Sent: 12-04-2011 09:52:04
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The commodity super cycle catch-cry continued to pepper debate at the commodities week conference in Singapore last week but fund managers were unclear about what they should do about it.
The commodities week Asia conference is primarily for institutional investors thinking about investing in commodity markets. The conference looked at the outlook for commodity markets but also spent much of its time pondering how portfolio managers could best obtain commodity exposure.
One suspects the conference organizers targeted speakers who were going to be most enthusiastic about the sector so that those present were not necessarily representative of the views in the market about the future trajectory of commodity prices.
Fund managers like Frank Holmes, the highly respected resource sector fund manager heading up US Global Investors, are unabashedly bullish. So, too, were those managers who specialized in the bullion markets and food related products. Then there were a plethora of service providers such as S&P, Citi and Dow Jones each counting on the longevity of the current commodity price cycle so they can sell new indices to eager new investors. They are unlikely to urge caution.
On the price outlook, the debate came down to two schools of thought. The bullish school says that there has been a structural change within the markets. Cost structures have risen rendering the old analytical models redundant. The outlook for inflation, a transfer of wealth to emerging economies and heavily constrained supply will, on their view, keep prices high.
The miners seemed most seduced by this view. In my capacity as moderator of a panel discussion, I asked the copper producers what chance they ascribed to copper prices being lower in two years' time. None was ready to concede the possibility. One said perhaps 10%.
This is the mirror image of market conditions in the 1980s when copper producers were almost universally bearish and reacted by cutting back their output and closing mines. Now, they are reacting to their preferred view of high prices to boost output wherever they can.
Like all forecasters, miners have a tendency to place a heavy emphasis on their most recent experience and, far from forecasting, are doing little more than extrapolating the most recent set of business conditions.
The second school of thought comes from those who have looked at history and observed how consistently commodity markets revert to the norm. Over time, high prices are pulled down toward marginal costs of production just as low prices were eventually pushed up toward marginal production costs after the trough in prices had been reached in the 1980s.
Among the bulls is a sub group which concurs that a structural change has occurred. However, members of this group are inclined to concede that prices will go lower just never again as low as they had in the previous cycle.
If a vote had been taken at the conference, the super cycle adherents would probably have won. The mean reversion advocates would have come a dismal last.
No matter how bullish they might be, one of the problems facing prospective commodity investors is how they can actually get the exposure their analysis implies.
The conference discussed at length how it is not generally possible to invest in spot markets and how returns on futures prices, the most frequently used source of commodity price exposure, might bear little relationship to a spot market benchmark. On benchmarks, the conference also spent a good deal of time dealing with the illogical preparedness to use West Texas Intermediate as a crude oil benchmark in commodity indices.
The absence of suitable commodity benchmarks for portfolio investors is being addressed by a plethora of new indices, a sure sign that no one has truly come to grips with what commodity investors should be trying to achieve. When in doubt, create as many alternatives as possible seems to be the motto being followed.
As one conference participant observed, the overtly bullish case suggests that 40-60% of portfolios could easily be given over to commodity linked investments. However, in the Asian market, portfolio managers are allocating on average not much more than zero. A courageous manager might opt for 5%.
In other words, despite all the talk, the professionals are analytically and practically confused. They are just as likely to leave their asset allocations unchanged as open a Pandora's Box by actually trying to address the important analytical questions of which commodities and by how much.
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