Saturday, January 13, 2007

Are falling commodities prices a sign of economic weakness ahead?

Some commentators are suggesting that falling commodities prices are a leading indicator of economic weakness ahead. In the old days, yes, commodities prices indicated the health of the economy, but in the "new" economy that linkage is no longer true or at least no longer always true.

In fact, the linkage wasn't even always true in the old days. Price indicates the relative balance between supply and demand. Yes, lower emand will trigger a decline in prices, but rising supply can trigger declining prices as well. This is really, really, basic Econ 101, but some commentaters pretend that it isn't true.

There is also the distinction between real demand by end users of the commodities and speculative demand by speculators and other intermediaries who place themselves between the suppliers and the users. In other words, they create a "bubble" which distorts supply and demand and hence prices. That is the primary effect that we have been seeing over the past two years, with the big run-up of commodities prices as well as the current retracement of prices.

Sure, there are always speculators in any market, but two key differences in the current commodites speculation "bubble" are the vast amount of capital being thrown at commodities, especially by hedge funds and large "investment" banks and a mob of smaller "investors", and the willingness of these large players to actually take physical delivery of the commodities when the front-month futures contracts run out. They don't actually take real delivery, but simply become the owners electronically and begin to pay storage costs for the physical commodities. Taking delivery effectively has reduced supply, helping to push prices up. This accounts for why energy prices could be high even though inventory levels have also been high. Much of those inventories have been held off the market. Is this legal? Apparently. Whether it should be legal is a matter of debate, but the fact that so many Wall Street commentaters haven't given the American people a clear accounting of why energy costs have been so high is truly conconscionable, although oh-so typical of Wall Street. Essentially it is a conflict of interest because these firms that offer retail investors "advice" also have in-house trading desks which are heavily engaged in speculation. Be clear: Wall Street is not your friend; their goal is to take as much of your money as legally possible. And then some.

In a normal commodities market, speculators can still push prices up, but prices then fall back down as speculators sell the front-month futures contract and buy the next month contract. There are still speculative bubbles, but they are too small to be worth worying about. At some point we will (or may) revert to such a normal market, in which case real economic signals will work again, but we certainly aren't there yet.

So, the decline in commodities is primarily due to a decline in demand, but of speculative demand rather than real demand.

If we were to see oil fall below $15, that would be an indication of declining real demand indicating significant economic weakness, but even at $50 or even $40 or $30, there would be no hint of a significant decline in real demand for oil. Ditto for other commodities.

-- Jack Krupansky


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