Commodities Bubble?

Some gurus believe that commodities are the latest bubble. According to a Financial Times article Warning on market risks as prices fall (subscription required), Stephen Roach of Morgan Stanley and Richard Bernstein of Merrill Lynch are two such gurus.

About $90bn of funds track commodity indices, a sixfold increase in the past four years. Now that commodity prices are falling, some investors may be abandoning their positions, although one Goldman Sachs executive said “on balance, we are still seeing net inflows into funds following the indices”.

Stephen Roach, the chief economist at Morgan Stanley, said this week that the commodities market had become the latest in a series of bubbles. “It too will burst, the only question is when.” And Richard Bernstein, US strategist for Merrill Lynch, said there was a 50 per cent speculative premium in commodity markets at the end of April.

I am certainly no guru, but I do not agree with Roach and Bernstein. To put $90 billion of funds tracking commodities in perspective, ExxonMobil Corporation (XOM) has a market capitalization of $366 billion and Chevron Corporation (CVX), $130 billion. These are just two American oil companies. If all commodity companies from all countries around the world were added together, then $90 billion is a very small number in comparison.

Rather than focusing on the amount of money tracking commodities, I would prefer to understand the supply demand for commodities. Can the world continue to grow oil production at two to five percent per year, every year? Can we continue to supply more electricity to meet heating and cooling needs? Can we supply sufficient quantities of gold, silver, copper, lead, and other metals as emerging countries join the developed countries?

With respect to oil and gas, both commodities are becoming harder to find and more expensive to find. Moreover, both commodities are often located in some of the more challenging places in the world, resulting in increased risks to companies. Finding and developing new mines is similarly harder and more expensive. New mines require much more environmental assessments and remediation. The permitting process takes longer. And governments want higher royalties or taxes or both.

So I believe the commodity landscape has changed. There will still be the inevitable peaks and valleys with respect to prices. But that does not deter my longer term bullish outlook. That said, prices cannot rise more than consumers can afford to pay. But consumers might find that they have to allocate more of their budget than they have in the past.

As both commodity bulls and bears argue their cases, commodity prices are bound to be volatile. Time will tell which side is ultimately correct.