No More Free Ride for Commodities

MAY 6, 2011     the wall street journal

By LIAM DENNING

In 1911, Winston Churchill helped kick-start oil's ascent by converting the Royal Navy to run on it. But investors shellacked by the sudden reversal in the price of oil and other commodities this week would be better off remembering words spoken by Churchill decades later as the tide turned in World War II: "Now, this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning."

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Commodities markets, slammed in late 2008, resumed their bull run in early 2009. Economic recovery, led by China, was a major factor, particularly for oil and copper. But loose monetary policy, which aided recovery and pushed investment dollars toward hard assets, has also helped, particularly for precious metals.

Two years into this run, the balance of risk for where commodities prices go from here is turning negative.

This week, silver, a late-comer to the party, has dropped almost a quarter. Crude oil slumped as much as 7.7% Thursday morning despite nominally bullish drops in U.S. inventories announced the day before. Instead, investors are probably focusing on weak gasoline demand.

Copper, meanwhile, has struggled to gain momentum since December. Efforts to rein in the property market and inflation in China, which accounts for 39% of global copper consumption, appear to be biting.

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The wild card is U.S. monetary policy. Real interest rates are very low, particularly at the near end of the curve. This has juiced precious metals in particular. But Francisco Blanch at Bank of America Merrill Lynch Global Research points out that real rates also display a reasonable inverse correlation of 36% with oil prices since 1990. That makes sense, as low real rates suppress supply by encouraging hoarding of oil by speculators and producers in expectations of higher returns in the future.

Monetary policy is tightening already in major emerging markets such as India, Brazil and China—key demand centers for commodities—as well as Europe. The question is, what happens when the Federal Reserve's second phase of quantitative easing, or QE, ends next month?

For commodities bulls, Thursday's weak U.S. employment data are actually supportive for commodities, because that should prompt more QE, reducing real rates further.

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This week, silver, a late-comer to the commodities party, has dropped almost a quarter

QE3 is not a given, though. If it were, gold and silver would be strengthening. And while the Fed probably won't reduce the size of its balance sheet for months to come, Chairman Ben Bernanke acknowledged explicitly earlier this month that further monetary easing risked escalating inflation and derailing recovery.

There is a further twist. Even if QE3 materializes, it could ultimately hurt industrial commodities especially. China's continuing linkage of the yuan to the dollar means further U.S. monetary easing would intensify domestic inflation. The risk of Beijing slamming on the brakes to contain prices, significant already, would rise further. And if China's appetite for raw materials is sated suddenly, you better be betting on QE33 to sustain the commodities bull run.

Write to Liam Denning at liam.denning@wsj.com