Saturday, May 22, 2010

Why Commodity Prices Remain Down

While there is no doubt the bull commodity market will continue on, as demand for raw materials isn't going to decline any time soon, we do have to look at what is causing the temporary drop in commodity prices in the midst of the bull market.

Although there are numerous variables, I only want to touch on the major ones, as most of the others are primarily offshoots of these several factors, and aren't as important in understanding the big picture.

First of all, nothing has changed in ordinary market behavior. Prices fall because demand falls. There's nothing else to it.

Having said that, we need to understand what's behind demand falling in order to grasp the implications and how to invest in response to them.

I do want to start with natural gas, not because it's actually connected to what I want to get into, but because it has unique elements outside what we're going to talk about, so I want to get that out of the way.

It's not that there isn't the potential for a lot of natural gas demand, it's that there is now so much more natural gas to supply our needs, that the sheer volume of it has changed the supply/demand picture, and prices are falling because of the enormous quantities in the U.S., and continually being discovered in other parts of the world.

So there's an oversupply for decades, if not longer, and that has changed the prices as far as natural gas goes.

Now as far as most other commodities, there's a different reason for demand falling, and that's because banks are doing little lending, and businesses are doing very little borrowing. Even though we here the occasional media story to the contrary, the truth is there is no confidence in the economy, as it has been propped up by government spending on dubious stupid and unsustainable projects and not by the private sector.

But the reason why the private sector isn't participating in the recovery, is because they, along with the banks, don't trust this so-called recovery either, and aren't trying to secure loans because there has to be projected demand for products and services, and they don't believe that the demand is out there. And no matter how hard politicians call for business loans to be made, there aren't that many buyers out there that want or need them.

So with with bankers and businesses not trusting the recovery, or that there really is one, other than taxpayer money being thrown at the problem in attempts to prop up prices, it's likely that commodity prices will continue to be under downward pressure, with occasional exceptions related to a specific commodity.

Here's another example of that to watch for, so you don't take this as a blanket statement for every commodity. I'm just talking about commodities as an overall sector will probably continue to lose value.

One exception may be aluminum. A unique factor has recently been introduced which could drive the price up because of a new source of demand, and that is the introduction of several aluminum ETFs in the latter part of the year, which will include in the holding of physical aluminum, just like gold ETFs do with physical gold.

That means there will be an increased aluminum demand that has never been there before in history; at least in the way the ETFs operate.

So near the end of 2010 and onward, we could see aluminum prices go up because Rusal, and to a lesser degree, Alcoa (NYSE:AA), will be the major providers of aluminum for the funds, and Rusal is reportedly having a difficult time coming up with enough aluminum, so Alcoa will be a secondary provider.

The point is revealing this is to understand any commodity can be an exception at one time or another, and even though the overall commodity sector will probably continue to fall in prices in the near-term, there are always exceptions, and we need to remain vigilant while understanding why prices are being pushed downward.

Once banks start releasing their money into the economy again, i.e., lending to businesses, there could be, and should be, an explosion of upward commodity price movement. Until that happens, we have to watch for anomalies in the market which could make it different for specific commodities within the sector.

Without getting into it, gold should be another exception for pretty obvious reasons, as it will continue going up for some time, and is of course unique to the overall picture concerning commodities.

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