Riding Out the Storm
by Lawrence Roulston | September 24, 2008
PrintInvestments are down across the board and around the world,
but the worst damage was inflicted on commodities.
The demise of two more of Wall Street’s most venerable firms highlights the fragile nature of the U.S. financial system and further intensifies investor insecurity. Comments from Henry Paulsen, U.S. Treasury Secretary, link the latest troubles to the on-going problems in the housing market.
The takeover of Merrill Lynch by Bank of America provides value for shareholders of Merrill and makes sense from a business perspective. The combination will seemingly create a stronger firm in the long term.
Shareholders of Lehman Brothers were not as fortunate, as the firm was forced into bankruptcy. After intensive efforts to find a buyer, no company could be found to take on their massive liabilities. The fact that no buyer was willing to take over a firm that was once respected as a top investment bank leads investors to wonder how bad the situation in the financial markets really is.
The intense volatility and uncertainty over the past year has led many investors to simply run for cover. Investments are being dumped on the market with no thought as to the underlying value. Speculators have fled the commodities markets, pushing most of the prices sharply lower from their recent highs.
It is not a complete surprise that commodity prices corrected. Oil had soared to a level that even the most bullish forecasters could not have imagined. Wheat, rice, fertilizers and virtually every other commodity had spiked in value.
That speculators were hard at work was evident. Even stodgy pension funds were playing the commodities markets. Investors were putting money into oil, potash, soybeans, platinum and other materials that they knew little about.
For many commodity investors, it was beyond hoping for further rises in prices. Fears of a collapse of the American financial system and further deterioration in the value of the dollar led a large number of investors into the commodities markets as a place to park some wealth until the dust settled.
Since August 2007, when the extent of the idiocy in the banking industry became evident, a favorite play among hedge funds was to short the American financials and go long on commodities. Hard assets, especially commodities with their world-wide appeal, were seen as a safe place to have your money as the financial sector was sinking and taking down the dollar.
The shorts in the financial sector were putting intense downward pressure on the banks at a time when they desperately needed to raise new equity to offset the massive losses from their over-indulgence in the mortgage market. The American financial sector was literally on the verge of collapse.
The enormous influx of capital into commodities propelled some of the prices well beyond levels that could be supported by even the strongest fundamentals. The soaring oil and food prices were becoming a political hot potato in an election year.
The griping from voters about gasoline prices was bad enough. A far greater concern to government officials was the growing sense throughout the economy that inflation was inevitable. The policymakers are keenly aware that the most significant contributor to inflation is the belief that there will be inflation. As rising fuel and food prices were working their way through to consumers, the expectation of ever higher prices was taking hold on Wall Street and on Main Street. Clearly, the notion of rising prices had to be doused before there was a widespread move into inflation mode.
Donald Coxe, chairman and chief strategist of Harris Investment Management in Chicago, is one of the most respected investment authorities in North America. His September Basic Points provides a well-written and insightful account of the steps taken by the U.S. government to head off disaster.
The Treasury Secretary and the Chairman of the Federal Reserve were facing the biggest potential crisis since 1929. They had to move fast to avert a catastrophe. They knew that hedge funds and other speculators held large and highly leveraged commodity contract positions. They were also aware that there were large short positions against the banks and other financial firms such as Fannie Mae and Freddie Mac.
Strong and decisive action was taken on Sunday, July 13 when the government expressed their intent to prop up the financial sector and to put a halt to soaring commodity prices. Their announcement was timed to hit the open of the Asian markets.
The promise of strong government support for the financial sector made it clear to Asian traders that the long commodity/short banks trade had run its course. Investors moved quickly to unwind their positions. In the thinly traded Asian markets, the prices of the banks moved sharply higher. Commodities headed in the opposite direction.
When the markets opened in Europe, the momentum continued to build. By the time traders got to work in New York on Monday morning, it had evolved to a classic short-covering rally for the banks. Traders scrambled to lock in whatever profit remained in their trades... or to cut their losses.
The Securities and Exchange Commission joined that concerted government effort to right the wrongs of the market place. Their first move was to impose new rules that restricted short selling of American financial firms. They supported the other side of the government mandate by announcing that they were planning to impose restrictions that would limit pension funds and other institutions from participation in the commodities markets.
Fund managers didn't stop to think about the legal or practical implications of the government telling investors what they could or could not invest in. With commodity prices already in a free fall, they couldn't get sell fast enough.
Perceptions among some American investors that the slowing US economy would plunge the rest of the world into recession contributed to further downward pressure on the commodities markets.
As always, the pendulum swings too far to either side. From a position of overbought, commodity prices moved decidedly into oversold territory.
Now that the speculators have been largely flushed out of the system, what's next for commodities?
Commodity prices, measured in dollar terms, will naturally rise as the dollar shrinks. Furthermore, renewed downward pressure on the dollar will lead some investors back to gold and other hard assets to protect them from the falling dollar.
Looking quickly at fundamentals for the metals: Debate still continues about whether the U.S. is or is not in a recession. Whichever side of that line the economy eventually falls on, the net result is that the country will use roughly the same amount of metals this year as was used last year.
Headlines scream out that growth in China has slowed. Reading beyond the deadlines: Growth in China in the latest quarter slowed to 10.1%, down from a level of 11.4%. That pace of expansion, and growth in many other parts of the world will see demand for metals continue to grow.
Supply disruptions continue to plague the mining industry, highlighting the tight supply/demand balance for many of the metals.
The August 23, 2008 issue of the venerable Economist magazine explains that future metal supplies will likely decline. “Kona Haque of Macquarie Bank points out that copper mines have produced 1m tonnes or so less than planned in each of the past three years (over 5% of global output), and are likely to do so again this year.” The article goes on to note that, for mines in general: “the quality of the ore is falling as the richest seams are exhausted” and noting that shortages of people and key components are creating bottlenecks. “Such bottlenecks have been hampering the opening of new mines and the expansion of existing ones.”
When you add it all up, demand for metals continues to grow, supply is constrained and mines are being depleted. Nothing has changed the basic premise that new metal deposits are needed by the mining industry.
With share prices of the exploration and development companies having been beaten down to absurdly low levels, we can look forward to a flurry of take-over bids as the larger companies take advantage of the low prices to secure quality metal deposits.
Clearly, it will take some time for investors to get over the shock of the past few weeks. Many individual investors will never come back to the equities markets. Some of the institutional investors who were hurt will steer clear of commodities. Yet, there are many others – both individual and institutional – who will have the wisdom to understand the fundamentals and see the profit potential in this sector – especially from the current oversold positions.
Over the coming weeks, as a market bottom becomes apparent, bargain hunters will turn more aggressive. Once upward momentum has been established, other investors will come back into the market.
Copyright © 2008 Lawrence Roulston
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Lawrence Roulston, editor of Resource Opportunities, is a geologist, with engineering and business training, and more than 20 years of hands-on experience in the resource industry. Lawrence conducts frequent property visits as part of his due diligence and has toured mining and exploration projects in many parts of the world. Lawrence is frequently quoted and interviewed in the media, including national television. He is renowned as a headline speaker at mining and investment conferences around the world. Mr. Roulston's years of hands-on experience and extensive personal contacts in the industry provide unique insights that have generated an impressive track record for Resource Opportunities.
After completing his studies at the University of British Columbia in 1975, Mr. Roulston worked as an analyst for the major mining company Cominco Ltd. He also worked in a management role for several years with a mid-sized Calgary oil group. In 1984 he became the vice-president of a group of mineral exploration companies. He was also vice-president of an investment management firm focused on the resource industry. From 1994 to 1997, he was president and CEO of a mineral exploration company. Since then, he has been a resource industry consultant and independent mining analyst. He began writing Resource Opportunities in 1998.
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Lawrence Roulston | Vancouver, Canada | Website
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