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What's causing the commodity crash?

Oct 8, 2008

After stocks and bonds, it's time to say goodbye to the heydays of commodities. As was recently reported by Bloomberg, commodities markets are heading for their biggest annual decline since 2001. Throughout 2007, commodities were in what they called a 'super-cycle' that pushed their prices to record levels. Some commodities in fact leapt higher than the fundamentals merited. For instance, crude oil surged almost 45% and agricultural-commodities like wheat doubled.

Metals also performed strongly, driven by consumer demand as well as a global construction boom. Copper prices, for example, quadrupled during the period 2002 to 2007.

But expectations for a recession in the US and an economic slowdown worldwide are now hitting the commodities market. Oil is already down 39% from its peak attained in July. Metals have corrected sharply and are expected to go down further as well.

Another reason for the fall in commodities (and their stocks) is the exiting of leveraged bets by speculators. A large number of hedge funds that had built massive commodity exposure before the crisis erupted are facing massive redemption pressure. And hence, they are offloading whatever positions they have in whichever commodity.

The Bloomberg report, in fact, cites research from Merrill Lynch, which estimates that crude oil might plunge to US$50 a barrel next year. It has also mentioned the 12% and 18% cut in copper and aluminium prices respectively forecast by Goldman Sachs in the next twelve months.

Stocks from the metals space worldwide have been among the worst hit in the recent crash...though of course still lower then their financial counterparts!

Indian commodity (metal) stocks have not been spared either. Over the last 12 months, some of these like Sterlite and Tata Steel have in fact lost 60% of their value. And it seems as if they aren't done as yet.

How much further down they can go is still not clear. But given India's expected demand over the next 15 to 20 years for some of these commodities as the country builds up its infrastructure (especially in the power sector), demand is not going to die down anytime soon. Simply put, the Earth is being stretched to the limit as countries like India (and China) joins the affluent society and per capital consumption rises.

However, being a cyclical industry, commodities never had and will never have a straight line of rise. Investors need to be ready to face violent dips along the way, as they are witnessing now.

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