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In retrospect, 2009 was a very impressive year for the commodity markets. For most of 2009 commodities were seen as “the” place to be, with many analysts touting them as a new and potentially sustainable investment class. Indeed, certain commodities forged very impressive rallies in the face of highly uncertain economic conditions, with the Continuous Commodity Index forging a gain of more than 30% from the end of 2008 to the October 2009 highs. If one also takes into consideration the low to high rally in crude oil prices of 74% and the 94% run up in sugar prices, it would seem like certain commodities are well on their way to pricing in a recovery.
With the sharp, surprising run-up in equity prices of 67% in 2009, there are a number of analysts who view the equity markets as pricing in positive growth for 2010. While the outlook for the economy remains very suspect as of this writing and many might consider the commodity markets as overstating the recovery potential, it is possible that a bit of historical perspective will lead one to the conclusion that many commodity prices still have significant upward price potential ahead.
In our opinion, a large portion of the commodity price gains that were forged in 2009 were simply a rejection of severely deflated pricing. In some cases markets fell to (and even below) the cost of production and did so off of sentiment that suggested demand was going to fall to depression type levels and not recover for years.
But as the situation was so extreme (interest rates approaching zero, widely accepted expectations for a continuous deflationary spiral and, for a while, little or no hope of an end to the crisis) the conditions that had sent prices to extreme lows in 2008 and early 2009 may not be repeated very soon. It could be very difficult for markets like natural gas, crude oil, sugar, cotton orange juice, copper, coffee and corn to return to the lows they have forged over the last 18 months. And while markets like cocoa, soybeans, soybean oil, cotton and wheat may seem to lack the fundamentals that would allow for a strong upside extension, against a backdrop of a falling Dollar, fairly consistent global demand growth and ongoing investment flows toward commodities, even those “weak horses” can catch some spillover support.
One could say that 2009 was a year to “close your eyes and buy everything physical.” In contrast, 2010 looks like a year to be more selective. To be sure the direction of most commodity prices will still be largely a function of the direction of the economy, but while we have to assume that the US will slowly claw its way out of the sub-prime disaster, we have to be aware that there will likely be periodic setbacks.
However, never in history has the US Federal Reserve been so forced into a position of erring to the side of inflation. Adding into the equation what appears to be a long term devaluation of the Dollar and unprecedented quantitative easing by the most of the world’s central banks, one is presented with a spectacular, classic inflationary setup for commodities.
While the commodity appreciation potential is being recognized by the “funds” who have poured in copious amounts of money to commodities, there could be some form of showdown in 2010 between commodity speculators and the regulators. However, in the wake of the move toward proposed position limits in certain commodities, it would appear that inflows to commodities from the funds have actually accelerated. In 2009 moves to restrict index trader activity in some markets forced them to rebalance their positions, which meant that while they may have liquidated positions in some markets they turned around and bought into some other markets. For example, they may have been forced to liquidate some longs in Chicago wheat, but they simply replaced those with longs in Kansas City wheat.
In the event that regulators make a move to significantly lower position limits in 2010, there could be a temporary, aggressive liquidation in some commodity markets. In most cases one might expect those commodity markets with massive long spec positions to see a concentrated liquidation event. Therefore traders should be aware of which commodity markets have tight fundamental setups and be prepared to get long or add to their long positions in the wake of any compacted washout brought about by regulatory changes. Telling the world they can’t own commodities probably increases the interest in them two-fold!
In the near term, the maintenance of ultra low rates in the face of a gradual recovery in the global economy should increase the odds of inflation. In fact, we see the 2009 commodity laggards to be the stellar performers in the coming quarters. Therefore, traders should be looking to invest in orange juice, natural gas, silver and sugar on any near term, broad-based corrective action.
