Comment on commodity markets: BGF

By Paula Wallace

Grigor said that market speculators and “derivative instruments” are the cause of massive distortions to real industry decision making.
While the real demand for commodities from China and the ability of industry to supply those commodities is the centre of the speculative fervour, he said that today’s decision making is based more on liquidity of capital and leverage than supply and demand.
“Industry and its gentlemanly behaviour have been relegated to the back row as financial gurus and their suits have moved into the market to enhance and take advantage of volatility,” said Grigor, “The metals markets are the new playground of the rich and the smooth, real mining men might as well stand aside.”
The “reasonably rational” exercise of matching supply and demand and accurately measuring economic growth has changed, primarily with the emergence of China and its extraordinary growth.
“With a lack of reliable historical data to input into economic models meaning that forecasting methodology has to be overhauled, the old relationships are no longer valid,” said Grigor.
But the ball game has changed for another reason: the recognition by aggressive funds in commodity markets and associated derivatives that this is a legitimate market to be playing in order to maximise returns on capital, especially when interest rates and therefore opportunity costs are so low.
“Speculators play an important role in markets, they take risk and help set the price accounting for 5-10 per cent of the trades they provide liquidity,” said Grigor, “However, when their activities start to account for 50 per cent or more of daily trading, they totally change the dynamics of markets. They become financial markets when the original basis for them, being the trade of commodities for industry and industrial purposes, becomes incidental.
“They no longer serve the traditional economic function of a physical market to balance supply and demand and that effectively means market failure.”
He said volatility is good in that it proves “life”, it provides trading opportunities and underwrites volume, however excessive volatility is a real problem.
“What we have today is excessive volatility and that…is undermining the legitimacy of our commodity markets. Market failure is more than threatening, it is actually happening.
“The speculative activity that is dominating the markets is overpowering the efficient allocation of resources. The size of the markets is so small relative to the pool of liquid investment funds that we are very easily and frequently seeing them be manipulated.
“And that excessive volatility is leading to truncated supply responses - companies cannot plan with enough certainty, banks are spooked by the inability to realistically estimate revenues so financing becomes more expensive.”
Grigor demonstrated the volatility in base and precious metal markets by looking at percentage moves rather than actual price moves.
“It is this sort of volatility that attracts the traders. Even though these commodities are still well below their recent highs except for gold, the recovery in percentage terms has been spectacular.”
He said what is confusing many observers is the strength of some metals, such as aluminium, lead, nickel, tin and zinc at the same time as the build up of stockpiles.
In relation to stocks in coal, iron ore, uranium, and other energy resources, he said none of these have been spared the volatility of the last eighteen months.
“The difference between uranium and other commodities at present is that uranium stockpiles are shrinking…there’s going to be a serious shortage of uranium in the foreseeable future but at a spot price of $46 a pound there hasn’t been…enough of an incentive to address the supply curve.”
Whether or not the coal and iron ore prices can maintain their levels going into the next twelve months is open to conjecture, especially given that steel prices in China have slumped 20 per cent in the recent weeks.
Getting the commodities market forecast right, according to Grigor, is all about analysis of cycles and effectively trading those cycles.
The boom that was experienced from 2003 to 2008 may have continued “but for the disgraceful behaviour of investment banks that led to the sub prime crisis and global financial meltdown”, he said.
“We may have just seen the first wave of a supercycle that will play out over a 15-25 year timeframe. There is one short-term caveat though, metals prices are rising at the same time as stockpiles are building and this is anomalous.”
While we may be tempted to believe that this has already been factored into the markets, the sub prime crisis is evidence that seeing is not the same as believing.
“The sub prime crisis issue was known and documented by journalists and analysts six months before it really hit and before the market reacted.
“What impact will stockpiles have and just how domineering will the traders be and what’s going to cause them to make their next move…so that’s where we are, we’re in a world of chaos.”
But what makes Grigor think we have started the second wave of the supercycle? He said we have survived a perfect storm and China is not about to stop consuming and expanding - meaning it is still a ‘seller’s market’.
“It doesn’t matter that the Chinese growth rate might slow from 10-12 per cent to 7-8 per cent per annum, if you do the numbers you’ll see that 8 per cent growth in the Chinese economy, at the size it is today, results in the same physical offtake tonnage that it had with a 12 per cent growth rate back in 2003 on a smaller economy.”
He told delegates, “Take heart, providing we can survive the chaos of capital markets there’ll be a strong need for new mining projects for some time yet.”