Friday, December 24, 2010

The Bubble that Wasn't

   An economic bubble is often described as "trade in high volumes at prices that are considerably at variance with intrinsic values (Wikipedia).
   Some analysts claim that the commodities market is in the middle of another bubble, as the prices of crude oil, copper, wheat and coffee reach multi-decade highs while these products attract record financial investments. Tobias Levkovich, Citigroup’s chief US strategist, holds this view. He says in a recent report that commodities, particularly gold, are looking like a “bubble prospect” as “easy money and speculative juices combine to drive prices unsustainably higher”. But whether commodities have truly become the third and last bubble of the past decade is open to debate. Kevin Norrish, at Barclays Capital, disagrees with the view of a bubble. “The price rise is fundamentally driven,” he says, pointing to robust demand, lagging supply in spite of record prices for key raw materials, and jumping production costs. John Kemp, an economist at Sempra Metals, a London-based commodities brokerage, says a bubble has probably emerged as investors pile into raw materials on the expectation that prices will continue to rise. “It will be a mistake to assume that commodities prices will rise further without doing damage to the economy and triggering a response from central banks worried about inflation,” Mr Kemp says.
   The above passage actually comes from an article by Javier Blas in the Financial Times on March 10, 2008 titled Analysts differ about commodity bubble. In reality, the only thing mentioned above that has really changed in the last two and half years is that few analysts currently believe commodities represent a bubble. For most individuals, aside from changes in the price of crude oil which are overly apparent in the rapid price changes of gasoline, the price of most commodities probably goes unnoticed. Therefore one could be forgiven for not recognizing the remarkable price swings that have taken place over the past several years. In order to paint a clearer picture of the true magnitude of these fluctuations, let's look back at the price of several commodities over the previous decades.
   For a general representation of commodities, I've selected those mentioned in the above article (crude oil, copper, wheat, coffee) while adding silver and sugar to round out the group. Prices of various commodities are generally represented by futures contracts with the front month (nearest to current date trading) establishing the spot price for trading. The time series in consideration looks at the front month futures' closing price at the end of each month starting in January 1980 (except crude oil which begins in March 1983 and copper in December 1988). The graphs (courtesy of Bloomberg) shown below depict weekly closing prices of these front month contracts for the past 10 years.

Crude Oil
   In the early 1980's crude oil spiked due to foreign tensions and threats of cutting off supply. However, by 1983 the tensions had subsided and crude oil sat at $29.29 a barrel. Despite substantial economic growth during the rest of the 1980's, the price of crude oil actually fell to $21.82 by the end of the decade. The 1990's followed, marking one of the strongest decades of economic growth for the U.S. Yet for most of the decade crude oil prices held steady, until a 25% increase in the final 6 months pushed crude up to $25.6. As the new millennium began, the dot com bubble was well under way and the general consensus was that the Internet would dramatically expand worldwide economic growth. In 2000 the price of crude oil rose to nearly $34 before the first bubble of the decade popped and the ensuing recession sent prices back down under $20 by the start of 2002. It wasn't until early 2004 that crude oil topped $34 again and although it wasn't clear then, a massive run-up had begun. In the next 9 months, the price of crude would rise over 50% to nearly $52 a barrel. Another 10 months passed and the price reached almost $69. The price then staggered over the following two years, closing the first half of 2007 just above $70. This period later proved to be the calm before the storm as crude oil prices erupted in the following year, reaching a peak near $150 a barrel in July 2008. Crude oil prices peaked just as the subprime mortgage crisis was taking hold and most of the world was entering or already in a recession. Even more remarkable than the over 700% rise in 5 years was the dramatic decline that would follow. Within 5 months after reaching its peak, crude oil prices would fall to a low of $32 a barrel in December 2008. At the time, many economists and analysts considered the astonishing rise to have been a bubble, unsupported by fundamental demand/supply constraints and subject to significant speculation. While that premise seemed obvious at the time, 2009 brought about another rapid rise in prices to nearly $80 a barrel by year end. Although the upward momentum has slowed during 2010, crude oil seems poised to close above $90 a barrel this year. Looking ahead, most analysts expect a continuing trend with price predictions ranging between $100 and $120 a barrel for 2011. 

   Back in 1988, copper swapped hands for $1.56 per pound. By 1990, copper prices had fallen by over 50% to just below $1. The 1990's were not much better for copper as prices dropped another 15% to $0.85. After closing below $0.70 per pound at the end of 2002, China's rapid expansion sparked massive real and perceived growth in demand. Over the next 3 1/2 years, prices rose more than five fold to above $4 per pound by early 2006. The following two years witnessed some volatility with the price falling below $2.50 before topping out slightly above $4 again in early 2008. The ensuing decline rivaled the fall in crude oil as copper prices plunged below $1.25 per pound by the end of 2008. Although the drop failed to match similar extremes, the recent rise has actually exceeded that of crude oil. In 2009 copper nearly tripled, ending the year above $3.30 per pound. Helped by a greater than 10% rise in the past month, copper prices reached a new all-time high this week above $4.28 per pound.    

   Wheat began the 1980's trading around $4.70 per bushel but fell to just over $4 by the end of the decade. The 1990's proved even worse for wheat with prices falling nearly 40% below $2.50 per bushel. Unlike oil and copper, wheat actually rose early in the new millennium climbing to $3.25 by the end of 2002. However, by 2006 little had changed with wheat trading just below $3.40per pound. Wheat joined the general commodity trend of astonishing growth a bit late but made up for it quickly. In slightly over 2 years wheat prices nearly quadrupled, eclipsing $13.30 per pound on the last day of February 2008. This massive rise was equally short-lived as prices declined below $5 per pound before year's end. Comparatively, the 50% increase in wheat over the past two years appears slim, but recent shortages suggest wheat may play catch-up in the near future.   
    Similar to several other commodities, the 1980's were negative for coffee prices. During the decade, coffee fell more than 50% from over $1.60 per pound to just below $0.80 by the start of the 1990's. The 90's was a particularly volatile decade for the coffee market as prices fell near $0.50 towards the end of 1992, rallied above $2 late in 1994, fell back below $1 in 1995, spiked above $2.75 briefly in 1997 and ultimately settled around $1.25 per pound entering the new millennium. The new decade began similarly to the previous one as prices fell dramatically to just above $0.40 per pound near the end of 2001. Volatility would decrease and prices began rising steadily, peaking above $1.60 per pound in early 2008.  Differing from many other commodities, coffee prices were not as deeply affected by the credit crisis with prices remaining above $1 throughout the recession. As the world economy regained its footing and began expanding more rapidly, coffee regained its upward momentum. Over the past 6 months, coffee prices shot upwards from $1.35 to over $2.35 per pound and are quickly approaching new all-time highs. 
   Silver prices began the 1980's in a much different place than other commodities, near all-time highs above $35 per ounce. This peak was short-lived as the price plunged to $12 in two short months. Although silver rose above $20 per ounce again later that year, it quickly reversed course and that price level would not be seen again for decades. By mid-1981, as Paul Volcker began his quest to break the back of inflation, silver had fallen below $10 per ounce. Silver remained in steady decline for a majority of the decade, closing at just above $5. Contrary to many other commodities, silver prices experienced minimal volatility during the 1990's and ended the decade practically where it had begun. The early part of the new century brought little change for silver prices as well. In 2004 the U.S. economy was back on track and interests rates remained very low, helping spur demand for commodities. Breaking out of a nearly 15-year range, silver's slow rise became more dramatic entering 2008 when prices rose above $20 per ounce for the first time since 1980. Then the credit crisis struck and a period of deflation began, sending silver back below $10 per ounce in 6 months. As silver hit a trough, interest rates were being lowered dramatically around the world and fear sparked demand for precious metals. A combination of fear, economic growth, negative real interest rates and money printing have greatly increased demand for silver since. After nearly doubling in 2009, the price of silver has risen nearly another $10 in the past 4 months and currently rests near $30 per ounce.     
   Sugar's price movements over the pat 30 years resemble that of silver. In 1980 alone, the price of sugar nearly doubled from $0.22 per pound before ending the year slightly above $0.30. Only 16 months later, the price would fall below $0.10 and by mid-1985 the price rested barely above $0.02 per pound. Sugar would rally back in the second half of the decade, finishing the 80's around $0.13 per pound. Prices fluctuated minimally most of the 1990's before a rapid decline in 1998-1999 dropped the price to $0.06 per pound to end the century. Once again, sugar prices bounced along the bottom until beginning a steep incline in mid-2005. By early 2006 the price nearly touched $0.20 per pound before falling back towards $0.10 later the same year. Sugar prices briefly peaked again in early 2008, though only near $0.15 per pound. The ensuing decline was equally minimal compared to other commodities. Joining the trend again, in late 2008 sugar prices began an astonishing rise from $0.12 to $0.30 per pound in just over 12 months. What has happened since is even more surprising as prices fell below $0.15 at the end of May 2010 before rising back above $0.34 this week. 

   The story of these commodity prices represents the remarkable volatility over the past few decades and especially the past several years. Although inflation is unaccounted for in these prices, actual core inflation in the U.S. (as measured by the Fed) during the past decade could only explain a minuscule portion of the rising prices. Back in 2007-2008, the main story on the street was that ever increasing demand for commodities by China and other emerging markets would outstrip supply offering a sure bet on higher future prices. Yet somehow as fear of an impending second depression spread, demand appeared to nearly evaporate. Suddenly oversupply ruled market sentiment sending prices sharply lower and spurring talks of a bursting commodity bubble. Two short years later, economic growth has picked up, governments are printing more money, interest rates in developed countries remain between 0 and 1% and global demand has picked up. Once again, the widely accepted view holds that demand will vastly exceed supply in coming years. Attempting to front run expectations, prices of many commodities have already jumped back above previous peaks with several approaching or hitting all-time highs. 

   All of this begs the question, were commodity prices in 2007-2008 a bubble? When demand appeared nonexistent in late 2008, early 2009 the answer would have seemed an overwhelming affirmative. Considering prices today, a strong argument can be made against this idea. For those considering investing in commodities today, whether through futures, ETFs or stocks, pondering this question in incredibly important. As recent experience has shown, global demand for raw materials can be far more volatile than most believed. Speculation on future prices can not be ruled out either and investor sentiment has proved even more volatile than demand. Ultimately the answer to the question may reside somewhere in the middle. Given a long investment horizon (10+ years), global demand is very likely to increase and out-pace supply. However, since that view is nearly universal, current prices may already reflect a substantial portion of the expected growth story. Either way, caution is advised, as the past 30 years have demonstrated investors may be in for a very bumpy ride!

No comments:

Post a Comment