COPPERHEADS RATTLED:

Oil's not well: A fall in commodity prices raises concerns about the appetite for risky assets (The Economist, Jan 11th 2007)

The enthusiasm for commodities in recent years has been part of a general move into "alternative assets", a term that covers everything apart from shares, bonds and cash. The idea was to find assets that were uncorrelated with traditional holdings, a move that should improve the risk-reward trade-off of portfolios.

When such a fashion takes hold, it can rapidly gain momentum. This is because alternative-asset classes are often small and new investment flows drive prices up very quickly. To those participating in the trend, that confirms the wisdom of their original decision and encourages others to jump aboard.

With commodities, institutional investors often bought index portfolios, which meant putting money into raw materials, regardless of the fundamentals of each market. (One problem for copper is that its index weighting, along with that of other base metals, is being reduced.)

Oil is the biggest single component in most commodity indices. Citigroup estimates that, from 2003 onwards, financial flows had pushed up the price of oil by some $35 per barrel.

Such was the scale of investment flows that the structure of the commodity markets changed. Traditionally, futures prices were lower than spot, or current, prices; a state known as "backwardation". This allowed investors to buy the future and wait for its price to rise to the spot level. This gain, known as the "roll yield", was an important part of commodity returns.

But financial speculation forced the futures price of some commodities well above the spot level, an unusual phenomenon known as "contango". This meant investors in futures were losing money; in other words, the roll yield was negative. So whereas The Economist's commodities index rose 28% in 2006, the Goldman Sachs Total Return Index (which incorporates both oil and the roll return) fell 15%.

That seems likely to have disillusioned many converts to the commodity cause. Speculative investors have been getting out of their positions. They may be worried about Vladimir Putin, but they are more worried about cutting their losses.

It's disturbing enough that guys like Dick Morris have toe-sucking fetishes, but commodity fetishists are suckers generally.

Posted by Orrin Judd at January 11, 2007 5:28 PM