Commodities Sag, but Why?

The punishment that financial markets have been doling out recently has finally hit the last bastion of strength: commodities. Most believe that the decline in everything from oil to corn to wheat is the result of investors raising cash:

Investors with losing trades in credit markets -- mortgage bonds or collateralized debt obligations, for example -- are being required by banks and others to set aside more cash to cover the money they borrowed to make trades, a process called "deleveraging." To raise the cash, some investors and hedge funds have sold some of their commodity winners.

"It's a classic deleveraging trade," says Bill O'Neill, a partner at investment-advisory firm Logic Advisors in Upper Saddle River, N.J. He says the unwinding of winning commodity trades has been playing out for most of this week, especially in the first half of the week.

Others give the victory to Bernanke:

Investors who had poured money into gold, oil and corn, seeking a hedge against inflation and a weak dollar, sold commodities to raise cash or buy stocks. The Reuters/Jefferies CRB Index of 19 commodities tumbled 8.3 percent this week, the most since at least 1956, after touching a record on Feb. 29.

``Bernanke took care of the commodity bubble,'' said Ron Goodis, the retail trading director at Equidex Brokerage Group Inc. in Closter, New Jersey. ``Commodities are coming back to earth. The stock market looks OK, and Bernanke is starting to look a little better.''

Concern that the central bank would let inflation get out of control eased after the Fed cut its key interest rate by 0.75 percentage point on March 18, less than the reduction of at least 1 point that investors had expected.

I think there is more to this than de-leveraging and investors respecting Bernanke's inflation-fighting prowess. I believe that investors are beginning to call into question the strength of global growth and sensing that it is simply not credible that India, China, Brazil and other engines of growth around the world will remain oasis' of prosperity when the world's largest economy (though technically smaller than the Euro-zone thanks to the weak dollar) experiences significant financial stress. Remember just 10 years ago Russia defaulted on billions of dollars of debt (remember LTCM) after the Asian crisis led to a global slowdown that pushed oil prices down to $11 a barrel and took away a major source of income for the Kremlin. Now oil prices are 10 times that on the back of one of the longest episodes of global growth on record. There is certainly plenty of room for commodity prices to fall further, especially if we start to see the slowdown in the US spreading more aggressively to the rest of the world.

Hat Tip: WSJ and Bloomberg

New Records are Not Good

This year has been a year of records. Here are some of the benchmarks we have hit in the three short months of 2008.

1) Gold rises above $1,000 an ounce:

Most-active April gold futures reached a new high of $1,001.50 on the Comex division on the New York Mercantile Exchange Thursday.

The metal has climbed steadily since 2001 after falling as far as $250s a number of times during the period from 1999 to 2001.

The several-year bull market accelerated rapidly since August after the Federal Reserve signaled it was easing monetary policy to shore up the economy amid worries about the credit markets due to sub-prime problems. In fact, to hit $1,000, April gold futures soared 50% since the Aug. 16 low of $666.40.

Hat Tip: WSJ

2) Oil first rises above $100, and now sits at a record $111:

Crude oil for April delivery rose more than $1 to hit $111 a barrel on the New York Mercantile Exchange in mid-morning trading. It was last up 85 cents, or 0.8%, to $110.77 a barrel. Crude has gained nearly $6 since Monday.

Crude prices, denominated in dollars, tend to rise when the greenback falls, as a weaker U.S. currency makes crude less expensive to buyers holding other currencies. It also eats into oil producers' dollar revenue and forces them to raise prices. The weak dollar is also pushing up prices of other commodities.

Hat Tip: Marketwatch

3) The Dollar falls to record lows against the Euro.

The euro has been on an upward trajectory since late 2001, but its rally has intensified since the credit crisis shocked financial markets last August and aggressive U.S. interest rate cuts sent dollar to record lows.

The latest, some say third, wave of the credit crunch in recent weeks has seen the dollar's broad decline accelerate and on Thursday the euro surged to records above $1.56 and the dollar broke to 12-year lows under 100 Japanese yen.

Policymaker protests are well underway.

Hat Tip: Guardian, Bespoke

4) The Dollar falls below ¥100 for the first time since 1995:

``Dollar-yen is going lower,'' said Ray Farris, head of foreign-exchange strategy at Credit Suisse in London. ``It will definitely overshoot our 98 forecast in the very near term. Our forecast was for the dollar to reach 98 in three months. The big question now is whether there will be intervention.''

Japanese officials are unlikely to intervene now in the foreign-exchange market because the yen is ``cheap'' compared with other currencies, Sakakibara said. The U.S. and Japan may intervene to weaken the yen should it break through 90 and head toward 80 per dollar, he said.

The yen's real effective exchange rate, measured against 15 currencies of major trading partners including China, Europe and Canada, is 99.5, according to Bank of Japan figures. The rate averaged 121.9 in the first quarter of 2004, when the bank last intervened on behalf of the Ministry of Finance.

Hat Tip: Bloomberg

5) Carlyle Capital becomes the next hedge fund implosion:

The credit crisis has claimed another victim.

Carlyle Capital Corp. said late Wednesday it expects its lenders will seize its assets, causing the likely liquidation of the fund, which until recently owned $21.7 billion in mortgage securities.

"Although it has been working diligently with its lenders, the Company has not been able to reach a mutually beneficial agreement to stabilize its financing," the fund said in a statement.

Hat Tip: WSJ

Commodities Extend Rally

I have been writing on this blog for over a year that I feel that most investors have a severe underweight to commodities in general and agricultural commodities specifically. This is just one part of the "Endowment Style" of investing that I think is missing from most portfolios. We have aggressively positioned ourself in real assets because we feel that the declining dollar, underestimated inflation, and strong global growth will lead to a sustained rally in commodities. In fact in our annual newsletter we said our top idea for this year is agricultural commodities (corn, wheat, grains, soybean, sugar).

	3 Months	1 Year
Corn	32%	22%
Wheat	31%	100%
Sugar	42%	26%
Soybeans	30%	72%

With each major ag commodity up over 30% over the past three months we feel validated, but recently we have become concerned. One of our agricultural commodities positions is already up nearly 25% this year and has captured nearly two thirds of the return we projected for the full year. Up until now we had been buying pull-backs but we stopped doing that when the position breached the 20% mark.

This bring up an interesting question: what do you do when a long-term position rises swiftly towards the target price you set for a long period of time? Do you let it ride? Do you trim and rebalance? Do you sell it all at the target?

In this case we are monitoring the position closely, watching the underlying fundamentals and putting in strategic sells stops to protect our gains. I think it is safe to say that you can expect more comments about the ongoing agricultural commodity run-up in the near future.

Agricultural Commodities Revisited

For the past few years our firm has been systematically overweighting commodities as a secular asset allocation decision. More recently we have trimmed our energy exposure and increased our exposure to agricultural commodities. The last time I wrote about this shift was back on December 5th. Since then our core agricultural commodity holding is up over 20% and is up 13% already in 2008, providing a great counterweight to falling equity prices:


In an environment of falling real interest rates and rising inflation owning "real assets" is absolutely critical. We feel that even after the recent run up in food prices this trend still has some legs. If you are looking for a place to park money that you've pulled out of equities this area deserves a look.

Global Food Prices on the Rise

We continue to receive validation from independent research that our firm's commitment to a secular overweight of commodities in general and agricultural commodities in particular is a sound asset allocation decision in light of the macroeconomic environment. My personal bet is that soybeans (pictured right), soymeal and soybean oil will be a particularly attractive place to park money over the next 6 months (and not just because of my personal edamame addiction). Here is the latest validation via Bloomberg:

Agricultural commodities may rise by as much as 50 percent next year because of crop shortages and demand from emerging Asian economies, Schroders Plc said.

Corn and palm oil will advance because of ``continued'' demand for ethanol and vegetable oils to make biofuels, while soybean and coffee may gain on smaller inventories, said Christopher Wyke, product manager at London-based Schroders, which manages $3 billion in commodities.

``The supply-demand balance for these commodities is very tight, which means they're vulnerable to any setbacks in production,'' he said in a telephone interview today. He declined to forecast prices.

Standard and Poor's GSCI Agriculture Index has advanced 32 percent this year as wheat rose to a record, while corn and soybeans climbed to multi-year highs. Commodities, which are outperforming stocks and bonds this year, may beat such asset classes in 2008 as the U.S. heads into a recession, Wyke said.

The UBS Bloomberg Constant Maturity Commodity Index of 28 futures contracts has returned 17 percent this year, compared with a 4.3 percent gain in the Standard & Poor's 500 Index of stocks. U.S. Treasuries have returned investors 8.9 percent, according to Merrill Lynch & Co. indexes.

On a side note, is anyone else feel relieved that oil is back under $88?

The Economics of Buying a Hybrid

If you are considering buying a hybrid you must first go check out TheIssue.com's analysis of the economics of buying a hybrid:

Hybrid cars are often considered the perfect match for the thrifty and environmentally conscience consumer. They save gas money, reduce pollutive emissions and ease demands on strained energy sources. While these benefits are almost certainly true, the cost-benefit equation is more complicated. Many would-be buyers find that the technology premium outweighs gas savings, and others point to environmental drawbacks like battery manufacturing.

Read on at TheIssue.com.

Crude Approaches $76 a Barrel

Light sweet crude is approaching $76 a barrel after dipping as low as $55 earlier in the year. That's a 38% increase for those of you counting at home. We now look poised to explore the highs from last summer. The good news is the stock market seems to totally ignore crude oil prices these days . . .

BHP Billiton: A Great Commodity Play

BHP is the world's largest diversified resource company and is dual listed on the London and Australian stock exchanges. Its roots date back to the 1800's but it has existed as BHP Billiton since 2001 following the merger of BHP with Billiton. The company maintains its headquarters in Melbourne, Australia. BHP explores for, mines or produces the following commodities: Petroleum, Aluminum, Base Metals (silver, zinc, lead, uranium etc.), Carbon Steel Materials, Diamonds, Energy Coal and Stainless Steel Materials.

The company has benefited greatly in recent years from rising commodity prices and will in all likelihood continue to do so in the future. While I do like some of BHP's rivals, namely Anglo-American (AAUK) and Rio Tinto (RTP), I think BHP is the best of the bunch. The company has fatter margins than its rivals and trades at a forward PE of 15 even after its dramatic rise over the last 5 years, when it has been up 488%. While I prefer using commodity futures to get direct commodity exposure, a company like BHP can get similar exposure with some idiosyncratic risk.
BHP is up over 72% this year, RTP is up 45% and AAUK us up over 32%. It has been a hot sector, which makes me a little bit nervous. But, I still think rising demand for commodities from China, India and elsewhere make the sector a good value even at these prices.

Asset Allocation with Commodities and TIPs

In a post from June 8th about Bill Gross I discussed the importance of commodity and TIPS exposure in a portfolio. Today's market provided a brilliant example of why commodities and TIPS work as diversifiers. In a day where most equity indexes were down over 1% two ETF's performed quite well: the Powershares DB Commodity Index (DBC) and iShares TIPS (TIP).

1. iShares TIPS (TIP) +0.79%
2. Powershares DB Commodity (DBC) +0.68%
   
3. Dow -1.09%
4. NASD -1.15%
5. S&P 500 -1.41%

Clean Energy and Water

Two ETF offerings from PowerShares -- PBW and PHO -- have been core parts of the commodity allocation of our portfolios over the past 12 months and have performed very well.

We started buying the Powershares WilderHill Clean Energy ETF (PBW) around this time last year when the fund was trading in the 17's. At the time the fund had retreated almost 40% from its high on the year. It is up 28% so far YTD and we continue to feel that it is still well positioned to take advantage of investor interest in clean energy technology. It has accumulated roughly $900 million of investor money.

We started buying the Powershares Water Resources ETF (PHO) in 2006 as well, accumulating when PHO was trading under $19. The fund is up almost 16% YTD and has accumulated $1.54 billion of assets.

We still like PHO but we are currently analyzing a new Powershares ETF called the Global Water Portfolio (PIO). The fund just launched and only has $47.79MM of assets but due to its global slant it may be more attractive in the long run than PHO. The two ETF's are actually very similar and share 13 of the same holdings, which is about a third of each fund. (Shared holdings are highlighted, click to enlarge.)

The main advantage of PIO is that it offers broader international exposure. It has holding in Japan, the UK, Singapore, Canada, China, Austria, Germany, France and Finland as seen below:
I wouldn't be surprised that if PIO attracts enough assets it will show up in our portfolios sometime later this year. We have also looked at the Claymore Global Water ETF (CGW) and the First Trust ISE Water Index ETF (FIW).

Alternative Assets Update

There have been a lot of great articles on hedge funds, private equity and commodities recently that I haven't had time to write complete blog posts on. So, if you have a few minutes come take a look. The picture to the right is John Arnold, he is happy because he was on the other side of the Amaranth natural gas bet . . . oh yeah, and he made nearly $2 billion in 2006. He'll probably tell you that running a hedge fund beats working at Enron!

Hedge Funds

1. "Behind the Hedge" is a great New York Magazine article on Hedge Funds, including bios on the "top dogs", "brainiacs", "bad boys", "single hitters", "home run hitters", and "whippersnappers" in the industry.
2. "Top Ten" What did the top hedge fund managers make this year? Let me give you a quick breakdown: Jim Simons and John Arnold edged out the competition by making somewhere between $1.5-2 billion in 2006. Coming in 3-5 were the other biggest names in the industry: Eddie Lampert, T. Boone Pickens and Steve Cohen. All managed to make over $1 billion. Not a bad payday if you ask me.
   
3. In this Bloomberg Article we learn that at the G-7 conference the leaders are calling in hedge fund managers to discuss "risks associated with their growing role in financial markets."
   
4. In this CNN Money Article "Bernanke: Hedge Fund Oversight Working" our Fed Chairman speaks about hedge funds and the positive effects they have on the economy. His comments were well timed before the G-7 conference meets in Canada to discuss hedge funds.
5. "Hedge Funds Still in Regulator's Sites": Perhaps a new administration in the US could encourage tighter regulation of hedge funds.
   

Private Equity Good News

1. From the WSJ article "Big Deals, Yes They're Possible Without Buyout Clubs" we learn that LBO activity is on track to do close to $2 billion of deals this year and is making up nearly 30% of all merger activity. Not too shabby.
2. PE shops raised $44 billion during Q12007. With this much liquidity I expect the buyout binge to continue for some time.
   
3. More good news: Much was made of the fact that Congress was contemplating taxing "carried interest" at income tax rates (35%) rather than capital gains rates (15%). In "The Tax Threat to Private Equity? " we learn that for various reasons this change is unlikely to occur. I can almost hear the collective sigh of the big players in the industry.
   

Private Equity Bad News

1. Bad News for the entire market: "Private Equity Breaks Records, IMF Gets Nervous" - While the level of activity has been high, the systemic risks are not going away. Many are saying that just like Sam Zell selling EOP high, the fact that Blackstone and others are looking to IPO may signal a peak in the PE Market.
   
2. The PE deals are getting more expensive. Or so says Taneesha Kulshrestha in "Downside of PE." The multiples firms are willing to pay for earnings have increased, this could be another sign of a market top.
   
3. The other major threat to PE is how the public perceives it. In "Hedge Funds lack buyout firm skills". The article first rips on hedge funds masquerading as PE shops, but goes on to say that miscommunicating their intent with the public, the employees and the media could lead to a significant backlash.
4. Perhaps Private Equity needs an image makeover. Or so argues Andrew Sorkin in "How to Show that You're No Gordon Gekko."

Commodities

1. "Crude Contract falls 4%" on unwinding of the "Iranian Risk Premium." It just makes you wonder if the Iranian government is placing bets on oil futures before it goes out and captures British soldiers. If I were a dictator in the Middle East looking to make a quick buck, it would seem a sensible strategy to me.
   
2. Jim Rogers foresees the comming commodity boom. He is a little wacky but I think having commodity exposure in your portfolio these days is a must, even if used just as an inflation hedge.
3. Prices at the pump have risen 2-3% since I last blogged about gas prices on March 26th. But, they appear to have leveled off for the time being. I will continue to track this as we approach the summer driving season. Check out the graph below courtesy of SanDiegoGasPrices.com (click to enlarge):