best of financial blogs online trading

David Enke of Bull Bear Trader May 9, 2008 Email this article to a Friend  Printer friendly page

Recently there has been a lot of discussion as to whether the run-up in commodity prices is a bubble or not, or whether there is a fundamental factor at work, primarily a sustainable supply-demand imbalance.

A recent WSJ survey found that 51% of those surveyed said that demand from China and India was the prime factor for high energy prices, with 41% blaming demand for rising food costs. Supply constraints were listed by 20% as causing higher food prices, while 15% felt that supply was resulting in higher energy prices. Only 11% felt that a speculative bubble was in the works.

So what should we take of this? Those surveyed felt that the supply-demand imbalances were the major cause of higher commodity prices, and not speculation. Furthermore, demand is driving the growth and higher prices, and not simply lower supply. This is something often debated, but those surveyed felt differently on average - we have enough for now to go around, people are just demanding more of it. This makes sense to me, given that China and India are continuing to increase their energy needs to grow their economies and increase the standard of living for their citizens. This higher standard of living is putting further pressure on food commodities, no only to consume directly, but also to feed livestock as the demands for protein-based foods increases in these areas of the world. Supply may eventually become more of an issue, but demand appears to be driving prices.

As with any survey of economist and analysts, there were "two-handed" inconsistencies. The same survey group felt on average that the price of crude oil would fall to about $105 by the end of next month, and to about $93 by the end of 2008. Demand is high, supply in check, but prices will fall? Possibly, and this course is the argument surrounding the falling dollar. But this is not what the responses feel. Only 15% believed that currency (i.e., dollar woes) were causing higher energy prices, and only 7% felt they were contributing to higher food prices. This is somewhat surprising given the amount of talk recently about how weakness in the dollar is contributing to the high cost of crude oil, with some estimates showing nearly 50% of recent price increases resulting from the falling dollar.


In the end, even with the discussions of crude oil prices being too high, and pronouncements of $150-$200 a barrel prices in the next 6-24 months (bringing back images of Internet valuation calls in the late 1990s - where a yearly price target was raised one day, only to see the stock move to that new level a few days later), it is still difficult to foresee a complete collapse of commodity prices, at least a sustained collapse over the long-run. Will there be sell-offs and short-term corrections? Yes. Will there be volatility? Absolutely. Will there be adjustments as the dollar strengthens? Most likely. But will there be a total collapse in demand? It is doubtful. Demand destruction is always a worry, but people will always want to eat, and emerging countries will need energy to continue their growth, just as the United States has in the past, and will continue to in the future.

So as commodity investors, in particular energy investors, what do we do? The safer investments may still be in the "consequence" plays, i.e. the seed and fertilizer companies for the food commodities, and natural gas for the energy plays. The Potashes of the world still have tremendous demand and pricing power. Natural gas, while also having a nice run-up recently, is still trading at a lower BTU multiple than crude oil. Using historical comparisons, natural gas still has room to move to the upside, even with crude oil leveling off. If crude reverses its upward trend, this lower than historical multiple may also cushion the fall of natural gas if crude oil was to begin selling off.

The moves in energy have no doubt been sharp, and the prices do seem high, but this may in fact be the issue that we struggle with when considering investments in commodities. We have not seen $125 crude oil before, and the recent spike does seem over-extended, so it certainly seems scary. Of course, if crude oil was a stock, and the company had the same level of demand, pricing power, growth forecast, future supply issues, and strong technicals, many of the same investors might be jumping into the stock, while at the same time shying away from crude oil. Of course, commodities and stocks are very different animals, and stocks also top and end badly, or at least have large corrections, even for good companies (i.e., Google), but the analogy is not totally lost. The key is to eliminate the emotion as much as possible and examine the fundamentals and technicals for what they are. When they change, they change - and this could happen today, tomorrow, or next year. But when they are in place, they are hard to ignore. Right now they look pretty good.

Tickers: POT, AGU, MOS, MON, UNG

by David Enke (Bull Bear Trader)

Disclaimer:

Please note that charts and commentary provided by the moderator are for educational purposes only. Any trades placed upon reliance on the moderator’s charts or information is taken at your own risk for your own account. Past performance is no guarantee of future results. While there is great potential for reward trading stocks, futures and options, there is also substantial risk of loss and you must decide your own suitability to trade. Future trading results can never be guaranteed. This is not an offer to buy or sell stock, futures, options or commodity interests.

Most trading systems are based on historical formulas which have worked in the past. However, what has happened before may or may not happen again. You can lose all your money trading stocks, futures, and options and you must decide your own suitability as to whether or not to trade. Only trade with true risk capital you can afford to lose. Only trade markets you can properly afford to trade. Properly funded trading accounts typically perform better than those that are not. Never risk more than 2-3% of your account on any one trade. Always define your risk before entering a trade and place a stop to limit your risk.

There are no guarantees or certainties in trading. Trading involves hard work, risk, discipline and the ability to follow rules and trade through any tough periods during a system’s draw downs. If you are looking for a guarantee, trading is probably not for you. Most people lose money trading. One of the reasons is that they lack discipline and are unable to be consistent. A system can help you become consistent. Ironically, worrying about the monetary aspect of trading can contribute to and cause a trader to make trading errors. Therefore, it is important to only trade with true risk capital.