Hedge Funds Take Direct Stakes in Commodities ... Should We Be Wary?

ScotiaMocatta, the Canadian commodities trader and subsidiary of the Bank of Nova Scotia (NYSE: BNS), has asked regulators to approve plans for a fund that would take physical positions in copper.

Credit Suisse Group AG (NYSE ADR: CS) is working with Glencore International AG, the world's largest trading house, on an exchange-traded fund (ETF) that will be backed by actual aluminum supplies.

And ETF Securities Ltd., a $15 billion U.K.-based firm that makes commodity-investment products available to retail investors, is offering U.S. investors gold-and-silver ETFs that are backed by the precious metals stored in vaults, instead of the more-conventional financial futures contracts.

ETF Securites is now also considering a U.S. oil fund that's tied to swap contracts with a member of Big Oil. It already has such an arrangement with Royal Dutch Shell PLC (NYSE ADR: RDS.A, RDS.B) in Great Britain.

Hedge funds and other institutional investors that invest in commodities are beginning to demand physical delivery - and not just futures contracts, the Financial Times reported last week.

Institutional investors are making these moves in order to sidestep expected regulatory changes. But with gold at near-record levels, and other commodity prices advancing, too, a major migration to the physical commodities market will translate into an actual jump in physical commodities demand.

Such a shift will push up commodity prices - and it has the potential to rev up inflation and cause major economic disruptions.

Regulatory Imbroglio

The world's hedge funds all piling into commodities doesn't matter much if the funds all stick to futures contracts. Dealers arrange the futures markets so that at expiration, the demand for physical pork bellies - or whatever - doesn't outstrip the physical supply.

Even the major purchases of futures contracts we cite in our example would likely be enough to push up the price of pork bellies. But that increase would be limited in scope and consumers have learned to deal with such increases in living costs. What's changing, however, is that the U.S. government is talking of introducing "position limits" to futures markets, and commodities speculators are worried that their hedging-and-speculating activities may be restricted.

Federal regulators are looking at these restrictions in part because of the way speculators allegedly whipsawed oil prices last year - causing them to zoom to more than $147 a barrel in mid-July 2008, only to drop to a four-year low at less than $40 a barrel by mid-December.

Gary Gensler, chairman of the U.S. Commodity Futures Trading Commission (CFTC), which regulates the U.S. futures markets, has said that he wants position limits to be applied consistently across all commodity markets.

Here's the problem. In an attempt to reduce risk, many institutional investors will seek to maintain certain investment levels in commodities. And if they can't maintain those levels via financial futures markets, they may dump the futures and hoard the physical commodities.

That's something that neither the CFTC - nor British counterpart, the U.K. Financial Services Authority - could do anything about, since neither one regulates the "spot" market for commodities.

In short, regulators could end up jump-starting the very problem that they are trying to avoid - for several reasons.

First of all, physical commodities investments are very different than their financial-futures counerparts - if only because physical supplies are limited. When a hedge fund buys a ship full of copper ore, that ore is no longer available to smelters, and the copper supply chain may get disrupted.

Similarly, investors buying iron ore, coal, aluminum or other commodities that are crucial to our industrial economy can potentially disrupt the economy itself. Supplies of most commodities are adequate, yet the supply/demand situation is in close balance in the short term. Since new mines or smelters cannot be opened quickly, even a moderate withdrawal of supply through investors buying up available inventories can wreak havoc on market prices.

Such pricing discordances can't help but have a negative impact on the economy, too.

And the math is more than a little scary.

Scary Math

Hedge funds alone have about $1.9 trillion under management. Central banks in Japan and China have about $2 billion each at their disposal. And there are comparable amounts in the Middle East.

The grand total: Roughly $8 trillion.

Since all U.S. goods imports last year totaled only $2.1 trillion, you can see that there could easily be problems. If speculators tie up a big percentage of the physical global supply of a particular commodity, there will be a shortage for users. If that happens with a number of different commodities, that means that a swath of key industries could be plagued by super-steep prices - or even paralyzed outright.

Although it's admittedly a worst-case situation, such a scenario could potentially spawn a deep recession. The reason: production patterns get disrupted and large numbers of people get thrown out of work.

This won't be your typical recession, however, for it's a downturn of a type that we haven't seen globally.

In 1837-41, and again in 1929-33, the two worst downturns in U.S. history, severe shortages of liquidity caused disruptions, 25% price declines - and, finally, an economic collapse.

The problem we're dealing with now is just the opposite: We have too much liquidity, so that money becomes worthless because it can't physically buy the goods needed to carry on production.

These kinds of recessions have happened in single countries in wartime: Think of the worthless "continentals" in the U.S. War of Independence, or the "assignats" in the French Revolutionary War.

Single countries have had this problem. Argentina has from time to time had people starving - even though it is a major food producer - because its currency has collapsed. However, we haven't seen it worldwide. If it happens, you can expect shortages and sharp output declines, but combined with rapid inflation, much more rapid than in the 1970s.

That's the theoretical possibility. Will it happen? After all, except for gold, commodities prices are still lower than they were last year, and even gold is well below its 1980 high of $875, which would be about $2,400 in today's money.

However, there are two factors that stand as the fundamental causes of the run-up in the prices of gold and other commodities. And they're related. The first is the surge of liquidity that we've seen. And the second is the super-low interest rates that the central bank policies of the world have produced in the last year. If you have too much money sloshing around, you'll get speculation. And this time around, that speculative money is going into commodities.

We need to stop the bubble before the trend of investing in physical commodities gets too strong. As I said, futures-markets investments don't matter. Though they may lead to modest price increases, the fallout ends there. It's the investments in physical commodities that have the potential to actually disrupt the world economy.

Keeping the Bubble at Bay

To stop the commodities bubble, interest rates have to rise. "Exit strategies" by central banks that involve taking away liquidity - using "reverse repos" or similar instruments - will be no help if interest rates don't rise.

If rates stay low while commodity prices soar, commodities will look like a great investment. That will send the lower liquidity flow into commodity speculation and crowd out real investment. Only higher interest rates will make commodity speculation less profitable, and keep the bubble at bay.

Apart from watching the U.S. Federal Reserve directly, you can see how this bubble is progressing by watching the price of gold. If gold prices keep rising, interest rates are still too low and commodities speculation still too attractive. If gold dips in price, but then rebounds, the progress against the bubble may be only temporary. Only if the price of gold falls sharply - by 25% or more from its peak -- will the bubble have been beaten and normal economic growth again be possible.

As investors, we should focus our attention on commodity plays. Cash is not king. If inflation gets going, cash will fall in value.

But companies supplying commodities will do well. You don't have to buy a mining company directly. It's not surprising that Alcoa Inc. (NYSE: AA) reported good third quarter earnings last week; it mostly controls its raw materials, and aluminum itself is a commodity, essential for the world economy.

Brazil's Vale SA (NYSE ADR: VALE) - with its huge iron ore deposits is another good play. The Market Vectors Gold Miners ETF (NYSE: GDX) allows you to bet on inflation directly, without having to guess which gold mines will do best.

Commodity investments will remain a good play, better than cash, until the Fed and other central banks get serious about interest rates - say 2% above the prevailing rate of inflation. That means a Federal Funds Rate of 4%-5%. We're a long way from that point, yet, so commodities are a good place to put your money.

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