Monday, June 2, 2008

Distorting food and fuel prices

Monday June 2, 2008

Distorting food and fuel prices

Between the lines
By C.S. TAN

HUGE investment funds are driving up prices of commodities, said US Senator Joseph Lieberman, chairman of the Senate Homeland Security and Government Affairs Committee recently.

Having formed this view after listening to testimony from experts, he said he might draft legislation to limit the participation of institutional investors in commodity markets.

This was the debate in the US. Fund managers might have added fuel to the prices of commodities – food, oil and metals – that were already rising due to demand from the billion over population of China and India.

A hedge fund manager, Michael Masters, told the Senate Committee that on its question of whether institutional investors are contributing to food and energy inflation, “my unequivocal answer is yes.”

He listed pension funds, sovereign wealth funds and university endowment funds as a new category of participants in the commodity futures markets.

He offered some data to support his viewpoint – institutional investors' allocation for commodity futures rose from US$13bil at end-2003 to US$260bil at the end of March.

Over the same five-year period, the increase in demand for oil futures from institutional investors was almost as much as the increase in demand from China. The institutional investors had similarly bought massive amounts of futures contracts for corn and wheat, he said.

Masters absolves traditional speculators from any fault, drawing a distinction between them and institutional investors. Traditional speculators buy and sell futures contracts, and provide liquidity for the markets.

In contrast, institutional investors buy the contracts and later roll over their positions. They don't sell. Hence, they consume liquidity and bring no benefit to the functioning of the markets.

In a widely reported plan, California Public Employees' Retirement System (CalPERS) said in February it might increase its investments in commodities to US$7.2bil by 2010.

It had seemed harmless when fund managers ploughed long-term capital into commodities. In fact, it seemed to be a new but profitable asset class for them. Now, with too much money chasing commodities, including food, the US may impose limits to their purchases.

That would lead commodity prices to decline further from record levels but prices would likely remain moderately high.

Commodity gains

All the steel milling companies reported a surge in earnings in the first quarter (Q1) of this year. Their profit margins from the conversion of scrap iron into billets and steel bars widened as China's exports declined, which led to a rise in steel prices.

Some of the steel profits came from stocking up scrap when management anticipated costs would soar. There could thus be substantial “inventory gains,” as most analysts have noted. The quantum of such gains, however, is not unclear.

As such “inventory gains” could be hefty, it is helpful for investors if the companies could provide an estimate of it. If not, a sharp drop in earnings, when the cheap inventory has run out, would surprise investors. A clear picture would help investors to prepare a more accurate valuation of the steel companies.

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