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By Knight Kiplinger

The Kiplinger Washington Editors

July 3, 2008

The largest U.S. banks are hurting badly, and the pain is starting to spread. Most small and midsize banks are still ready to lend to businesses, but they're getting nervous. This week's Kiplinger Letter examines the outlook.

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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

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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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POSTED BY: Steve Benard (April 08, 2008 04:04 PM)
The key to commodities prices isn't speculation. It's high demand and short supply. Demand remains strong. The USDA has recently mentioned that grain stocks in the US are at multi-decade lows; wheat hasn't been in such short supply for 60 years -- not since World War II! That's the stuff of famines, not bubbles! Commodities traders don't care whether prices are going up or down. I know, I'm one. I'll sell soybeans or oil just as quickly as I'll buy them, but I'll do what the market wants, whether its buy or sell. Right now, the fundamentals support higher prices, not lower ones. When that changes, I'll be the first one in line to sell. If you are correct that we will see "big stock market gains", and the business climate improves, so will demand for oil, industrial metals, and food commodities. It will be even worse if the US doesn't grow a bumper crop of grains this year. To the contrary, if the Fed keeps up the easy money policies, we may very well see hyperinflation.

POSTED BY: Alex K (April 09, 2008 12:24 PM)
You never post my posts if they even slightly question your views. This is typical mainstream advice that fails to mention the falling dollar. The entire article is biased speculation. Steering people away from commodities may slightly delay the dollar's collapse. No mention of unsustainable printing of "Monopoly" money? Do your readers really believe such nonsense. Go ahead, censor me.....

POSTED BY: Chris Durant (April 09, 2008 05:02 PM)
One major problem with Jim Ostroff's reasoning: he left out the problems with the dollar. Let me illustrate: The US budget deficit for the month of February 2008 was 145 billion dollars. On planet Earth, for the entire year of 2007, there were at most 85 million ounces of gold mined. At $1000 per ounce, that amount of gold would be worth 85 billion dollars. On planet Earth in 2007, there were at most one billion ounces of silver mined. At $20 per ounce, that would be worth 20 billion dollars. On planet Earth, for the entire year 2007, there were at most 10 billion ounces of platinum mined. At $2000 per ounce, that would be worth 20 billion dollars. So if in one month, the US debt can grow for an amount worth more than all the precious metals mined on planet Earth in one year, it is the dollar that has a problem, not commodities. And the US is just one of dozens of countries that are printing fiat money to the tune of 15% money supply growth annually. Precious metals and oil have to be mined and pulled out of the ground, not created with a keystroke. I will continue to invest my wealth in gold and oil, and with my passing grade in third-grade arithmetic class, I remain confident that the dollar has a great deal further to fall.

POSTED BY: Raul (April 09, 2008 05:38 PM)
What a load of outdated, uninformed nonsense. The facts are that commodity prices are high due to the debasement of the US currency in conjunction with extremely strong world demand that is outstripping efforts to bring on supply. And it's demand that is causing coal to rise 200% yoy. Iron ore to rise 70%. Those are basic building blocks that are ubiquitous commodities. It points to a powerful demand pull by developing economies that is just in it's infancy. Perhaps some commodities (like oil) can be manipulated by cartels (OPEC is the only one I know of). The rest are simply the price set in an open market by willing buyers and sellers. The reality is that it takes 10 years to bring on a new mine or oil field. It's a mine field of dicey countries, hysterical enviro-nazis, ever declining grades and an industry that doesn't have enough people or equipment to ramp supply quickly enough. And the idea that commodity prices are gonna fall when the US economy rebounds in H2 '08 is patently ludicrous. But hey, why not go invest in Financials and Tech? A perfect way to lose money. Me, I've comfortably exceeded 40% average gains for 5+ years. I'm already up 15% this year by investing in "risky" commodities.

POSTED BY: Buck Meister (April 09, 2008 05:39 PM)
The author falsely suggests he can read minds and in fact speculates himself by arguing that the commodities boom is a bubble by investors chasing profit, ergo irrational "herd' behavior. In truth, investors are simply running from a US currency that has no moral or market support, and the same government that has driven safe interest yields to near zero. In law it could be called a fraud on the US saver. When they seek to preserve their savings by real money in gold or corn, they are perfectly rational not mindless bulls.

POSTED BY: toktomi (April 10, 2008 02:06 AM)
Nonsense. This will be easy to debunk. We'll just wait three or four months.

POSTED BY: Jim Ostroff (April 10, 2008 07:36 PM)
The anemic dollar is an issue, as we noted in this article. The dollar is likely to move lower with the next Fed interest rate cut. Demand for many commodities remains strong. No commodities price crash is imminent. A strong price correction IS very likely. The factors that have pushed up prices will reverse. WTI oil is a good example. The supply/demand situation is better than one year ago. The risk premium is down a bit from last April. Yet, prices now are 70% higher. Fact is, markets cannot ignore the fundamentals over time, whether these relate to the value of securitized loans or internet businesses. The jump in commodities prices since winter is underpinned by a wave of investment by people and companies seeking better returns than they can get in equities, bonds, mutual funds, etc. Investors should be leery of those who contend we are in a sustained period of commodity price increases underpinned by shortages, unending demand growth, hyperinflation, an ever-sinking dollar, or other end-of-history nostrums. Most who buy in and take this skies-the-limit gamble are sure to lose. No one can defy gravity forever.

POSTED BY: Will Media (April 11, 2008 01:42 PM)
I concur with Jim Ostroff's comment re gravity. "What goes up must come down". Seems with each "boom" internet, real estate, commodities, there's an irrational belief that it will go on for ever. Usually, the smart folks are out way before the lemmings start heading over the cliff. I remember the oil "shortage" of the seventies. Seemed like prices were never going to stop rising. Then the bottom of the oil market dropped out.

POSTED BY: JMacG (April 12, 2008 12:12 PM)
Either I am prescient, or this is a repeat of the article I read last week.

POSTED BY: Mark Anthony (April 20, 2008 03:00 AM)
This article is just so absurd that regardless whether you agree with it or not, it should be removed because it doesn't adhere to even the minimum standard of publication. It presents lots of pure hypothesis and imaginations, but no fact except for the observation that speculators are attracted to the commodity boom. It's only natural that any booming economic phenomena attracts speculators. That's NOT an indication of bubble whatsoever. Please read how Mr. Gene Esptein's commodity bubble theory is debunked, since yours is even worse than his: seekingalpha dot com /article/70907-investing-in-a-resource-constrained-world-part-iii It's supply and demand!

POSTED BY: Will (April 21, 2008 01:08 AM)
I wish professional writers would back up their material with facts. I want to know what is really going on. Where are the commodity inventories? If this is a bubble, why are people hungry for a product as basic as rice?

POSTED BY: Howard Stevens (April 24, 2008 02:32 PM)
While I share the sentiments of the author, it is journalistic malpractice in my opinion to not support a thesis with underlying objective evidence. "Commodities are way out of whack with the dynamics of supply and demand." Really? FACTS PLEASE!!!

POSTED BY: JODY (April 27, 2008 04:40 PM)
Why dosen't J. Ostroff back up his statements with a modicum of data? Maybe he could support his position in a future article.

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