. Schneider contributed to this article.

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