From the July 2008 issue of Wealth Manager Web • Subscribe!

Caveat Emptor

Commodities have come a long way from the 1980s and 1990s when commodity markets were considered the Wild West, populated by cowboy commodity traders who could not-or would not-embrace the concept of risk aversion. But times change, and while in 2001 there was an estimated $10 billion invested in commodity markets by speculative participants, today it's thought to be in the area of $250 billion invested by fund and index traders. Why this enormous influx into the markets? After 9/11, managed money recognized that a similar wildcard inherent in commodity markets was introduced to the equity markets-terrorism-and we experienced a steady increase in the diversification from equities into commodities.

There are huge sums of money in the hands of speculative/index funds that need to find a home. This enormous influx in a relatively short time span has skewed prices and created a bubble that has seen prices appreciate to levels that have no relation to the underlying value of the physical commodity that the market represents. For example, coffee futures saw a price appreciation in a two-month period of over 40 percent, while the open interest doubled as a result of new speculative /index fund participation-all this in the face of what is estimated by the trade to be record upcoming crops from the world's two largest producers, Brazil and Vietnam. At the same time that speculatives/funds were pushing futures prices to new highs, corresponding differentials on physical coffee prices from origin producers were widening, thus confirming that the intrinsic value for the physical commodity was divorcing itself from the futures market price action.While fundamental factors have helped in price appreciation in some markets, overall supply-and-demand considerations were not relevant to the vast majority of price spikes in many commodity futures markets. Most index funds do not even consider fundamental factors when determining their participation, but instead use technical considerations or matrix models to purchase a basket of commodities to spread risk and attempt to net the most fish. Expanding open interest, volume and price appreciation are all indicators used to increase positions which then push futures market prices further away from intrinsic value- creating a "Ponzi scheme" type of scenario. Physical market participants (trade and industry) are forced out of the market due to inability to cover margins on physical hedges, exacerbating the price rise and further skewing futures prices. All this led to additional inflows that pushed markets to further unrealistic levels. But futures markets ultimately seek intrinsic value based on the underlying fundamental realities of the market. The resulting "adjustments" (coffee traded from a high of roughly $1.75 to below $1.30 in a three-week period on ICE futures) are a result of that reality.

If there is one lesson for those who are participating in these markets, it's that they must be aware of the realities of the fundamentals of the underlying physical commodity and dovetail that to the technical side so as to be able to determine intrinsic value that, and to recognize that the herd is not always the group to run with-regardless of how big it may be.

Matthew J. PhillipsConsultant, Futures and Options Trading StrategiesThe Branco Peres Group, Brazil

Editors Note: Phillips was president of Branco Peres International, New York City, from 1991 to 2004

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