Last year was one of commodity market psychosis. The term is not used lightly – the dictionary definition is "severe mental disorder in which the individual's contact with reality becomes highly disordered", an apt description for the manner in which investors piled into commodities regardless of weak fundamentals.
Aluminium is probably the most glaring example, because in the real world the industry is suffering from an obvious and severe structural overhang of excess production capacity versus demand. As such, by early August global warehouse inventories were already at all-time highs of just over 4m tonnes. Yet the price had jumped from around $1,500 per tonne to $2,000 per tonne in the preceding month. Four months later, inventories have risen further, to some 4.6m tonnes – but so has the aluminium price, to around $2,260.
Investment flows into aluminium are largely responsible for this mismatch between price movement and reality. And the same story of failing demand, excess supply and soaring inventory stocks can be seen to a greater or lesser extent across other key commodities such as copper, platinum and oil.
So where do we go from here? If 2009 has proved anything, it is that the markets will not let anything as paltry as fundamentals get in the way of a good momentum story. Riding these price bubbles has been the most rewarding form of behaviour so far, and will be so for as long as they continue to expand. But what could pop them, and will we see it in 2010?
Two factors have underpinned most of the herding into commodities in 2009, and there are good grounds to suppose that both will be reversed in 2010.
First, an unexpectedly strong and long Chinese restocking drive across base metals and ores, regardless of actual near-term demand considerations, helped analysts flog yet another variation of the 'this time it's different story' in which emerging market commodity demand bounces back regardless of ongoing developed world economic weakness.
The Chinese inventory build of 2009 was certainly without precedent, but while some of it was no doubt due to the massive government-backed domestic stimulus, a lot of it was also due to various Chinese interests physically hoarding the commodities in question as a speculative investment. This Great Restocking was only seen as winding up a month or two ago, leaving China Inc stuffed to the gills with metals and ores. The next restocking cycle should begin after the next Chinese new year ends in February, but with so much material already to hand, the sensible assumption would be that we will not see a repeat of the 2009 import fever. And if the 2010 Chinese restocking season fails to take off, a lot of the wind will have to come out of the commodity bulls' sails.
The other factor for last year's commodity price strength was dollar weakness, and a variation on the 'carry trade' where cheap dollars are recycled into higher-yielding assets. But we are already seeing this trade being partially unwound – witness the recent strength of the dollar, and the concomitant fall in the value of the commodity most closely leveraged to it: gold.
The days of quantitative easing now seem numbered and, as the dollar continues to rise in anticipation of a hardening stance on US interest rates next year, in due course prices for commodities other than gold will also come under pressure, with copper and platinum probably the most obvious candidates.
Oil should arguably also weaken, but the black stuff presents somewhat of a special case – having been ramped up by financial investors from very early in the year, by July it was capped in a $70-$80 a barrel range even as other commodities continued to rise. This was probably partially due to concern that US regulators would move to restrict speculative interest in oil futures, but probably also a recognition that the oil price had by then already reached the very outer limits of credibility given the obvious bearish fundamentals in the market. Still, the recent dollar strength has also seen oil pull back below $70 per barrel.
In summary then, I would expect a weakening across the commodity complex in 2010. The most obviously exposed – aluminium – could fall the hardest. Others such as oil, which have already seen market ardour cool somewhat, will suffer less. Copper is somewhere in between. Gold is a special case – personally, I have been amazed at what I see as another massive bubble being blown in this particular commodity in 2010, and with it just coming off what I think is its peak of around $1,226 an ounce, there could still be very significant downside and prices significantly below $1,000 are not inconceivable.
