Swimming Naked In Commodities

Last year as copper was reaching new multi-year highs, I wrote a negative commentary pointing out that some strange things were going on in that market to inflate the price of this important commodity above and beyond the traditional demand and supply forces (See: Copper Set For A Stumble).

According to Bloomsbury Minerals Economics, the notional value of copper based on production costs, inventory levels, industrial demand and currency effects was less than half of the then current market price:

copper notional market price long term chart Oct 2010
Source: Der Spiegel

Something was obvious awry. But copper just kept climbing, ignoring all rational explanations or expectations.

Of course, there were theories as to what was causing this strange occurrence. The most common is that copper is being used as a speculative trading vehicle. In effect, being stock-piled instead of used for its industrial uses.

Today, thanks to Mish, we have a plausible explanation from Michael Pettis, a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets.

He writes that copper is being used as a way to get around credit restrictions by Chinese companies:

Credit-starved companies were importing copper because they could obtain trade finance or some other sort of foreign financing, and then used the physical copper (or warehouse receipts, I guess) as collateral for domestic borrowing. The financing was continually rolled over. Buying copper was just a way to borrow for companies that needed loans and were otherwise unable to get them.

As I mentioned two weeks ago, when I discussed this in February with a senior executive in a major commodities company, he responded by saying that he thought the same thing might also be happening in soya. Borrowers are resorting to some fairly convoluted and expensive ways of obtaining short-term credit largely because they cannot obtain financing from the local banks.

Source: Michael Pettis (via Mish’s Global Economic Trend Analysis)

This reminds me of a famous quote from Warren Buffet: “It’s only when the tide goes out that you learn who’s been swimming naked.”

In other words, only after the financial mania is over do we discover about all the shenanigans that were going on. Only when the real estate bubble in the US had imploded did we find out about all the crazy (and outright illegal and fraudulent) things that were going on during the mania. This is true for all bubbles and mania of course. It is only in the aftermath of the event that we can start to analyze exactly what individual causes came together to create it in the first place.

What if we realize, after the fact, that a large portion of the demand from China for commodities was simply bogus? like so much NINJA mortgages? It is such scenarios that Grantham misses completely and which would very well create a perfect storm for the decimation of the commodity market if the Chinese economy so much as sneezes.

As a technical and (sentiment wise) contrarian trader, I pay very little attention to fundamentals. So it is easier for me to not get hypnotized by Grantham’s arguments. The chart and the retail trader sentiment speak to anyone willing to listen.

Arguments for why “this time is different” just don’t pass the sniff test for me. The same for all the arguments about supply and demand, “peak oil” or ramblings about “fiat” when it comes to silver. In the aftermath, everyone wants to forget about demand and supply. Or fiat money, inflation, etc.. Miraculously, all those rationales and forces just disappeared overnight 4 days ago.

Or is it more likely that silver, copper, oil, etc. all part of a commodity complex that is much closer to a secular top?

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