So Much for Supply and Demand

 | Apr 18, 2013 | 8:02 AM EDT
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Is there suddenly too much of everything? Or has there been too much for everything for a long time and we just didn't know it? Was there too much of gold before its collapse? Are we now discovering that there was way too much copper all along? Did we always have too much oil and we didn't know it?

I think everyone has to be thinking along these lines right now because of the sudden declines in so many commodities that seem to all have gone from some tightness to equilibrium to glut in a blink of an eye.

Let me offer you my theory.

In the last two decades we have seen an unprecedented financialization, if you will, of all commodities. Pretty much everything is traded either through glibly-created ETFs or through futures backed up by warehouses somewhere or through physical hoarding via tanker ships. The pools of money that have chosen to make commodities as an asset class is much larger than we can ever know because those funds aren't registered anywhere and pretty much report to no one.

I am sure at one time, before the ETFs and the large pools of capital, you might have traded these commodities on ACTUAL supply and demand. But if you look at the excellent work that Alcoa's (AA) done on commodities you would know that supply and demand have had little to do with any of the prices of metals in the last few years.

What mattered was the financial buyer not the natural buyer. Right now, for example, when Alcoa looks at all the smelting facilities that are open, when it looks at how much aluminum is available vs. pretty constant needs -- as opposed even to the accelerating ones we are seeing -- supply, after overwhelming demand, is finally getting tight. But it has done NOTHING at all to the price of aluminum, which is very weak.

That shouldn't be. But it is. Trying to understand how it can be requires you to think like a hedge fund manager, not an aluminum merchant. And here's how you think: China's going to reaccelerate growth so I will take down a lot of aluminum and when China does reaccelerate I will make a killing. In the meantime, interest rates are so low I can afford to warehouse the stuff.

That's been the case for several years now.

Unfortunately, as we read in the papers, the Chinese economy is downshifting. So now you have this financial glut where you know your marginal buyer is going away and the possibility of rates going up (end of Fed pumping) is upon us.

So what do you do? You unleash the aluminum on the market and close down the warehouse.

I don't think copper is any different. Hedge funds bought copper to market up and sell it to China. Pension funds put commodities in the allocation menu and bought copper, perhaps the physical but also through the copper ETF.

Again, you read the papers, you think OK, that allocation is going to get killed, dump it.

You can even make the same case with gold. The Chinese economy is slowing and the nominal buyers -- the great but now struggling middle-class -- aren't buying. At the same time gold FAILED to spike at the time of Cyprus, so when the heck would it spike? Might as well sell that too, before you lose money on it.

I think the latter, by the way, is crucial to the thinking of all the financial minds here.

"This trade hasn't made us money and it is about to cost us money" would be the way I would look at it.

The last glutted market? Oil. Here, again, giant financial buyers have controlled the market, making it tighter than it should. But unlike all of the other markets, there have been breathtaking discoveries of oil that have distorted world flows and that has caused the price to actually come to make sense. Think about it. With economic activity actually down, double digits in many of the fuel using industries in Europe, did it make any sense for Brent to be more than $100, especially after the zeal with which they approach their hatred of renewables?

Come on, does that make any sense at all? Yes, if you think China is reaccelerating and not conserving. Yes, you would want to hoard it.

But not now. Not with the papers reading the way they are. So the financial buyers are dumping Brent at the exact same time that the actual producers in the United States are getting their product to the world market instead of having it landlocked in the Midwest.

The result? The world price is coming down. Now, of course, unlike all of the other markets there is a swing producer here in Saudi Arabia. The Saudis may not know about all of the oil discovered here or can't game it because we do not have a government with an energy policy, so you don't know what will be used -- Canada tar sands -- and what will forever be locked into the ground because of the lowered price.

But they know Iraq is starting to pump much more than it used to and that Libya is back on line. They know that the big Nigeria-to-U.S. oil trade isn't slowing. Neither is the Algeria trade. So it is possible that they cut back and make the market tight again. Remember the tug of war there. They must keep the price tight enough to maximize profit without encouraging more drilling or conservation.

If they pull back then the financial buyers have nothing to fear.

But if they don't, then oil will be in the same free fall that all of the other commodities that have been propped up by the China marginal buyer trade.

So, the financial buyers are being margined out, globally, or they are giving up on the trade and what you are seeing is an unprecedented rollback in prices on everything raw.

Oh, one more thing.

Don't forget that it is good for all but a handful of companies that actually produce iron, aluminum, nickel, copper, oil and the like.

It's just not good enough right now for people to realize it.

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