Speculators at risk as IEA confirms demand destruction has set in

Just the other day I wrote the Fundamental Bullish Commodities Story Is Still Intact, saying:

Much of the fundamental story remains intact, therefore – especially given the low or negative real yields we see across the EM space, which supports credit growth. This accommodative policy is apparent in Turkey, Brazil and Chile, and China – right across the EM space. China may add fuel to the commodity rally. Elsewhere, EM policy-makers are finally starting to ‘get it’.

Nevertheless, it is in the developed economies where we have to look for signs of demand destruction. Unless we see greater personal income growth in the US and Europe, demand destruction is going to happen. Before the drop in the commodities sector last week the International Energy Agency was pointing to the possibility that demand destruction was already occurring.

That’s all fine. But my conclusion was this:

So, you have strong growth in emerging markets offset by weaker growth in the developed economies. Who wins this battle? For now, EM is winning and that is bullish for commodities over the near-term.

So far, this is the case.  But only just. The BBC is reporting that the IEA is downgrading its demand growth forecasts for 2010.

The body says global oil demand is set to average 89.2 million barrels a day this year, up from 87.9 million in 2010 but lower than a previous forecast.

Higher prices and a weaker economic outlook were behind the revision…

Oil prices fell following the IEA report. Brent crude fell by nearly $1 to $111.58 a barrel, while US light sweet crude dropped $1.51 to $96.78 a barrel.

The US fall comes on top of Wednesday’s $5-a-barrel drop which was sparked by rising US petrol inventories and falling domestic demand for the fuel.

"We clearly have seen demand growth slowing compared to last year’s level and we’re seeing it very much concentrated where the price feed through is most direct, notably in North America in terms of gasoline," said David Fyfe, head of the IEA’s oil industry and markets division.

I think the setup is right: higher demand in emerging markets, lower demand in the developed economies. And I am still right that EM is winning right now. But I do wonder whether oil prices have peaked for now? I have been looking at the commodities complex as a block. Yu can get blanket exposure view ETFs like GSG (iShares S&P GSCI Commodity-Indexed Trust ETF) or DBC (PowerShares DB Commodity Index Tracking ETF) or you can focus on ag commodities, precious metals, gold, silver, oil, you name it. Here’s a great list of the commodities ETFs on Seeking Alpha.

My thinking up to now is that the ‘commodities complex’ was largely moving in tandem. But this could be breaking down. All commodities are falling at the moment. However, it is silver’s parabolic run-up and collapse plus oil’s demand destruction which are clearly setting the scene.  When the initial volatility ends, what is the likely path of the commodities complex? If oil doesn’t participate because of demand destruction, how are the ag commodities or metals going to rise when they are dependent on oil?  I think the potential for a divergence in price movement is certainly upon us. But, at the same time, I have a hard time believing that oil won’t drag the rest of the commodities complex down with it.

And that get’s me to the second part of this post. Just yesterday, Andy Lees posted an interesting note on Chinese commodity speculation. Let me bold the most important parts:

Dow Jones news wire reports that "Soybeans are emerging as a financing tool for Chinese commodity trading companies, which are using imports of the oilseed to finance unrelated cash loans”. The article goes on to suggest this may have been adding to food inflation, but my interest is the need for this hidden form of financing. The trading companies doing this need cash for other unrelated projects. The banks are issuing letters of credit against soybean imports and “when the shipments come in, they sell the soybeans at whatever price, then they use the money to pay off the loan, which only comes due in three or six months compared with a shorter period of only about 1 month to get the soybeans. “They don’t care what the soybean price is, because they need the cash immediately”. The letters of credit are often provided interest-free to the trading companies, as the banks that provide them usually have a larger loan relationship with these companies on other projects, analysts said. The companies get about six months to pay up these LCs, while they are able to cash what they import against the LCs or pledge it for fresh borrowing in about a month, allowing them to utilize the funds for the rest of the period for other purposes. The practice is similar to a development in the Chinese copper market, where record volumes of the red metal are sitting in bonded warehouses as collateral for bank loans, despite import prices at a significant premium to local prices for much of the year.  Standard Chartered bank estimated “a majority” of some 650,000 metric tons of copper held in bonded warehouses are being used for financing and not to meet actual downstream demand.  While analysts had similar estimates for soybeans, some said about 30%-40% of current port stocks–which reached record levels of 6.65 million tons last week, compared to 4.96 million tons a year earlier–were being used for financing deals. These trading companies are often willing to take shorter-term losses in soybean re-sales in exchange for gains in their longer-term development projects." Whilst this may sound amazing to the outside observer, it is clearly no different to the kind of off-balance sheet transactions that were going on in Western banks leading up to 2008, and it ties very nicely with the book Red Capitalism which looks at the scale of off-balance sheet debt the Chinese banks are sitting on. It also reinforces the potential scale of the risk unwind that could happen when QE2 ends, particularly given the scale of capital inflows into China that have been in excess of the tiny trade surplus over the last 4 months.

This is going to end very badly. Forget about QE2 for a second and start thinking about oil demand destruction taking oil down and dragging the whole commodities complex down with it. Legitimately, this is a bullish scenario for inflation and consumers hit by that inflation. Nevertheless, the potential for financial market disruption and non-performing loan problems in China is definitely there.

  1. Edward Harrison says

    The server is acting flaky now (probably because of traffic overload from Naked Capitalism). Sorry for the inconvenience.

  2. Edward Harrison says

    OK, it’s back now.

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